Mortgage Products

 

Why are there so many different types of mortgages?

In a word, the answer is “diversity”: among borrowers, lenders, and economic conditions.  

Any type of mortgage that appears in the market in significant numbers must be broadly acceptable to both borrowers and lenders, and must fit into the prevailing economic environment. Yet some mortgage types are very clearly designed in the first instance to meet specific borrower needs; some are designed to meet specific lender needs; and some are designed to meet a special challenge posed by the economic environment.  

On the borrower side, numerous mortgage types are designed to enhance initial affordability by lowering payments in the early years at the cost of higher payments in later years. These include interest-only, graduated payment and buy-down mortgages. Many types of adjustable rate mortgages also have rising payment features.  

Borrowers interested in paying down their loan balances as quickly as possible are attracted to biweekly mortgages, which pay off before term, and fixed-rate mortgages with short terms. Borrowers who need funds intermittently, often for home modifications, are attracted to line-of-credit mortgages. Elderly homeowners may be attracted to reverse mortgages, on which they can draw funds by increasing their balances. 

Lenders always look for assurances that they will be repaid, but that is the case across all mortgage types. Lenders with short-term liabilities, which include many types of depository institutions, look for protection against interest rate risk. For this reason, they prefer adjustable rate mortgages (ARMs) and balloon loans on which rates are periodically reset. But both may include features attractive to borrowers, just as mortgage types designed to meet specific borrower needs will have features that appeal to lenders.  

Interest rates in inflationary environments are so high and volatile that conventional mortgage types become impossibly costly to either borrowers or lenders. Special mortgage types have been developed that are designed to work in this kind of environment, in the sense of providing affordable payments to borrowers while allowing lenders to earn an adequate inflation-adjusted returnOf these, the most common are the price level adjustment mortgage (PLAM) and the dual index mortgage (DIM). These instruments have their problems, but they keep the system functioning.  

Not all mortgage types are covered in these articles, this is a work in progress. I expect to add more articles as time permits, and I also look for contributions from others, especially from outside the US, who can comment on experience abroad. In the meantime, readers are invited to peruse the many articles on the different mortgage types that appear on my web site, see Types of Mortgages.  

 

 

Fixed Rate Mortgages

Fixed Rate Versus Fixed Payments: An FRM is a mortgage that has no provision for changing the interest rate. Hence, the rate stated in the note is fixed for the entire term of the loan.

By prevailing practice, the term "FRM" without any modifiers means a mortgage with a fixed rate and level payments that fully pay off the balance. For example, on a $300,000 30-year 6% FRM, the monthly payment is $1798.66. If the borrower makes that payment every month for 30 years, the 360th payment will reduce the balance to zero. This should be (but usually isn’t) called a "level-payment fully amortizing FRM" to distinguish it from other types of loans that have a fixed rate but not a fixed payment.   For example, one of the earliest types of fixed-rate mortgages was repaid with equal monthly payments of principal, plus interest. If the loan was for $300,000 at 6% and the term was 300 months, then the payment in month 1 would be $1,000 of principal plus $1500 of interest for a total $2500. Each month the total payment would decline because interest would be calculated on a lower balance. This was the standard type of mortgage in New Zealand for many years, despite the obvious disadvantage of high payments in the early years.

A fixed-rate mortgage can also have a rising payment. The version in the US is called a "graduated payment mortgage", or GPM. They have pretty much died out in the US but were the dominant type of mortgage in Portugal when I was there some years ago.  The interest-only version of a fixed-rate mortgage also does not have fixed payments. Borrowers begin paying only the interest, which declines if they voluntarily pay any principal, until the end of the interest-only period. At that point, the payment jumps and it becomes a level-payment fully amortizing FRM.

Calculating the Fully Amortizing Payment: The fully-amortizing monthly payment on an FRM is calculated from an algebraic formula, those interested can find it at the Mortgage Professor website.

The much easier way is use a financial calculator, such as an HP19B, or an on-line calculator such as my Monthly Payment Calculator: Fixed Rate Mortgages. Technophobes can buy a book of monthly payments at a book store.

Rising Principal Payments Over Time: On an FRM, the composition of the payment between principal and interest changes every month. At the beginning, it is mostly interest but the principal portion gradually rises over time. In the example, the principal payment in month 1 is $299, in month 12 it is $316, and in month 60 it is $401.

