# The steady arm.

THE STEADY ARM

The search for the "perfect" mortgage continues. In response to the volatility of interest rates over the past few years, a variety of new products have entered the market. The menu of mortgage types now includes variable rate mortgages, in particular, adjustable rate mortgages (ARMs), negative amortization mortgages, biweekly payment mortgages, graduated payment mortgages (GPMs) and growing equity mortgages (GEMs), to name just a few.

While many of these instruments are designed to increase mortgage affordability (as is the case with GPMs and GEMs), a principal motivation behind some new mortgage products, especially ARMs, is a desire on the part of lending institutions to reduce their interest rate risk. In the case of ARMs, interest rate risk is partly or wholly transferred to the borrower; in the case of biweekly payment mortgages, interest rate risk is reduced by shortening the effective duration of the mortgage. This is done by accelerating the repayment of principal. In either case, the borrower expects to be compensated for the lender's risk reduction, usually through a lower interest rate.

With ARMs, however, the problem for the borrower is that an increase in interest rates results in higher mortgage payments. Consequently, the lender might simultaneously reduce interest rate risk but increase default risk. As a result, borrowers generally sort themselves into one of two groups. Group one consists of those borrowers who desire the certainty of a fixed interest rate (and, thus, a fixed mortgage payment). Group two consists of those borrowers who are willing to accept some or all of the interest rate risk (and, hence, a variable mortgage payment). Group one borrowers will usually opt for a fixed-rate mortgage; Group two borrowers will usually opt for an ARM.

There exists, especially among apartment and office building developers, a third group. Group three borrowers may be willing to accept some interest rate risk (especially if the terms of the ARM were attractive) but are reluctant to assume the risk of dramatically increased payments (they may face rent control guidelines, a highly competitive rental market or institutional restrictions that make it difficult to pass mortgage payment increases along in the form of higher rents). As a result, this third group of borrowers will usually choose a fixed-rate mortgage.

Complicating the environment for these new mortgage instruments is the increasingly large number of mortgage defaults that have put stress on financial institutions. Upward limits on annual increases in mortgage payments combined with declining real estate values have often caused the loan-to-value (LTV) ratios on mortgages to exceed 100 percent - raising the likelihood of borrower default. Consequently, mortgage lenders have become equally concerned with default risk as with interest rate risk.

Is it possible to satisfy the twin desires of group three borrowers as well as afford the lender increased protection from default? The answer is yes, and the mortgage instrument that can do the job is one that I will refer to as the "Steady ARM." The Steady ARM is a hybrid product combining the variable interest rate feature of an ARM with the fixed-payment feature of a fixed-rate mortgage.

Adjustable rate mortgages - some

preliminaries

There has been much discussion of the features and pricing of ARMs. A consistent theme is the transfer of some of the interest rate risk from lender to borrower through the periodic adjustment of mortgage payments to reflect changes in lenders' cost-of-funds. However, because most ARMs are resold in the secondary mortgage markets to buyers such as Freddie Mac and Fannie Mae, a high degree of standardization now exists among the terms of ARMs offered by various mortgage originators. One specific feature of many ARMs is the upward cap on annual changes in mortgage payments. Most borrowers with these kinds of mortgages retain the option to limit payment increases to either the amount necessary to compensate the lender for changes in the cost-of-funds or 8 percent, whichever is less.

Obviously, a sustained, dramatic rise in interest rates over a period of years may lead borrowers to invoke the 8 percent payment cap option, resulting in monthly mortgage payments that are not sufficient to meet the lender's cost-of-funds. In this circumstance, negative amortization occurs. Most ARM contracts limit negative amortization so that the principal balance outstanding may never exceed 125 percent of the original mortgage balance. However, if real property values are declining, this may result in LTVs in excess of 100 percent.

Even if a default does not occur, the lender may realize a yield well below the cost-of-funds for a substantial period of time. Under a typical ARM, it is conceivable that the principal balance may exceed the original loan amount as late as 10 years into a 30-year mortgage. Clearly, such a circumstance is not entirely satisfactory to a lender. To reduce default risk, typically the lender would like to avoid the prospect of negative amortization. This is where a Steady ARM can become the mortgage instrument of choice

The Steady ARM: how it works

The best way to illustrate the concept of the Steady ARM is by example. Suppose you are a developer in an area where it may be difficult to pass along rent increases caused by increased capital costs. A typical example is a situation where leases are controlled by city, state or federal guidelines. If you finance the development with an ARM and interest rates rise, you might face a severe cash flow squeeze - while capital costs rise, revenues may stay constant or fail to rise enough to cover capital cost increases. The squeeze might become so severe that you either liquidate the property or default on the mortgage. As a result, you eliminate ARM financing as an alternative.

