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Answers to CH05 - CHAPTER 5 NOTES

Real Estate Finance And Investment (Baruch College CUNY)

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Solutions to Questions—Chapter 5
Adjustable and Floating Rate Mortgage Loans
Question 2
How do inflationary expectations influence interest rates on mortgage loans?
Most savings institutions had been making constant payment mortgage loans with relatively long
maturities, and the yields on those mortgages did not keep pace with the cost of deposits. These
problems prompted savings institutions (lenders) to change the mortgage instruments to now make
more mortgages with adjustable interest rate features that will allow adjustments in both interest rates
and payments so that the yields on mortgage assets will change in relation to the cost of deposits.

Question 5
List each of the main terms likely to be negotiated in an ARM. What does pricing an ARM using
these terms mean?
Initial interest rate, index, adjustment interval, margin, composite rate, limitations or caps, negative
amortization, floors, assumability, discount points, prepayment privilege. Anytime the process of risk
bearing is analyzed, individual borrowers and lenders differ in the degree to which they are willing to
assume risk. Consequently, the market for ARMs contains a large set of mortgage instruments that
differ with respect to how risk is to be shared between borrowers and lenders. The terms listed above
are features that might be used in pricing an ARM and establishing the bearing of risk.

Question 6
What is the difference between interest rate risk and default risk? How do combinations of terms in
ARMs affect the allocation of risk between borrowers and lenders?
Interest rate risk is the risk that the interest rate will change at some time during the life of the loan.
Default risk is the risk to the lender that the borrower will not carry out the full terms of the loan
agreement. The fact that ARMs shift all or part of the interest rate risk to the borrower, the risk of
default will generally increase to the lender, thereby reducing some of the benefits gained from shifting
interest rate risk to borrowers.

Question 7
Which of the following two ARMs is likely to be priced higher, that is, offered with a higher initial
interest rate? ARM A has a margin of 3 percent and is tied to a three-year index with payments
adjustable every two years; payments cannot increase by more than 10 percent from the preceding
period; the term is 30 years and no assumption or points will be allowed. ARM B has a margin of 3
percent and is tied to a one-year index with payments to be adjusted each year; payments cannot
increase by more than 10 percent from the preceding period; the term is 30 years and no assumption
or points are allowed.
ARM A is likely to be priced higher, because it has a longer-term index and adjustment period.
Subsequently, the lender bears more risk and can expect a higher return.

Question 8
What are forward rates of interest? How are they determined? What do they have to do with indexes
used to adjust ARM payments?
Forward rates are based on future interest rate expectations that are implicit in the yield curve and
reveal investor expectations of interest rates between any two maturity periods on the yield curve. For
example, the yield for a security maturing one year from now is 8 percent, and the yield for a security
that matures two years from now is 9 percent. Based on these two yields, we can compute a forward
rate, or rate that an investor who invests in a one-year security can expect to reinvest funds for one

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additional year. This forward rate will be 10 percent because if investors have the opportunity to invest
today in either the one- or the two-year security and are indifferent between the two choices, the
investor buying a one-year security must be able to earn 10 percent on funds available for reinvestment
at the end of year 1. This information is important and represents a reference point that may help
lenders and borrowers when pricing ARMs and calculating expected yields at the time ARMs are made.
Additionally, interest rate series, which may include forward rates of interest, comprise the indexes
used to adjust ARMs. This is especially true, if an index is long term in nature.

Question 9
Distinguish between the initial rate of interest and expected yield on an ARM. What is the general
relationship between the two? How do they generally reflect ARM terms?
One important issue in ARMs is the yield to lenders, or cost to borrowers, for each category of loan.
Given the changes in interest rates, payments, and loan balances, it is not obvious what these yields
(costs) will be. This means that the costs of each category of loan will be added to the initial interest
rate, thus producing an expected yield.

Question 10
If an ARM is priced with an initial interest rate of 8 percent and a margin of 2 percent (when the
ARM index is also 8% at origination) and a fixed rate mortgage (FRM) with constant payment is
available at 11 percent, what does this imply about inflation and the forward rates in the yield curve
at the time of origination? What is implied if a FRM were available at 10 percent? 12 percent?
The initial interest rate and expected yield for all ARMs should be lower than that of a FRM on the day
of origination. The extent which the initial rate and expected yield on an ARM will be lower than that
on a FRM or another ARM, depends on the terms relative to payments, caps, etc. One would expect the
difference between interest rates at the point if origination to reflect expectations of inflation and
forward rates as well. As a FRM’s interest rate increases from 11 percent to 10 percent and 12 percent,
greater inflation and/or greater uncertainty with respect to inflation is implied.

Problem 2
(1) (2) (3) (4) (5) (6) (7) (8)
EOY
BOY Annual Monthly Payments Monthly Monthly Annual Balance
Balance Interest Interest Interest Amort Amort. (1) - (7)
Rate Rate (2)/12 (3) x (1)
Year (4) - (5)
0
1 $200,000 6.00% 0.50% $1,199.10 $1,000.00 $199.10 $2,456.02 $197,544
2 $197,544 7.00% 0.58% $1,327.75 $1,152.34 $175.41 $2,173.82 $195,370

(a) Monthly Payment = $1,199.10

(b) Loan balance at EOY 1 = $197,544

(c) Monthly Payment = $1,327.75

(d) Loan balance at EOY 2 = $195,370

(e) Monthly Payment for year 1= $1,000

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