This feature, where borrowers make the same payment every month but the saving component of the payment increases every month, is powerful but underappreciated. Some borrowers don’t recognize that debt repayment is saving, and many of those that do think they aren’t earning any return on it. I am frequently asked whether they would not do better putting their money in a bank account earning 3% than repaying their mortgage.

In fact, a principal payment of $100 on a 6% mortgage earns the same return as a $100 bank deposit that pays 6%. The deposit earns $6 a year in interest while the principal payment reduces interest payments by $6 a year. The effect on the borrower’s wealth is the same.

Of course, if you can earn 10% on your money, paying down a 6% mortgage is not the best choice. The popularity of interest-only loans in the US has been encouraged by the notion that borrowers can earn a return higher than the mortgage rate by investing their money elsewhere. In my view, however, few borrowers can earn a return above the mortgage rate without taking unacceptable risk.

Different Terms on FRMs: FRMs come with different terms, ranging generally from 10 years to 40 years. In the US, the 15 and 30-year are the most popular. (In contrast, adjustable rate mortgages (ARMs) tend to have the same terms -in the US, ARMs are almost all 30 years.) Shorter term FRMs usually have lower rates and amortize more rapidly, but the payments are higher.

Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of FRMs to borrowers and lenders.

 

Borrowers
Lenders
    Advantages   

Guarantees payment stability over the life of the mortgage

Default rates are generally low. Simplicity and standardization encourage securitization

  Disadvantages   

Interest rate will be higher than those on mortgages with unstable payments

Exposes lenders with short-term liabilities to severe interest rate risk.

 

 

 

Graduated Payment Mortgages

The distinguishing feature of graduated payment mortgages (GPMs) is thatthe payment rises by a constant percentage for a specified number of months, after which it levels out over the remaining term and amortizes fully. The interest rate is fixed, although adjustable rate versions(GPARMs) existed for a brief period in the US during the 80s.  

How a GPM Works: As an example, the mortgage payment on a $200,000 FRM for 30 years at 6% is $1,199. Stretched over 40 years, the payment would be $1,100. But the initial payment on a 30-year GPM at 6.50%, on which the payment rises by 7.5% a year for 5 years, is only $941.   The quid pro quo for the low initial payment is a larger payment later on. The payment on the GPM rises for 5 consecutive years, reaching $1,351 in month 61, where it stays for the remainder of the term.   The initial payment on a GPM does not cover the interest. The dif­ference, termed negative amortization, is added to the loan balance. In the example, the loan balance peaks at $202,905 in month 36 before it starts down. Not until month 61 does the balance fall below $200,000. This rising balance is a feature that lenders don’t like, and it is why they typically charge a higher rate for GPMs than for FRMs.  

Alternative Types: GPMs may have different rates of payment increase over different periods. In the US. a second variant has a 3% graduation rate over 10 years instead of 7.5% for 5 years. Assuming the same 6.5% rate, the initial payment would be higher at $1,031, rising to $1,388 in month 121. Negative amortization, however, is smaller, peaking at $200,908 in month 24   In Portugal during the 80s when I was there, GPMs were the standard instrument, and the payment rose over the entire life of the loan.

GPMs Versus Temporary Buy-downs: The GPM is not the only type of mortgage with rising payments. FRMs with temporary buy-downs also carry lower payments in the early years. For example, the payments in the first 2 years on an FRM with a 2-1 buy-down are calculated at rates that are 2% and 1% lower than the rate on the FRM. On a 6% 30-year FRM of $200,000, the first-year payment would be $955, rising to $1,074 in year 2 and to $1,199 in years 3–30. And the buy-down loan amortizes as it would without the buy-down—there is no negative amortization.   For a temporary buy-down to work, however, someone must fund the required buy-down account. Withdrawals from this account supplement the payments made by the borrower in years 1 and 2 so that the lender receives the same payment ($1,199) throughout. The $4,436 required for the buy-down account must be provided by either the borrower or the home seller. GPMs don’t require a buy-down account.  

