Chapter 05:

Adjustable and Floating Rate

Mortgage Loans
McGraw-Hill/Irwin
 Definition of ARM/Floating rate
loans
 Floating rate mortgage loans refer to those mortgage
loans in which the rate of interest charged varies/changes
during the term of the loan.

 The term floating mortgage loan/adjustable rate mortgage

(ARM) are often used interchangeably.

 However, there is difference between these two terms.

ARM is used to refer to mortgage loans made for
purchasing residential property. Whereas, the term
“Floating rate mortgage” is used for mortgage loans used
to purchase commercial property.
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Difference between fixed rate mortgage loan and
Floating rate mortgage loan
Fixed rate mortgage loan Floating rate mortgage loan
The rate of interest is fixed and The rate of interest varies/floats
remains so during the whole term of during the term of the loan. Usually,
the loan. the rate is revised at periodical
intervals.
The interest rate risk is borne largely The interest rate risk is borne largely
by the lender. by the borrower.
The rate of interest charged will be The rate of interest charged initially will
higher compared to the start rate of a be lower compared to a fixed rate loan
floating rate loan because of the because of the greater risk borne by
greater risk borne by the lender. the borrower.
Risk bearing is not “symmetrical” Risk bearing is symmetrical.
between the lender and borrower –
when the interest rate rises the lender
bears the risk of loss but when the
interest rate falls the lender often
cannot gain as borrower simply goes
for refinancing. 5-3
 Interest rate risk: Details
 The interest rate charged by a bank/FI on its mortgage loan will
depend upon the real rate of interest (r ), risk premium (p) and
anticipated inflation premium (f).

 That is, I = r+p+f

 In a fixed rate mortgage loan, the bank is in fact forecasting what

the anticipated inflation and risk level will be during the entire loan
term. Thus, the forecasting horizon is quite large. This makes
forecasting difficult and if for some reason there is unanticipated risk
or unanticipated inflation, then the interest rate charged might
become inadequate and the bank will suffer losses.

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 Interest rate risk: Details
 For example, suppose a bank makes a $ 60,000, 10% fixed
mortgage loan (compounded monthly). It is a fully amortizing loan.
 The monthly payment for this loan would be $ 527 and if all
payments (360 months) are made regularly then the total loan will
be recovered in present value terms.
 However, during these 30 years the inflation rate was 2% more then
expected. This means that the interest rate SHOULD have been
12%.
 The amount of loan recovered after 30 years in present value terms
(at 12%) is in fact $51190.
 Thus, the bank has actually suffered a loss of (60000-51190)=
$8810 due to interest rate being inadequate.

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 Practice Math 1
 A bank is made a fixed rate mortgage loan of Tk
50,00,000 for 20 years. The real rate of interest is 4%,
anticipated inflation is 6% and risk premium is 5%. Thus,
they have priced the loan at 15% with monthly
compounding. During the loan term there was the actual
inflation rate was 8% due to unanticipated inflation. How
much loss did the bank have to incur due to the interest
rate risk?

 Ans: Tk. 511354

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 Answer
 EMI at 15% rate of interest = 65839.48
 PVA (65837.48,17%,240) = 4488646
 Loss = 5000000 – 4488646
= 511354

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 Interest rate risk: Details
 All in all, interest rate risk is higher in fixed rate mortgage loans
because there is no scope for the bank to revise the interest rate
with response to unanticipated inflation and unanticipated risk. In
comparison, floating rate loans are regularly revised to reflect these
unanticipated inflation and risk levels.

 Moreover, the forecasting horizon is much larger for fixed rate

mortgage loan (entire loan term) making it more likely that the
anticipated risk level and anticipated inflation will become
inaccurate. In comparison, the forecasting horizon is shorter in
floating rate loans (until the readjustment date- usually 3 month, 6
month, 1 year) and it is easier to forecast risk and inflation level
more accurately over this short period of time.

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 Price Level Adjusted Mortgage
(PLAM)
This is a type of mortgage loan where the pricing is done in such a way
so that the interest rate risk is minimized. This minimization of interest
rate risk is achieved by eliminating the need to forecast anticipated
inflation.

Under a PLAM, the rate of interest charged by the bank is set to equal
the sum of real rate of interest and risk premium.
I = r+p

The monthly payment is calculated using this interest rate and the
amortization is done accordingly. However, at each adjustment date the
loan balance is adjusted upwards or downwards by a price index
(typically the CPI).
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 Price Level Adjusted Mortgage
(PLAM)
 Payments would then be recalculated based on the new loan balance
adjusted for inflation.

