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Printable Lesson Materials
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lBy end of first year, index has risen 2%, and lender increases interest rate on loan by 2%,to 6.5%.
Features causing negative amortization
Negative Amortization
(Example, continued)
lWithout payment cap, rate increase would cause payment to increase by $238.23, to $1,200.93.
�But payment cap limits increase to $72.20.
Features causing negative amortization
Negative Amortization
(Example, continued)
lWithout payment cap, rate increase would cause payment to increase by $238.23, to $1,200.93.
�But payment cap limits increase to $72.20.
lNew payment ($1,034.90) doesn’t cover all of the interest accruing on the loan.
�Lender adds unpaid interest to loan balance.�Balance goes up, not down, which
is negative amortization.
Features causing negative amortization
Negative Amortization
Many ARMs are structured to prevent negative amortization.
But if it is a possibility, loan may have a negative amortization cap.
�Limits amount of unpaid interest thatcan be added to principal balance.
�When limit is reached, loan must be recast.
Negative amortization cap
Negative Amortization
Option ARMs, popular during subprime boom, were designed to allow negative amortization.
Each month, borrower chooses payment option:
�P&I payment based on 15-yearamortization,
�P&I payment based on 30-yearamortization,
�interest-only payment, or
�minimum (limited) payment.
Option ARMs
Negative Amortization
lMinimum payment option doesn’t cover interest, resulting in negative amortization.
Option ARMs
Negative Amortization
lMinimum payment option doesn’t cover interest, resulting in negative amortization.
�Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month.
Option ARMs
Negative Amortization
lMinimum payment option doesn’t cover interest, resulting in negative amortization.
�Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month.
�After negative amortization limit reached and loan was recast, borrowers defaulted.
Option ARMs
Negative Amortization
lMinimum payment option doesn’t cover interest, resulting in negative amortization.
�Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month.
�After negative amortization limit reached and loan was recast, borrowers defaulted.
lOption ARMs no longer widely available.
Option ARMs
ARM Features
If ARM has conversion option, borrower allowed to convert loan to fixed-rate mortgage.
lConversion typically can only take place:
�on annual rate adjustment date;
�during a limited period (for example, only after first year and no later than fifth year).
lLender charges conversion fee.
Conversion option
Summary
Fixed or Adjustable Interest RateÄFixed-rate mortgageÄAdjustable-rate mortgageÄ IndexÄNote rateÄMarginÄRate and payment adjustment periodsÄLookback periodÄ Interest rate and mortgage payment capsÄNegative amortizationÄOption ARMÄConversion option
Real Estate Finance Lesson 6 Cumulative Quiz
1. A loan where the entire loan balance will be paid off at the end of the loan term is:
A. fully amortized B. interest-only C. nonrecourse D. partially amortized
2. A partially amortized loan:
A. includes both interest and principal in each payment B. requires a balloon payment at the end of the loan term C. will be fully paid off at the end of the loan term D. Both A and B
3. A balloon payment will be necessary with a/an:
A. interest-only loan B. partially amortized loan C. fully amortized loan D. both A and B
4. Compared with a 30-year loan borrower, a 15-year loan borrower:
A. will make larger monthly payments B. will make smaller monthly payments C. will make more monthly payments over the course of the loan D. will pay more total interest over the course of the loan
5. Which loan term would result in the borrower paying the least amount of interest over the life of the loan?
A. 15 years B. 20 years C. 30 years D. 40 years
6. A borrower takes out a loan with an 80% LTV to purchase a $400,000 property. What is the loan amount?
7. Which LTV would a lender believe to pose the greatest risk?
A. 80% B. 90% C. 95% D. 97%
8. The purpose of mortgage insurance is to reimburse:
A. the borrower in the event property improvements are destroyed by natural disaster B. the borrower in the event the lender becomes insolvent C. the lender for losses in the event of the borrower's default D. the lender in the event that title is unmarketable
9. A common restriction on secondary financing is that:
A. the borrower must qualify based on combined payments for both loans B. the borrower must still make a downpayment out of her own funds C. the secondary financing must be from an institutional lender D. Both A and B
10. Between the 1930s and 1970s, virtually all loans:
A. had adjustable interest rates B. had fixed interest rates C. had interest rates higher than 10% D. had LTVs of 90% or higher
11. A lender compensates for the increased risk to an ARM buyer by:
A. charging a lower initial interest rate B. requiring mortgage insurance for any ARM loan C. using a shorter repayment period D. using less strict underwriting standards
12. An ARM begins with a stated interest rate of 5%. The ARM is based on the 11th District cost of funds index, which is currently 3%. The _____ is 5%.
A. index B. lookback period C. margin D. note rate
A. a regularly published report reflecting changes in the cost of money B. the difference between the index and the interest rate charged to the borrower C. the initial rate stated in the promissory note D. the length of time between points at which the lender can change the rate
14. A 5/1 ARM has an initial _____ of five years.
A. interest rate cap B. mortgage payment adjustment period C. mortgage payment cap D. rate adjustment period
15. On December 31, an ARM's interest rate is adjusted. It is adjusted based on where the LIBOR index stood on November 15. The loan's _____ is 45 days.
A. lookback period B. mortgage payment adjustment period C. mortgage payment cap D. rate adjustment period
16. An ARM borrower's interest rate goes up 2% in a particular year, but the index the loan is based on went up 4% that same year. This loan must have a/an:
A. interest rate cap B. lookback period C. mortgage payment cap D. negative amortization cap
17. Before making the monthly payment of $2,000 on his ARM, Alex had a loan balance of $250,000. Alex owed $2,100 in interest, so after making the payment, his balance was $250,100. This is an example of:
A. negative amortization B. partial amortization C. payment shock D. usury
18. There is a risk of negative amortization occurring if a loan has a/an _____ but no _____.
A. index rate, interest rate cap B. interest rate cap, mortgage payment cap C. mortgage payment cap, interest rate cap D. mortgage payment cap, lookback period
19. A borrower may change an ARM to a fixed-rate loan at designated points if the loan:
A. has a conversion option B. has an index rate C. has a negative amortization cap D. is a hybrid ARM
20. An ARM has a 2.5% margin. It is based on the Treasury securities index, which two months ago was running at 4%. The loan has a two-month lookback period. The loan had an initial 'teaser' rate of 4.5%. If today is the day for adjusting the loan's interest rate, what is the new rate that will be charged to the borrower?