GPMs Versus Option ARMs: Rising payments are also available on many types of adjustable-rate mortgages, most notably on the flexible-payment or option ARM. Under its minimum-payment option, the first-year payment on this ARM is calculated at rates as low as 1.95%. On a $200,000 30-year loan, this amounts to $734, strikingly lower than the $941 on the 5-year GPM. Increases in the ARM payment, furthermore, are limited to 7.5% a year for the first 5 years, just like on the 5-year GPM. In year 5, therefore, the ARM payment has risen to $980 as compared with $1,256 on the GPM. In month 61, however, the chickens come home to roost. The GPM payment rises by 7.5% one more time, to $1,351, where it stays. The ARM payment increase, on the other hand, could be 7.5%, or it could be 75% or even higher, depending on what happens to interest rates.   The core difference between the GPM and the option ARM is that the borrower with a GPM knows in advance exactly how and when the payment will change. The option ARM borrower, in contrast, is throwing the dice. A new eruption of inflation is bound to cause market rates to rise markedly, which will clobber all ARM borrowers, but especially those who make the minimum payment on an option ARM. GPMs carry risk to borrowers, who must be able to meet the scheduled rise in payments, but the risk is known in advance.

Advantages and Disadvantages: The tables below summarize the advantages and disadvantages of GPMs relative to option ARMs and temporary buydowns, as alternative ways of reducing payments in the early years, at the expense of higher payments in later years.

 

 
Borrowers
Lenders
Advantages (Relative to Option ARMs)

Future payment increases are known in advance.    

Default rates are lower because payment shocks are avoided.

Disadvantages (Relative to Option ARMs)

Payment reduction in the early years is not as large.    

Long duration makes management of interest rate risk difficult.

 

 

Interest-Only Buydown Mortgage

The distinguishing feature of interest-only buydown mortgages (IOBMs) is that initial payments are adjusted to the income of the individual borrower, but without incurring negative amortization. In the early years, the borrower pays less than the interest, depending on income, but the lender receives the interest. The difference is made up by a withdrawal from a buydown account that is funded by either a home seller or a government agency. The interest rate is fixed. The payment increases by a preset percent every year. When the payment reaches the point where it covers the interest, the buydown account is exhausted. The payment continues to rise, however, until it becomes fully amortizing. Borrowers who begin with lower payments will face longer periods of payment increase than borrowers who begin with higher payments. There is no negative amortization. The loan balance is constant until the payment has risen to the point where it more than covers the interest. At that point, the balance begins to decline. The IOBM has been used by builders in the US to stimulate demand by home buyers who are limited in the amount of house they can buy by the mortgage payment. Contributions to a buydown account reduce the initial mortgage payment by more than a price reduction equal to the contribution. The IOBM also has potential as a cost-efficient subsidy tool. In contrast to interest rate subsidies that extend over the life of the mortgage, an IOBM subsidy is phased out over time. It also has the merit of requiring that the total present value of the subsidy be funded at the outset in the buydown account, as opposed to the practice of committing now to pay subsidies in the future.  

The tables below summarize the advantages and disadvantages of IOBMs relative to option ARMs as alternative ways of reducing payments in the early years.

 

 

Borrowers
Lenders
Advantages  (Relative to Option ARMs)    

Future payments are known in advance.    

Default rates are lower.  

Disadvantages  (Relative to Option ARMs)    

Initial payment are not as low.  

Longer duration makes management of interest rate risk more difficult.

 

 

Indexed Adjustable Rate Mortgages

The distinguishing feature of indexed adjustable rate mortgages (ARMs) is that they are subject to interest rate adjustments based on a market rate index. Such adjustments are mechanical, based on a formula. In this respect, indexed ARMs are very different from discretionary ARMs on which rates are adjusted at the discretion of the lender. Thenceforth, the term “ARM” here will be used to mean an indexed ARM.  

How the Interest Rate on an ARM Is Determined: There are two phases in the life of an ARM. During the first phase, the interest rate is fixed, just as it is on an FRM. The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. In the US, the period ranges from a month to 10 years. At the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index plus a margin. For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7.75%. The adjustment rule, however, is subject to two conditions. The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. In the US, adjustment caps are usually 1 or 2% but range in some cases up to 5%. Adjustment caps limit the size of any interest rate change. The second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates in the US are usually five or six percentage points above the initial rate. During the second phase of an ARM’s life, the interest rate is adjusted periodically. This period may be but usually is not the same as the initial rate period. For example, an ARM with an initial rate period of 5 years might adjust annually or monthly after the 5-year period ends.  