But suppose lenders are so concerned with interest rate risk and other risks that the capital cost of a fixed-rate mortgage is prohibitively high? If you choose to develop under this situation, the market might not support the rents necessary to cover your capital costs. Your cash flow gets squeezed so the property is not developed.

Enter the Steady ARM. Under a Steady ARM, the monthly mortgage payment for principal and interest will never increase, even if interest rates rise dramatically. And, if interest rates stay below the yearly caps as specified in the ARM, you may have the option of either reducing your payment or reducing the term of the mortgage. How does the Steady ARM do this? It does this by accelerating the reduction of the principal amount of the mortgage during its early years. Your monthly payment is higher in the early years than it would be under a standard ARM, but all of the additional payment goes toward reducing the principal. And even in a worst-case situation (sustained, high interest rates), payments in the latter years of the Steady ARM are less than they would be under a standard ARM. You save on your total interest charges and build up equity faster.

The lender is happy as well. His return on the Steady ARM is almost exactly the same as it would be under a standard ARM. And cash flow is better in the early years. And, because of the accelerated principal reduction, default risk is lowered, making the Steady ARM more attractive for the lender.

Advantages of the Steady ARM

As a hybrid mortgage that combines many of the desirable features of a fixed-rate mortgage and an ARM, the Steady ARM eliminates many of the undesirable features as well, and offers the following benefits: * A payment that will never go up - Like

a fixed-rate mortgage, the payment

on the Steady ARM starts at

its maximum level. There is no

"payment shock" for the borrower

in subsequent years and less lender

concern about the borrower's ability

to repay the mortgage if interest

rates rise; * The borrower benefits when interest

rates stay down or drop - If interest

rates don't hit the Steady ARM's

caps, the borrower may have the option

of reducing the term of the

mortgage or lowering his or her

monthly payment. With a conventional

fixed-rate mortgage, the borrower

usually only has the option to

reduce the term, not the monthly

payment. The Steady ARM allows

the borrower to benefit from low interest

rates without having to renegotiate

the terms of the mortgage.

Thus, refinancings are less likely

with a Steady ARM than with a

fixed-rate mortgage; * Rapid principal reduction - Faster

repayment of principal under the

Steady ARM decreases default risk,

increases equity buildup and increases

lender cash flow. The duration

of a Steady ARM will always

be less than that of a standard

ARM or conventional fixed-rate

mortgage; * No negative amortization - Many

standard ARMs give the borrower

the option of limiting year-to-year increases

in future payments if interest

rates rise substantially. This

may result in increases in the principal

balance of the mortgage during

some years. Under the Steady ARM,

negative amortization is eliminated.

Lender cash flow is immunized

from rising interest rates. * Increased flexibility for the borrower

when interest rates change dramatically - As

interest rates fall, the

spread between what the borrower

is earning on invested funds and

what he or she is paying on the

Steady ARM may increase substantially.

Accelerating the amortization

of principal reduces the borrower's

net interest payments (interest paid

minus interest earned). Similarly, if

interest rates rise, the spread may

decline (or even go negative). In

this situation, the option to reduce

payments makes more funds available

for investment - again, reducing

net interest charges. * A lower after-tax borrowing

cost - The Tax Reform Act of 1986

lowered the maximum corporate

marginal tax rate from 46 to 33 percent

and the maximum personal income

tax rate from 50 to 28 percent.

For corporations in the top bracket,

each dollar of interest saved increases

post-tax cash flow by 67 cents; for

individuals in the top bracket, each

dollar of interest saved increases

post-tax cash flow by 72 cents. The

reduction in the tax subsidy of interest

charges should stimulate corporations

and individuals to seek ways

to lower their total interest payments.