 PLAM therefore shifts the risk of changes in market interest rates brought
about by inflation to borrowers and relieves the lenders from the difficult task
of forecasting inflation during loan origination.

 However, interest rate risk will still exist due to unexpected/unanticipated

risk level (p) or because of the real rate of interest (r) not being adequate.

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 PLAM: Payment mechanics
 A bank has made a loan of $60,000 for 30 years. It will
structure the loan to be a PLAM. The real rate of interest is
3% and risk premium is 1%. Monthly compounding is
applied.

i) Calculate the monthly payments and principal amount

remaining after 1 year.
ii) After 1 year, the bank saw that the inflation rate as
apparent from the CPI was 6% during the first year. What
would be the adjusted loan balance remaining at the end
of year 1?
iii) What would be the monthly payments from year 2?
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 Solution
i) We know,
PMT * PVAF (0.003333%, 360 months) = 60,000
PMT * 209.4612 = 60000
PMT = 60000/209.4612
PMT = 286.45

We know,
loan balance/principal remaining at end of year 1 = PV of the PMT of
remainder 29 years
loan balance remaining = PMT * PVAF (0.003333%,348 months)
= 286.45* 205.77
= 58943

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 Solution
ii) Adjusted loan balance at end of year 1 = unadjusted loan balance at end of
year * (1+ CPI rate)

Adjusted loan balance = 58943* (1.06)

= 62480

iii) Payment from year 2:

PMT * PVAF (0.003333%, 348 months) = 62,480
PMT * 205.77 = 62480
PMT = 62480/205.77
PMT = 304

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 Practice math 2
 A bank has made a loan of tk 30,00,000 for 30 years. It will
structure the loan to be a PLAM. The real rate of interest is
3% and risk premium is 2%. Monthly compounding is applied.

i) Calculate the monthly payments and principal amount

remaining after 1 year.
ii) After 1 year, the bank saw that the inflation rate as apparent
from the CPI was 5% during the first year. What would be the
adjusted loan balance remaining at the end of year 1?
iii) What would be the monthly payments from year 2?

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PLAM payment patterns

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 Fixed Rate and Price Level
Adjusted Mortgage
 Fixed rate mortgages can lose substantial value
if an unanticipated rise in inflation occurs after
the mortgages have been made.
 The PLAM is designed to avoid the loss that
would otherwise occur due to unanticipated
inflation.
 As you might expect, the popularity of fixed rate
mortgages ebbs and flows with the state of the
market and the participants’ perception of the
stability of inflation rates.
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Price Level Adjusted Mortgage
The PLAM helps banks/FI’s avoid interest rate risk loss stemming from
unanticipated inflation.

However, PLAM has some problems as well as shown below:

1.CPI is not a perfect index for housing prices. If overall CPI growth rate is
higher than growth rate of housing prices than the loan balance outstanding
might surpass the property value and this will prompt borrowers to default the
property and go for foreclosure.
2.If borrower’s incomes do not increase at par with CPI, this may lead to the
borrower’s inability to repay. Specially, if inflation rises rapidly in the short run
then income may not rise at the same pace and borrower will be forced to
default.
3.CPI is a historical index. It reflects how prices have changed in the past.
Using this information to price future mortgage payments is conceptually
inaccurate. Last years CPI rate is used to calculate next years mortgage
payment. But past trend might not continue in the future.
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 Adjustable Rate Mortgages
 The shortcomings of the PLAM has made it unpopular in
real estate financing transactions. Instead, the
adjustable rate mortgage (ARM) is more popular.
 In an ARM, the interest rate charged by the bank is
indexed/linked with other market interest rates. These
other interest rates adjust/change at regular intervals
and as they do so does the mortgage loan interest rate.
 For example, a bank might give a mortgage loan with
interest being 6 month T-bill rate + 3%. If the current 6
month T-bill rate is 6% then the mortgage rate of the
ARM would be 9% (6%+3%). After 1 year the 6 month T-
bill rate increased to 7%. Thus, the mortgage interest
rate would become 10%.
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 Adjustable Rate Mortgages
 The ARM is superior to PLAM mortgage because of
multiple reasons.