The Quoted Interest Rate: The rate that is quoted on an ARM, by the media and by loan providers, is the initial rate—regardless of how long that rate lasts. When the initial rate period is short, the quoted rate is a poor indication of interest cost to the borrower. The only significance of the initial rate on a monthly ARM, for example, is that this rate may be used to calculate the initial payment.  

The Fully Indexed Rate: The index plus margin is called the “fully indexed rate,” or FIR. The FIR based on the most recent value of the index at the time the loan is taken out indicates where the ARM rate may go when the initial rate period ends. If the index rate does not change, the FIR will become the ARM rate.   For example, assume the initial rate is 4% for one year, the fully indexed rate is 7%, and the rate adjusts every year subject to a 1% rate increase cap. If the index value remains the same, the 7% FIR will be reached at the end of the third year. The FIR is thus an important piece of information, the more so the shorter is the initial rate period.  

ARM Rate Indexes: Every ARM is tied to a specific rate index. Ideally, the index is compiled by an independent third party, is publicly available, and is calculated at monthly or short er intervals. Lenders prefer indexes that closely track their cost of funds, but lender-specific cost indices that are controllable by the lender may lack credibility.  If borrowers have a choice of index, as they do in the US, they prefer one that is relatively stable. A lower index also is better for a borrower than a higher one, but lenders take account of different index levels in setting the margin. A 3% index with a 2% margin provides the same FIR as a 2% index with a 3% margin. Assuming volatility is the same, there is nothing to choose between them. In the US, the most stable of the more widely used rate indexes cover the cost of funds of depository institutions. Most of the others are significantly more volatile. These include series covering US Government securities and series based on LIBOR, The most complete source of current and historical values of major ARM indexes can be found on the Web site www.mortgage-x.com.  

How the Monthly Payment on an ARM Is Determined: ARMs fall into two major groups that differ in the way in which the monthly payment of principal and interest is determined: fully amortizing ARMs and negative amortization ARMs.  

  • Fully amortizing ARMs adjust the monthly payment to be fully amortizing whenever the interest rate changes. The new payment will pay off the loan over the period remaining to term if the interest rate stays the same. For example, a $100,000 30-year ARM has an initial rate of 5%, which holds for 5 years, after which the rate is adjusted every year. (This is referred to as a “5/1 ARM.”) The payment of $536.83 for the first 5 years would pay off the loan if the rate stayed at 5%. In month 61, the rate might increase to, say, 7%. A new payment of $649.03 is then calculated, at 7% and 25 years, which would pay off the loan if the rate stayed at 7%. As the rate changes each year over the remaining period if that rate continued.  
  • Negative amortization ARMs allow payments that don’t fully cover the interest. They have one or more of the following features:  
    • Payment Rate Below the Interest Rate:The payment rate, which is the interest rate used to calculate the payment, may be below the actual interest rate. If the payment rate is so low that the initial payment does not cover the interest, the result will be negative amortization.  
    • More Frequent Rate Adjustments Than Payment Adjustments: If, e.g., the rate adjusts every month but the payment adjusts every year, a large rate increase within the year will lead to negative amortization.  
    • Payment Adjustment Caps: If a rate change is large and a payment adjustment cap limits the size of a change in payment, the result may be negative amortization. Virtually all ARMs are designed to fully amortize over their term. This means that negative amortization can only be temporary and that at some point or points in the ARM’s life history the monthly payment must become fully amortizing. Two contract provisions are used to assure that negative amortization ARMs pay off at term. A recast clause requires that periodically, usually every 5 years, thepayment must be adjusted to the fully amortizing level. A negative amortization cap sets a maximum ratio of loan balance to original loan amount, for example, 110%. If that maximum is reached, the payment is immediately adjusted to the fully amortizing level, overriding any payment adjustment cap. In a worst-case scenario, the required payment increase may be very large.  

Overcoming Complexity: Because ARMs are complex, borrowers can easily be confused. The best way for them to understand an ARM and to compare one with another is to use a payment or cost calculator. My website  has six calculators in the Mortgage Payment series that show mortgage payments month by month using interest rate scenarios specified by the user. The site also has six calculators in the Comparing Two Mortgages series that compare either interest cost (an internal rate of return) or total horizon cost in dollars. The costs are calculated over the period the borrower expects to have the mortgage.

Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of ARMs, relative to FRMs, to borrowers and lenders.