Table 1 summarizes the similarities and differences among fixed-rate mortgages, standard ARMs and the Steady ARM. [Tabular Data Omitted]

Case example

Suppose you are developing an apartment complex where your borrowing need is $100,000 per unit. Your lender has offered you a standard one-year, Treasury-indexed ARM with the term as specified in Table 2, which include a 2 percent annual rate cap and a 6 percent rate cap over the life of the loan. The worst case, as indicated in Table 3, is that your monthly mortgage payment (on a unit basis) rises from an initial $733.76 per month to $1,171.77 per month (a 60 percent increase) in just three years. And, if interest rates stay high, you'll end up paying that $1,171.77 per month for the next 27 years. [Tabular Data Omitted]

Suppose, however, you pay $1,069.49 per month from the beginning. Even if interest rates skyrocket, your monthly payment will never go up. And, while you pay a little more in the first three years, you will pay $102.28 per month less each month during the last 27 years. In a worst-case scenario, you save $26,213.87 in interest charges on each unit. And the savings are even greater if interest rates do not shoot up. For example, if interest rates stay constant, your $1,069.49 monthly payment will pay off the mortgage in about 12 1/4 years (147 months).

It is important to note that there is nothing magical about the Steady ARM. The reason it saves interest is because of the accelerated amortization of principal. Returning to Table 3, we see that the borrower has reduced the principal balance by more than $10,000 by the beginning of the fourth year, while under the standard ARM, the principal has been reduced by less than $2,000. It is obvious that a borrower could realize the savings offered by the Steady ARM by taking out a standard ARM and simply accelerating the amortization of principal. There are, however, two very important financial reasons why lenders likely would prefer to originate the Steady ARM than the standard ARM.

First, the Steady ARM amortizes principal faster. Thus, the duration of the Steady ARM is shorter than an equivalent standard ARM. The lender's cash flow is higher, earlier on, making more funds available to the lender for reinvestment. Second, default risk is substantially less under the Steady ARM than a standard ARM. At any point during the life of the mortgage, the borrower's principal balance will be less under the Steady ARM - reducing the probability of borrower default. But, even if the borrower were to default under the Steady ARM, the lender would have less funds at risk. Furthermore, because there is no "payment shock" under the Steady ARM, the lender and borrower need not worry about the effects of increasing interest rates on the borrower's ability to repay.

The twin virtues of accelerated principal amortization and reduced default risk should induce lenders to offer Steady ARMs at lower rates of interest than standard ARMs. Suppose, for example, that a lender reduces the interest rate 25 basis points for the faster principal amortization and another 25 basis points for the lower default risk. Tables 2 and 4 illustrate the terms, the payment sequence and principal balances for a Steady ARM under this scenario. With the lender having reduced his required return by 50 basis points, the monthly payment under the Steady ARM falls to $1,033.33, a drop of $36.16 from the previous example. In a worst-case scenario, this Steady ARM saves more than $40,000 in interest charges. And, if interest rates stay constant, that $1,033.33 monthly payment will pay off the Steady ARM in less than 12 1/2 years.

An alternative option for the Steady ARM borrower is to reduce his or her monthly payment each year the Steady ARM does not hit its cap. Suppose, for example, the value of the underlying index (in this case, one-year constant maturity Treasury securities) for the Steady ARM does not change from year one to year two. In effect, the rate caps for the Steady ARM have been pushed forward by one year. Thus, the Steady ARM, like the standard ARM, could still march upward to its caps, but now, starting one year later.

Even if the Steady ARM were to march to its caps, the borrower can reduce his monthly payment to $983.53. If the Steady ARM's index stayed constant until the third year, the borrower could then reduce his or her monthly payment to $936.15. Table 5 compares a Steady ARM with a standard ARM under the assumption that the index stays constant for five years and then rises dramatically for the remaining 25 years. The Steady ARM borrower has seen the monthly payment drop to $848.23. [Tabular Data Omitted]

Even with the drop in monthly payment, the Steady ARM borrower has repaid nearly $19,000 of the principal and has the comfort of knowing that the payment will never rise above $848.23 a month. By contrast, the standard ARM borrower has repaid less than $3,800 of principal and still faces the prospect of a monthly payment as high as $1,136.49.

No matter what interest rate scenario you choose, the Steady ARM borrower draws down the principal faster and is better protected against interest rate increases than is the standard ARM borrower.

The Steady ARM market

What kind of borrowers can benefit from a Steady ARM? There are many groups who could enjoy real savings: * Apartment owners renting under contract

to city, state or federal housing assistance

programs - For example, the

HUD Section 8 rental program specifies

maximum contract rents owners

may charge. If capital costs exceed

maximum contract rents, the owner's

cash flow suffers. With the Steady

ARM, an apartment owner can calculate

maximum capital costs and determine

if they will be below maximum

rent guidelines. In addition, if interest

rates do not rise to the Steady ARM's

caps, the owner may actually be able

to lower rents in the future. * Office building developers - The

surety of a fixed, monthly payment

combined with the prospect of either

reduced monthly payments in

future years or faster write-off of

mortgage principal should be attractive

to developers faced with the ups

and downs of office lease rates. Because

interest charges are less, cash

flow improves, and the developer

can offer more competitive lease

rate in future years. * Residential borrowers - The attraction

of a standard ARM for many homebuyers

is the low initial monthly payment.