 Firstly, unlike PLAM, ARM’s interest rates are

determined with a future outlook. In PLAM, ex post
measure of inflation was used to determine future
interest rates.
 In ARM, the underlying market interest rates are typically
short term. The use of this market interest rates to
determine mortgage interest rates makes the latter more
accurate as short term projection of real interest rate, risk
premium and inflation is easier and more accurate for.
 .
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 Adjustable Rate Mortgages

 However, ARMs do not eliminate interest rate risk

 The longer the adjustment interval, the more interest
rate risk the lender will take on.
 Unexpected variations in r, f and p between the
adjustment intervals will still give rise to interest rate risk.
 Nevertheless, as the lender assumes less interest rate
risk by putting it onto the borrower, the lender should
expect to receive a lower rate of interest than it would
otherwise receive with a fixed rate mortgage.

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 Adjustable Rate Mortgages
terminologies
 A new loan payment is computed at each reset date
– Index
 Interest rate that is agreed by the borrower and the
lender to use while determining the loan interest rate
(composite rate). The lender does not control the index.
∙ Treasury securities rate
∙ London Interbank Offered Rate (LIBOR)
– Margin (or spread)
 Premium added to the index

– Composite Rate (actual rate charged for the loan) = index

rate + margin

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 Adjustable Rate Mortgages
 Reset Date
– The point in time in which the mortgage payments will be readjusted. This time
period is usually 6-12 months.
 Negative Amortization
– Periodic total payment does not cover the interest due. As a result, the loan
balance outstanding increases with each period.
 Caps
– Maximum increases allowed in interest rates, maturity extensions and negative
amortizations.
 Floors
 Assumability
– The ability of the borrower to allow a subsequent purchaser of a property to
assume a loan under the existing terms.
 Points
– Fees/charges taken by bank to increase its effective yield/
 Prepayment
 Conversion- Right of ARM borrower to switch to FRM
 Lock-out
– Provision that prevents borrowers from making loan prepayment for a few years.

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 Adjustable Rate Mortgages
Types/Variations
 Hybrid Loans
– These loan structures have both FRM and ARM component. The
loans are initially structured as FRM for a few years. After that
specified time period has elapsed, the loan becomes an ARM
with interest rate being adjusted at every reset date. Examples
of hybrid ARM are 3/1, 5/1, and 7/1 ARMs.
 Interest Only ARM and Floating Rate
– I.O. for initial period
– Then, depending on what has been negotiated
 Pay interest only
 Pay interest & some principal
 Sometimes negative amortization
 Fully amortizing payments required in future

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 Example
 A bank has made a loan of tk 30,00,000 for 5 years. The
interest rate to be charged is 6 month t-bill rate +2%.
The current 6 month T-bill rate is 8%. The adjustment
interval of the loan is 1 year. After 6 months, the T-bill
rate declined to 5%. After 1 year, the T bill rate changed
to 9%. After 2 years, the T-bill rate changed to 7.5%.
Thereafter, the T-bill rate was constant for the remainder
of the loan maturity.

 Calculate the installment payments at the beginning,

after 1 year and 2 year. Construct the amortization
schedule.
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 Practice Math 3

 A bank has made a loan of tk 30,00,000 for 5 years. The

interest rate to be charged is 6 month t-bill rate +3%.
The current 6 month T-bill rate is 8%. The adjustment
interval of the loan is 1 year. After 1 year, the T bill rate
changed to 10%. After 2 years, the T-bill rate changed to
11%. Thereafter, the T-bill rate was constant for the
remainder of the loan maturity.

 Calculate the installment payments at the beginning,

after 1 year and 2 year. Construct the amortization
schedule.

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 Adjustable Rate Mortgages
Yield & Rates
 The yield realized by the bank from a mortgage
loan will ultimately depend on
– Initial interest rate
– Index & margin
– Any points charged
– Frequency of payment adjustments
– Inclusion of caps or floors on the interest rate,
payments, or loan balances
All of these factors will interact with each other to
determine the expected yield of the lender from the
ARM.
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 Adjustable Rate Mortgages
Expected Yield & Risks
 Basic Relationships:
– FRM vs. ARM yield at origination
 ARM will have a lower initial interest rate than the FRM as it has less
interest rate risk.
– Short-term vs. Long-term indices
 Short term index are usually more volatile than long term index and
therefore more risky for the borrower. An ARM where a short term index
is used will have a lower initial interest rate and expected yield compared
to an ARM tagged with a long term index.
– Shorter vs. Longer time intervals between adjustments
 The shorter the adjustment interval, the more interest rate risk is borne by the
borrower. As a result, the initial interest rate and expected yield will be lower for
ARM’s with shorter adjustment interval compared to longer adjustment intervals.
– Impact of caps & floors
– Negative amortization
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 Adjustable Rate Mortgages
Expected Yield & Risks
– Impact of caps & floors
 Interest rate caps reduce the interest rate risk borne by the borrower and
increases it for the lender. Consequently, a lender will charge higher initial
interest rate and expect greater yield from an ARM with a interest rate cap
compared to an unrestricted ARM. The opposite will be true for an ARM with
a floor.