 

Borrowers
Lenders
Advantages

Provides lower initial rate and payment than FRMs.

Allows lenders with short-term liabilities to manage interest rate risk.  

Disadvantages

Difficult to understand. Subject to possible large future payment increases.

Default rates are higher than on FRMs. Diversity discourages securitization

 

 

 

Discretionary Adjustable Rate Mortgages

The distinguishing feature of discretionary adjustable rate mortgages (ARMs) is that the lender has the contractual right to change the interest rate at any time, for any reason, by any amount, subject only to a requirement that the borrower be notified in advance. The discretionary ARM is at the opposite pole from indexed ARMs on which rate adjustments are completely rule based.  

Discretionary ARMs were long the standard mortgage in the United Kingdom and in other English-speaking countries that imported it from the United Kingdom, such as India and South Africa. They never caught on in the United States because of concern that lenders would use their discretion to meet their own needs, while ignoring the needs of borrowers.  

There is good reason for this concern, since the discretionary ARM was designed to allow lenders to adjust the loan rate to match their cost of funds. In the UK, this is common practice. It amounts to voluntary (as opposed to contractual) indexing, but without rate adjustment caps or maximum rates.  

Lenders who write discretionary ARMs but don’t systematically adjust the rate to match their cost of funds because they don’t want to impose frequent payment changes on borrowers may be forced to makeone or more very large changes to accommodate an upward trend in interest rates. These are likely to be much more disruptive than frequent small changes. Mortgage lenders in India, after keeping rates on their discretionary ARMs stable for many years, were faced with this problem in the 90s.  

Discretionary ARMs do not allow lenders to adjust loan features based on the capacity of borrowers to bear risk. On indexed ARMs, borrowers can be charged more for, e.g., a longer initial rate period, or for lower rate maximums. On discretionary ARMs, every borrower must assume the maximum risk.

Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of discretionary ARMs, relative to indexed ARMs, to borrowers and lenders.

 

 
Borrowers
Lenders
Advantages

Easier to understand.

Allows lenders with short-term liabilities to manage interest rate risk effectively.  

Disadvantages

Borrowers are at the mercy of lenders.

Exercise of discretion may result in high default rates. Discretion inconsistent with securitization.

 

 

Balloon Mortgages

The distinguishing feature of balloon mortgages is that the interest rate is fixed, but the balance is payable in full after a period that is shorter than the term – the period used to calculate the payment.. Hence, the borrower must refinance the remaining balance at the market rate, from the same lender or a different one.  

The payment on balloon loans may cover interest-only, or may include some principal as well. During the 1920s, balloon loans in the US were interest only. At maturity, usually 5 or 10 years, the balloon that had to be repaid was equal to the original loan amount.  

Payments on balloon loans offered today in the US and Canada are calculated on a 30-year amorti­zation schedule, so there is some principal reduction. Assuming a rate of 6.5%, for example, a $100,000 loan would have a balance remaining at the end of the fifth year of $93,611.  

Maturities on balloons in the US are almost all 5 or 7 years, but balloons are much less common than indexed ARMs. In Canada, where balloons are the standard mortgage, maturities range more widely.

Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of balloon mortgages, to borrowers and lenders, relative to indexed ARMs with an initial rate period equal to the maturity of the balloon.

 

Borrowers
Lenders
Advantages Relative to Indexed ARMs

Simpler and easier to understand, easier to shop.  

Lower interest rate.

Makes management of interest rate risk easier by removing contractual constraints.  

Disadvantages Relative to Indexed ARMs

No protection against a rise in rates at maturity.  Changing lenders at maturity imposes refinance costs.  Lenders obligation to refinance at maturity may be ambiguous.

Lower interest rate.

 

 

Flexible Maturity Adjustable Rate Mortgages

Flexible maturity ARMs (FMAs) are a special type of indexed ARM. Their distinguishing feature is that changes in the interest rate result in changes in the maturity rather than the payment. Borrowers know in advance what their payment will be, but they don’t know how long they will have to pay. If rates go up, they pay for a longer period, up to some maximum, and if rates go down they pay off more quickly.  

For example, the initial term might be 15 years and the maximum 40 years. There is no minimum period.  

The initial term used to calculate the payment must be significantly shorter than the maximum in order to provide scope for rate increases. If the initial term is 30 years and the initial rate is 6%, extending the term to 40 years will offset an immediate rate increase only to 6.70%. This is not sufficient protection for lenders.  