The Steady ARM is not for

borrowers who hope to "grow into"

their mortgages. Sadly, those borrowers

may actually "grow out of"

their mortgages. However, the Steady

ARM should be attractive to homeowners

refinancing a high, fixed-rate

mortgage and to borrowers willing to

take some interest rate risk in exchange

for the prospect of lower future

payments or a quicker write-off.

In addition to being attractive to borrowers, the Steady ARM should see greater acceptance in the secondary mortgage markets than standard ARMs. A Steady ARM with fixed payments throughout its life should be much easier to administer (no need to calculate payment adjustments and send out adjustment notices each year) and easier to value by mortgage buyers. The rapid principal amortization and the absence of negative amortization make the Steady ARM a more liquid financial instrument while also reducing default risk.

Steady ARMs pooled to form a collateralized mortgage obligation (CMO) expose the investor to lower prepayment risk because refinancings are less likely than under standard ARMs. And investors purchasing strips of principal only (PO) securities backed by Steady ARMs will experience positive cash flow every period because negative amortization is not possible.

The starting point for negotiating the terms of a Steady ARM involves the same terms offered to the borrower under a standard ARM. In most cases, this involves specifying an initial rate; the yearly caps (and floors, if applicable); the index used for adjusting future payments (the prime rate or a Treasury rate); the margin over the index; and the length of the mortgage in years.

The Steady ARM is a product beneficial to both lenders and borrowers. And, it is easy to explain and to understand. Combining the best features of a fixed-rate mortgage and a standard ARM, the Steady ARM eliminates many of the shortcomings of both these products.

Stephen F. Thode is an associate professor of finance and director of the Murray H. Goodman Center for Real Estate Studies, College of Business and Economics, at Lehigh University in Bethlehem, Pennsylvania.

The search for the "perfect" mortgage continues. In response to the volatility of interest rates over the past few years, a variety of new products have entered the market. The menu of mortgage types now includes variable rate mortgages, in particular, adjustable rate mortgages (ARMs), negative amortization mortgages, biweekly payment mortgages, graduated payment mortgages (GPMs) and growing equity mortgages (GEMs), to name just a few.

While many of these instruments are designed to increase mortgage affordability (as is the case with GPMs and GEMs), a principal motivation behind some new mortgage products, especially ARMs, is a desire on the part of lending institutions to reduce their interest rate risk. In the case of ARMs, interest rate risk is partly or wholly transferred to the borrower; in the case of biweekly payment mortgages, interest rate risk is reduced by shortening the effective duration of the mortgage. This is done by accelerating the repayment of principal. In either case, the borrower expects to be compensated for the lender's risk reduction, usually through a lower interest rate.

With ARMs, however, the problem for the borrower is that an increase in interest rates results in higher mortgage payments. Consequently, the lender might simultaneously reduce interest rate risk but increase default risk. As a result, borrowers generally sort themselves into one of two groups. Group one consists of those borrowers who desire the certainty of a fixed interest rate (and, thus, a fixed mortgage payment). Group two consists of those borrowers who are willing to accept some or all of the interest rate risk (and, hence, a variable mortgage payment). Group one borrowers will usually opt for a fixed-rate mortgage; Group two borrowers will usually opt for an ARM.

There exists, especially among apartment and office building developers, a third group. Group three borrowers may be willing to accept some interest rate risk (especially if the terms of the ARM were attractive) but are reluctant to assume the risk of dramatically increased payments (they may face rent control guidelines, a highly competitive rental market or institutional restrictions that make it difficult to pass mortgage payment increases along in the form of higher rents). As a result, this third group of borrowers will usually choose a fixed-rate mortgage.

Complicating the environment for these new mortgage instruments is the increasingly large number of mortgage defaults that have put stress on financial institutions. Upward limits on annual increases in mortgage payments combined with declining real estate values have often caused the loan-to-value (LTV) ratios on mortgages to exceed 100 percent - raising the likelihood of borrower default. Consequently, mortgage lenders have become equally concerned with default risk as with interest rate risk.

Is it possible to satisfy the twin desires of group three borrowers as well as afford the lender increased protection from default? The answer is yes, and the mortgage instrument that can do the job is one that I will refer to as the "Steady ARM." The Steady ARM is a hybrid product combining the variable interest rate feature of an ARM with the fixed-payment feature of a fixed-rate mortgage.

