Adjustable Rate and Variable Payment Mortgages

A conventional adjustable rate loan has the borrower sharing the risks of a fluctuating interest rate economy with the lender. In Hong Kong, the ARM allows the lender to make interest rate adjustments by referring to the prime rate which is closely tied to the Federal Reserve policy in the United States.

The ARM in Hong Kong allows the borrower two alternatives for adjustment when mortgage interest rate increases. The borrower can either opt for an increase in monthly payments with the same term or an extension of the term with the monthly payments fixed. In either case, the analysis is straightforward. Let i be the monthly interest rate on the ARM before adjustment, p the corresponding monthly payments, and n the remaining number of monthly payments. Then the mortgage balance B is

Initial Interest Rate

This is the beginning interest rate on the ARM, usually somewhat lower than the market rate for fixed rate mortgages. It remains the same until the first adjustment period mentioned in the mortgage. At that time it may be adjusted upward or downward.

Adjustment Period

This is the time interval between the changes in the interest rate and/or monthly payment. Typically the adjustment periods are one, three or five years. As a borrower if you expect interest rates to move upward, it is in your best interest to negotiate for a long adjustment period. Conversely, if you anticipate lower interest rates in the future, a short adjustment period would be more favorable.

Margin

This is the spread or margin that the lender adds to the index to establish the interest rate on the loan. The amount of the margin varies depending on the adjustment interval and the initial interest rate.

Fixed Interest Rate Mortgage Loans

A fixed rate mortgage (FRM) is any loan having an interest rate that remains unchanged over the life of the mortgage. The typical term of fixed rate mortgages varies from 10 to 30 years in the United States. In Hong Kong the typical term varied from 10 to 20 years. The most popular fixed-rate mortgage is the fully amortized loan.

1. Growing-Equity Mortgages (GEM)

The GEM has provisions that appeal to many homeowners. With the Gem mortgage, loans of 80,90, or 95 percent loan-to-value ratio are common, with fixed interest rates and loan terms of 25 to 30 years. Although the interest rate is fixed, the monthly payment is used to reduce the mortgage balance, thereby accelerating the payoff on the mortgage.

Specific advantages of GEM are as follows:

• The homeowner will the home free and clear in shorter time period.
• The total interest paid is substantially less.
• The homeowner may obtain a lower rate of interest than on the traditional 20 year fixed rate loan.

In addition to being attractive to potential borrowers, this instrument also finds broad appeal among institutional investors and pension funds in the U. S. because of the relatively secure nature of the investment and the shorter time period of time over which their capital is tied up.

Main disadvantage of the GEM mortgage is that the monthly payment increases may outstrip the borrower's salary increases, thereby making the possibility of default morel likely.

2. Rapid-Payment Mortgages (RPM)

The RPM is another means of obtaining the benefits of the GEM mortgage without incurring the disadvantage of increasing monthly payments. Essentially, the RPM is just the standard, fixed rate mortgage with its term shortened from the traditional, say 25 or 30 years, to 10 or 15 years. Seemingly, shortening the term of the loan would greatly increase the fixed monthly principal and interest payment. Such is not the case.

3. Biweekly Mortgages

The biweekly mortgage is another variation of the conventional fixed rate mortgage. It was developed in Canada and was introduced in the United States in 1985. At times, some banks in Hong Kong also offered such loan payment scheme to the borrowers. The main difference between this and the traditional, say 20 years, fixed rate mortgage is that the borrower makes a payment every 2 weeks instead of every month. The biweekly payments reduce the principal balance faster, resulting in a much shorter loan term.

4. Graduated Payment Mortgage (GPM)

The GPM provides for reduced monthly payments during the early years of the loan. The payments rise by a predetermined amount every year for an agreed upon amount of time, usually up to say 10 years. The payments then remained fixed for the balance of the mortgage term.

This type of mortgage allows the homeowner to acquire a more expensive home than she could otherwise afford because of the initially lower monthly payments. The main disadvantages are negative amortization and increasing monthly payments in the early years of the loan.

5. Two-Step Mortgages

The two-step mortgages are very popular in many parts of the United States. The two-step mortgage is a fixed rate loan with a beginning rate as much as 3/4 to 1 1/2 percent below the market rate for a traditional fixed rate loan depending on the specific length of the initial step.

• The 7-23 plan offers a reduced interest rate for the first 7 years and is then adjusted upward for the remaining 23 years.
• The 5-25 plan offers a reduced interest rate for the first 5 years and is then adjusted upward for the remaining 25 years.

The interest rate is adjusted according to an index tied to some interest rate indices.

Interest Rates

In general, the nominal interest rate on a debt security consists of the pure rate of interest and the premiums which reflect expected inflation, the riskless of the security, and the security's marketability (or liquidity). The relationship can be expressed as follows:

k = k* + IP + DP + LP + MP

The real rate of interest is the interest rate that would exist on a riskless security if no inflation were expected. It may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world. It changes over time depending on economic conditions, especially (1) the rate of return corporations and other borrowers can expect to earn on productive assets and (2) people's time preferences for current versus future consumption.

Inflation premium compensates investors for the erosion of purchasing power. When investors lend money they add to the real rate an inflation premium equal to the expected inflation rate over the life of the security. It is important to note that the rate of inflation built into interest rates is the rate of inflation expected in the future, not the rate experienced in the past.

Default risk premium compensates lenders for bearing the risk of default. The greater the default risk , the higher the interest rate lender must charge.

Liquidity (marketability) premium compensates investors for having difficulty to convert the asset to spendable cash on short notice. Active markets, which provide liquidity, exist for government bonds, for the stocks and bonds of the larger corporations, and for the securities of certain financial intermediaries. Liquidity premium ranges between one to two percentage points if charged.

Maturity risk premium is included in the required interest rates for long-term assets to compensate for interest rate risk. When the interest rate changes (up/down) by one percent, the price of a 30-year bond fluctuates (down/up) more than the price of a similar bond with 5-year term.