To be attractive to lenders, the initial term on an FMA must not exceed 15 years. A term extension from 15 to 40 years would offset an immediate rate increase from 6% to 9.93%. If the increase was delayed for 3 years, the new rate could be as high as 11.65%. The longer a rate increase is delayed, the larger the increase that can be offset by an extension of the maturity.  

Because the payment at 15 years is larger than most borrowers can afford, FMAs offered in the US have never been very popular. An obvious remedy is to graduate the payment in the same way as on a graduated payment mortgage (GPM). For example, the payment could increase by 7.5% a year for 5 years, before leveling off. Then lenders would have the rate protection provided by the short initial term, and borrowers would have a more affordable initial payment. To my knowledge, however, no lender has ever offered this instrument.

Advantages and Disadvantages: The tables below summarize the advantages and disadvantages of FMAs relative to standard indexed ARMs.

 

Borrowers
Lenders
Advantages Relative to Indexed ARMs

Future payments are known in advance.    

Rate increases do not cause payment problems for borrowers resulting in defaults.

Disadvantages Relative to Indexed ARMs

Initial payment is higher.   Payoff period is uncertain.  

Loan duration is not known in advance.

   

 

 

Dual Index Mortgages

The dual index mortgage (DIM) is one of several types designed to function in an inflationary economy. The distinguishing feature of DIMs is that the rate is indexed to a market interest rate, while the payment is indexed to a wage and salary index. Since the indexes are independent of each other, there is no built-in mechanism that assures that the loan will amortize over its term.  

From a lender perspective, the DIM looks much like any other indexed mortgage. The lender earns a rate equal to a rate index plus a contractual margin that is fixed for the life of the loan. From the standpoint of the borrower, however, the DIM is nothing like an indexed ARM.  

The initial payment on the DIM is relatively low, consistent with what the borrower can afford.For example, at a time when the interest rate is 35%, the rate used to calculate the initial payment might be 15%. This would result in negative amortization for a period. As the payment increases based on changes in the wage and salary index, negative amortization will decline, then become positive amortization, and finally become fully amortizing.  

There is no assurance, however, that the loan balance will be fully paid off by the maturity date. Given the inflation rate, whether the DIM amortizes fully or not depends on: a) The term; b) The lenders’ margin over the rate index; c) The increase in the wage and salary index; and d) The payment rate used to calculate the initial payment.

A convenient way to view these relationships is to show the lowest initial payment rate that will result in full amortization at various values of the other variables. See the table below.  

 

 

Option Adjustable Rate Mortgages

Option ARMs are a special type of indexed ARM. Their distinguishing feature is that borrowers have options on how large a payment they will make in the early years. The options include making fully amortizing payments on 15-year or 30-year schedules, paying interest only, and making a “minimum” payment that is less than interest only, which results in negative amortization.  

Marketing Option ARMs: The main selling point of option ARMs is the low minimum payment option, which most borrowers select. The minimum payment in year 1 is calculated at the interest rate in month 1, which can be as low as 1%, The payment rises by only 7.5% a year for 5 or 10 years. The low initial payment entices some borrowers into buying more costly houses than they would have otherwise, or tempts them to use the monthly payment savings for other purposes.  

The Risks of an Option ARM: For those electing the minimum-payment option, the major risk is “payment shock”—a sudden and sharp increase in the payment for which they are not prepared. The rule that the minimum payment can rise by no more than 7.5% a year has two exceptions. The first is that every 5 or 10 years the payment must be “recast” to become fully amortizing. It is raised to the amount that will pay off the loan within the remaining term at the then current interest rate—regardless of how large an increase in payment is required.   The second exception is that the loan balance cannot exceed a negative amortization maximum, which can range from 110 to 125% of the original loan balance. If the balance hits the negative amortization maximum, which can happen before 5 years have elapsed if interest rates have gone up, the payment is immediately raised to the fully amortizing level.   Either the recast provision or the negative amortization cap can result in serious payment shock.  

Borrower Protection Against Payment Shock: There are three things borrowers can do to minimize the possibility of payment shock.  