Adjustable rate mortgages - some

preliminaries

There has been much discussion of the features and pricing of ARMs. A consistent theme is the transfer of some of the interest rate risk from lender to borrower through the periodic adjustment of mortgage payments to reflect changes in lenders' cost-of-funds. However, because most ARMs are resold in the secondary mortgage markets to buyers such as Freddie Mac and Fannie Mae, a high degree of standardization now exists among the terms of ARMs offered by various mortgage originators. One specific feature of many ARMs is the upward cap on annual changes in mortgage payments. Most borrowers with these kinds of mortgages retain the option to limit payment increases to either the amount necessary to compensate the lender for changes in the cost-of-funds or 8 percent, whichever is less.

Obviously, a sustained, dramatic rise in interest rates over a period of years may lead borrowers to invoke the 8 percent payment cap option, resulting in monthly mortgage payments that are not sufficient to meet the lender's cost-of-funds. In this circumstance, negative amortization occurs. Most ARM contracts limit negative amortization so that the principal balance outstanding may never exceed 125 percent of the original mortgage balance. However, if real property values are declining, this may result in LTVs in excess of 100 percent.

Even if a default does not occur, the lender may realize a yield well below the cost-of-funds for a substantial period of time. Under a typical ARM, it is conceivable that the principal balance may exceed the original loan amount as late as 10 years into a 30-year mortgage. Clearly, such a circumstance is not entirely satisfactory to a lender. To reduce default risk, typically the lender would like to avoid the prospect of negative amortization. This is where a Steady ARM can become the mortgage instrument of choice

The Steady ARM: how it works

The best way to illustrate the concept of the Steady ARM is by example. Suppose you are a developer in an area where it may be difficult to pass along rent increases caused by increased capital costs. A typical example is a situation where leases are controlled by city, state or federal guidelines. If you finance the development with an ARM and interest rates rise, you might face a severe cash flow squeeze - while capital costs rise, revenues may stay constant or fail to rise enough to cover capital cost increases. The squeeze might become so severe that you either liquidate the property or default on the mortgage. As a result, you eliminate ARM financing as an alternative.

But suppose lenders are so concerned with interest rate risk and other risks that the capital cost of a fixed-rate mortgage is prohibitively high? If you choose to develop under this situation, the market might not support the rents necessary to cover your capital costs. Your cash flow gets squeezed so the property is not developed.

Enter the Steady ARM. Under a Steady ARM, the monthly mortgage payment for principal and interest will never increase, even if interest rates rise dramatically. And, if interest rates stay below the yearly caps as specified in the ARM, you may have the option of either reducing your payment or reducing the term of the mortgage. How does the Steady ARM do this? It does this by accelerating the reduction of the principal amount of the mortgage during its early years. Your monthly payment is higher in the early years than it would be under a standard ARM, but all of the additional payment goes toward reducing the principal. And even in a worst-case situation (sustained, high interest rates), payments in the latter years of the Steady ARM are less than they would be under a standard ARM. You save on your total interest charges and build up equity faster.

The lender is happy as well. His return on the Steady ARM is almost exactly the same as it would be under a standard ARM. And cash flow is better in the early years. And, because of the accelerated principal reduction, default risk is lowered, making the Steady ARM more attractive for the lender.

Advantages of the Steady ARM

As a hybrid mortgage that combines many of the desirable features of a fixed-rate mortgage and an ARM, the Steady ARM eliminates many of the undesirable features as well, and offers the following benefits: * A payment that will never go up - Like

a fixed-rate mortgage, the payment

on the Steady ARM starts at

its maximum level. There is no

"payment shock" for the borrower

in subsequent years and less lender

concern about the borrower's ability

to repay the mortgage if interest

rates rise; * The borrower benefits when interest

rates stay down or drop - If interest

rates don't hit the Steady ARM's

caps, the borrower may have the option

of reducing the term of the

mortgage or lowering his or her

monthly payment. With a conventional

fixed-rate mortgage, the borrower

usually only has the option to

reduce the term, not the monthly

payment. The Steady ARM allows

the borrower to benefit from low interest

rates without having to renegotiate

the terms of the mortgage.

