KATIE SCHUBERGAND

LISA SHANNON

Mortgage Designs

Agenda

Fixed Rate Mortgage (FRMs) Two main issues with FRMs

Adjustable Rate Mortgage (ARMs) Interest Only

Balloon/Reset MortgageSub-Prime Mortgage

Subprime Meltdown

Importance of Understanding Mortgage Designs

97% of houses purchased in 2001 were funded through loans Only 1.6% were purchased using cash As we have seen in recent events different mortgage designs

can cause a dramatic effect on the United States economy! “U.S. foreclosures reached 274,399 in January, the 10th

straight month in which more than a quarter-million filings were processed, RealtyTrac Inc., the Irvine, California-based provider of real estate data, said in a statement yesterday. Foreclosure filings soared to a record last year, surging 81 percent to 2.3 million, as home prices fell and mortgage standards tightened. “ http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aC7x_GWO2

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Fixed Rate Mortgage System

Pay interest and principal in equal installments over a determined period of time.

Most traditional mortgage design; though it is not the most popular.

Was the founding mortgage design; the following mortgages took off from the principals behind the FRM

Two main issues of Fixed Rate Mortgages

Mismatch Problem Concept of borrowing short and lending long. Interest rate risk: Risk that depository institutions will

misjudge future interest rates and take positions that may create a negative spread when rates change.

Tilt Problem Fixed payments create a greater burden at the

beginning of mortgage.

Mortgage Design Comparison

Mortgage Type Monthly Payment

Interest Rate Rate Changes Total Interest Paid

Build Equity

30-Year Fixed-Rate Mortgage

Average Average Never changes Average Average

40-Year Fixed-Rate Mortgage

Notably lower Slightly higher Never changes Higher Slower

15-Year Fixed-Rate Mortgage

Notably higher Notably lower Never changes Notably lower Notably faster

5/1 Adjustable-Rate Mortgage (ARM)

Lower for first 5 years, then may change each year

Lower Fixed for the first 5 years (then may change once a year)

Varies depending on interest rates

Average

3/1 ARM Lower for the first 3 years, then may change each year

Notably lower Fixed for the first 3 years (then may change once a year)

Varies depending on interest rates

Average

NET 5® (5/1 Initial Interest-Only Payment) ARM

Notably lower for first 5 years because only interest is required, then may adjust each year

Lower Fixed for the first 5 years (then may change once a year)

Varies depending on interest rates

Does not build equity for the first 5 years

Adjustable-Rate Mortgage System (ARMs)

Most popular design in the United StatesInterest rates are reset every month, six

months, every year, two years, or longerShifts the interest rate risk from the lender to

the borrower Do not know how the interest rates are going to react

in the markets

ARMs continued

Interest Rate Caps and Floors Rate Cap

Limits the amount that the interest rate may increase or decrease at the reset date (typically expressed in percentage points).

Rate Floors The lowest amounts charged on the lifetime of the loan

Adjustable vs. Fixed Mortgages

Fixed Rate MortgageFixed Rate Mortgage

Amount of the loan: $  250,000

Annual percentage rate of interest:   7%

Number of years:     30 Payment Information:

Your monthly mortgage payment will be: $ 1663.26

Adjustable Rate MortgageAdjustable Rate Mortgage

Per Beg. Bal.

Int. Pmt End Bal.

Int. Rate

1 $250,000

$1042

$1342

$249,700

5.00%

120 $210,468

$1272

$1660

$210,079

7.25%

146 $200,011 $1333

$1754

$199,590

8.00%

198 $175,003 1313 $1864

$174,452

9.00%

294 $100,752 924 $2019

$99,657

11.00%

360 $2032 20 $2053

0 12.00%

Interest Only Loans

ARM design in where payments are comprised of just interest for the first period of the loan, typically five years.

In that first period no equity is earned besides the initial down-payment.

Enables payments to be notably lower than those of a traditional mortgage design.

Payment comparisonWhat issues can you foresee with a design

like this?

Additional Mortgage Designs

Primarily deal with the tilt problem of the FRM

Payments account for inflation Graduated-payment mortgage- nominal payments

increase each month for portion of loan and then level off at fixed rate.

Price-level-adjusted mortgage- payments fixed at real rate opposed to nominal rate (price level measured on index)

Dual-rate mortgage- payments start very low then rise at rate of inflation( computed on floating short-term rate)

Balloon/Reset Mortgages

Borrower is given a long term financing, but at the specified date (which is a while before the actual maturity date of the mortgage) the loan is paid off and the lender agrees to continue financing for the remainder of the term at a new mortgage rate. Lender and borrow figure out re-negotiation

periods at the time the contract is written up At the time of re-negotiation, they decide

what the new interest rates are going to be

Sub-prime Mortgage System

For people with lower credit ratings (typically below 600)

Do not qualify for conventional design (FRM)These people did qualify for the non-traditional

mortgages Payment option ARMs Interest only mortgages Balloon mortgages

Because: Lenders lessened standards to subprime candidates

High default risk Affordable payments with record-low interest rates

Sub-prime Meltdown

However, the historical low rates at time of issuance increased throughout the 3 to 5 year period.

Borrowers faced with much higher payments+ high default risk+ housing market depreciation= Sub-prime Meltdown

Explain why someone would want to choose:

-Fixed rate mortgage-Adjustable rate mortgage-Interest only mortgage-Balloon/reset mortgage