  • Measure the Risk: Calculator 7ci on my web site will show a borrower what will happen to the payment on their option ARM if interest rates follow any of a number of future scenarios selected by the borrower.  
  • Shop for the Lowest Margin: Since the margin affects the rate in months 2–360, it is the most critical price variable on an option ARM. The lower the margin, the lower the borrower’s vulnerability to payment shock.  
  • Take the Highest Initial Payment That Is Affordable:The higher the initial payment, the smaller the potential payment shock down the road. Since the initial payment is determined by the interest rate in month 1, borrowers should select the highest rate that results in a payment with which they are comfortable. Asking for a higher rate sounds a little strange, but the quoted rate holds only for 1 month.  

Who Should Take an Option ARM? It may make sense forborrowers who want to maximize their home-buying capacity, and either have a short time horizon, or confidently expect their income to rise in the future. As a refinance option, it makes sense only for borrowers whose incomes have fallen and who will be forced to default unless they can reduce their payment. I usually advise against using this instrument to generate cash flow savings to invest because few people have access to safe investments that yield more than the cost of an option ARM.  

Shopping for Option ARMs Is Relatively Simple: Because the initial interest rate holds only for one month, lenders don’t reprice them every day as they do other indexed mortgages, which makes comparison shopping much easier. Borrowers can shop the margin, which determines the rate after the first month.  

Option ARMs During the Housing Bubble and the Crisis That Followed: Option ARMs were a favorite instrument of speculators in the US during the housing bubble of 2002–2007, and their volume ballooned. When house prices began to decline in 2007, however, the combination of rising payments and negative equity caused a precipitous rise in defaults. In 2008 and 2009, no new option ARMs were written.

Advantages and Disadvantages: The tables below summarize the advantages and disadvantages of option ARMs relative to standard indexed ARMs. as alternative ways of reducing payments in the early years.

 

 

Borrowers
Lenders
Advantages Relative to Standard Indexed ARMs

Initial payment is lower, perhaps much lower.   Easier to shop.  

Monthly rate adjustments makes management of interest rate risk easier.

Disadvantages Relative to Standard Indexed ARMs

Vulnerable to severe payment shock.  

Default rates are higher because of potentially large payment increases.  

 

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2012Interest Only MortgagesFinancial Conduct Authority (UK)
2012Capital Inflows, Exchange Rate Flexibility, and Credit BoomsNicolas E. Magud
2011Government Policy and Fixed Rate MortgageMichael Lea
2010Financing Eco-Housing in India: A ReviewDr. Nitin Pandit, Dr. Mahesh Patankar, and Ms. Athale Prem
2010Regulation of Foreign Currency Mortgage Loans: The Case of Transition Countries in Central and Eastern Europe Hans-Joachim (Achim) Dübel and Simon Walley
2010International Comparison of Mortgage Product OfferingsMichael Lea
2010Mobilising Pension Assets for Housing Finance Needs in Africa – Experiences and Prospects in East AfricaDr. James Mutero
February 2009Consumer Handbook on Adjustable-Rate MortgagesFederal Reserve
2009Mortgage products and government policies to help troubled mortgagors: responses to the credit crisisKathleen Scanlon, Jens Lunde, Christine Whitehead
2009"Mortgage Instruments," In Housing Finance Policy in Emerging MarketsMichael Lea
2009Study on the costs and benefits of the different policy options for mortgage creditLondon Economics
2007MORTGAGED BACKED SECURITIZATION IN BANGLADESH: A TENTATIVE GUIDELINEBangladesh Bank
2007How do the Payment Rate and the Interest Rate Differ?Jack M. Guttentag
2007Interest Rates and Consumer Choice in the Residential Mortgage MarketJames Vickery
2006Home Loans - Recent Trends in Sri LankaS.H. Piyasiri
2005Adjustable Rate Mortgages With Flexible PaymentsJack M. Guttentag
2004Do Interest-Only Mortgages Amortize Faster?Jack M. Guttentag
2004Early Repayment of fixed-rate Mortgages - there is no free LunchHans-Joachim Dübel
1999A Flexible Mortgage PaymentJack M. Guttentag
1998Dual Index Mortgages: Lessons From International Practice and Conditions of Development in PolandLoïc Chiquier

About the Editor

Jack Guttentag
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Jack Guttentag is a Professor-Emeritus of Finance and has been a member of the faculty of the Wharton School since 1962. Dr. Guttentag is presently co–director of the Zell/Lurie Real Estate Center’s International Housing Finance Program.