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 Adjustable Rate Mortgages
Yield & Risks
 Typically, there is a tradeoff between the default risk incurred by a
lender and the interest rate risk incurred by the lender. As the
interest rate incurred by the lender increases, the default risk
incurred by it decreases and vice versa.

 An ARM shifts the threat of loss arising from interest rate changes
from the lender to the borrower. This makes the threat of payment
shocks greater for the borrower and increases the default risk.

 The terms of the loan (index, margin, interest rate cap, negative
amortization, payment cap etc.) also impact the default risk of the
borrower.

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 Exhibit 5-2
The Relationship between Interest Rate Risk, Default Risk,
and Risk Premiums

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 ARM payment mechanics
It is important to be able to understand the implication of
different terms of an ARM and construct the amortization
schedule keeping the implications in mind.

In general, we should be able to construct amortization

schedule of:
1.Unrestricted ARM
2.ARM with payment cap and negative amortization
3.ARM with interest rate cap and no negative amortization

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 Unrestricted ARM

A bank has made a loan of $60,000 for 30 years.

The interest rate is set to be one year US t-bill rate
+ 2%. Payment is to be made on a monthly basis.
The initial rate is 8%. It is assumed that the 1 year
T-bill rate for the next four years will be 10%, 13%,
15% and 10% respectively. It is also assumed that
the 1 year T-bill rate would remain constant at 10%
after that. The adjustment interval is 1 year.

Q) Construct the amortization table/

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 Practice Math 4
A bank has made a loan of Tk. 30,00,000 for 5 years. The
interest rate is set to be one year BD t-bill rate + 3%.
Payment is to be made on a semi-annual basis. The initial
rate is 10%. It is assumed that the 1 year T-bill rate for the
next 4 years will be 9%, 11%, 10% and 10% respectively.
The adjustment interval is 1 year.

Q) Construct the amortization table

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 ARM with payment cap and negative
amortization
A bank has made a loan of $60,000 for 30 years. The
interest rate is set to be one year US t-bill rate + 2%. The
initial rate is 9%. Interest is to be paid monthly. It is
assumed that the 1 year T-bill rate for the next four years
will be 10%, 13%, 15% and 10% respectively. It is also
assumed that the 1 year T-bill rate would remain constant
at 10% after that. The adjustment interval is 1 year. There
is a payment cap of 7.5% and negative amortization is
allowed.

Q) Construct the amortization table.

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 Note
 The payment change is calculated by
comparing the current years
uncapped/unrestricted PMT with the
previous years paid PMT.

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 Practice Math 5
A bank has made a loan of Tk. 30,00,000 for 5 years. The
interest rate is set to be one year BD t-bill rate + 3%.
Payment is to be made on a semi-annual basis. The initial
rate is 10%. It is assumed that the 1 year T-bill rate for the
next 4 years will be 13%, 15%, 18% and 14% respectively.
The adjustment interval is 1 year. The payment cap is 5%
per annum.

Q) Construct the amortization table

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 ARM with interest rate cap and
negative amortization not allowed
A bank has made a loan of $60,000 for 30 years. The
interest rate is set to be one year US t-bill rate + 2%. The
initial rate is 11%. It is assumed that the 1 year T-bill rate
for the next four years will be 10%, 13%, 15% and 10%
respectively. It is also assumed that the 1 year T-bill rate
would remain constant at 10% after that. The adjustment
interval is 1 year. There is a interest rate cap of 2% per
year and 5% over the lifetime of the loan. negative
amortization is not allowed.

Q) Construct the amortization table.

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 Practice Math 6
A bank has made a loan of Tk. 30,00,000 for 5 years. The
interest rate is set to be one year BD t-bill rate + 3%.
Payment is to be made on a semi-annual basis. The initial
rate is 12%. It is assumed that the 1 year T-bill rate for the
next 4 years will be 12%, 15%, 18% and 14% respectively.
The adjustment interval is 1 year. There is a interest rate
cap of 3% per year and 6% over the lifetime of the loan.
negative amortization is not allowed.

Q) Construct the amortization table

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