REE-4204 Lecture Notes - Lecture 7: Interest Rate Risk, Negative Amortization, Revolving Credit
27 Sep 2018
School
Course
Professor
- Price-Level Adjusted Mortgage (PLAM)
o Solves tilt problem and interest rate risk problem by separating the return to the
lender into two parts: the real rate of return and the inflation rate
o The contract rate is the real rate
o The loan balance is adjusted to reflect changes in inflation on an ex-post basis
o Lower contract rate versus negative amortization
- Problems with PLAM
o Payments may increase at a faster rate than income
o Mortgage balance may increase at a faster rate than price appreciation
o Adjustment to mortgage balance is not tax deductible for borrower
o Adjustment to mortgage balance is interest to lender and is taxed immediately
though not received
- Dual Index Mortgage (DIM)
o Uses more than one index for adjustment
▪ Borrower’s rate tied to wage and salary index
▪ Lender’s rate tied to interest rate index
▪ If the borrower’s payment does not catch up with lender’s payment –
balance at maturity
o From lender’s standpoint, similar to the ARM
o From borrower’s standpoint, not comparable to ARM
- Shared Appreciation Mortgage (SAM)
o Low initial contract rate with inflation premium collected later in a lump sum
based on house price appreciation
o Reduction in contract rate is related to share of appreciation
o Amount of appreciation is determined when the house is sold or by appraisal on
a predetermined future date
- Reverse Mortgage
o Typical Mortgage
▪ Borrower receives a lump sum up front and repays in a series of
payments
▪ “Falling Debt, Rising Equity”
o Reverse Mortgage
▪ Borrower receives a series of payments and repays in a lump sum at
some future time
▪ “Rising Debt, Falling Equity”
o Loan advances are not taxable
o Designed for senior homeowners with little or no mortgage debt
o Social Security benefits are generally not affected
o Interest is deductible when paid
o Reverse Mortgage Can Be:
▪ A cash advance
▪ A line of credit
▪ A monthly annuity
▪ Some combo