Thus, refinancings are less likely

with a Steady ARM than with a

fixed-rate mortgage; * Rapid principal reduction - Faster

repayment of principal under the

Steady ARM decreases default risk,

increases equity buildup and increases

lender cash flow. The duration

of a Steady ARM will always

be less than that of a standard

ARM or conventional fixed-rate

mortgage; * No negative amortization - Many

standard ARMs give the borrower

the option of limiting year-to-year increases

in future payments if interest

rates rise substantially. This

may result in increases in the principal

balance of the mortgage during

some years. Under the Steady ARM,

negative amortization is eliminated.

Lender cash flow is immunized

from rising interest rates. * Increased flexibility for the borrower

when interest rates change dramatically - As

interest rates fall, the

spread between what the borrower

is earning on invested funds and

what he or she is paying on the

Steady ARM may increase substantially.

Accelerating the amortization

of principal reduces the borrower's

net interest payments (interest paid

minus interest earned). Similarly, if

interest rates rise, the spread may

decline (or even go negative). In

this situation, the option to reduce

payments makes more funds available

for investment - again, reducing

net interest charges. * A lower after-tax borrowing

cost - The Tax Reform Act of 1986

lowered the maximum corporate

marginal tax rate from 46 to 33 percent

and the maximum personal income

tax rate from 50 to 28 percent.

For corporations in the top bracket,

each dollar of interest saved increases

post-tax cash flow by 67 cents; for

individuals in the top bracket, each

dollar of interest saved increases

post-tax cash flow by 72 cents. The

reduction in the tax subsidy of interest

charges should stimulate corporations

and individuals to seek ways

to lower their total interest payments.

Table 1 summarizes the similarities and differences among fixed-rate mortgages, standard ARMs and the Steady ARM. [Tabular Data Omitted]

Case example

Suppose you are developing an apartment complex where your borrowing need is $100,000 per unit. Your lender has offered you a standard one-year, Treasury-indexed ARM with the term as specified in Table 2, which include a 2 percent annual rate cap and a 6 percent rate cap over the life of the loan. The worst case, as indicated in Table 3, is that your monthly mortgage payment (on a unit basis) rises from an initial $733.76 per month to $1,171.77 per month (a 60 percent increase) in just three years. And, if interest rates stay high, you'll end up paying that $1,171.77 per month for the next 27 years. [Tabular Data Omitted]

Suppose, however, you pay $1,069.49 per month from the beginning. Even if interest rates skyrocket, your monthly payment will never go up. And, while you pay a little more in the first three years, you will pay $102.28 per month less each month during the last 27 years. In a worst-case scenario, you save $26,213.87 in interest charges on each unit. And the savings are even greater if interest rates do not shoot up. For example, if interest rates stay constant, your $1,069.49 monthly payment will pay off the mortgage in about 12 1/4 years (147 months).

It is important to note that there is nothing magical about the Steady ARM. The reason it saves interest is because of the accelerated amortization of principal. Returning to Table 3, we see that the borrower has reduced the principal balance by more than $10,000 by the beginning of the fourth year, while under the standard ARM, the principal has been reduced by less than $2,000. It is obvious that a borrower could realize the savings offered by the Steady ARM by taking out a standard ARM and simply accelerating the amortization of principal. There are, however, two very important financial reasons why lenders likely would prefer to originate the Steady ARM than the standard ARM.

First, the Steady ARM amortizes principal faster. Thus, the duration of the Steady ARM is shorter than an equivalent standard ARM. The lender's cash flow is higher, earlier on, making more funds available to the lender for reinvestment. Second, default risk is substantially less under the Steady ARM than a standard ARM. At any point during the life of the mortgage, the borrower's principal balance will be less under the Steady ARM - reducing the probability of borrower default. But, even if the borrower were to default under the Steady ARM, the lender would have less funds at risk. Furthermore, because there is no "payment shock" under the Steady ARM, the lender and borrower need not worry about the effects of increasing interest rates on the borrower's ability to repay.

The twin virtues of accelerated principal amortization and reduced default risk should induce lenders to offer Steady ARMs at lower rates of interest than standard ARMs. Suppose, for example, that a lender reduces the interest rate 25 basis points for the faster principal amortization and another 25 basis points for the lower default risk. Tables 2 and 4 illustrate the terms, the payment sequence and principal balances for a Steady ARM under this scenario. With the lender having reduced his required return by 50 basis points, the monthly payment under the Steady ARM falls to $1,033.33, a drop of $36.16 from the previous example. In a worst-case scenario, this Steady ARM saves more than $40,000 in interest charges. And, if interest rates stay constant, that $1,033.33 monthly payment will pay off the Steady ARM in less than 12 1/2 years.

An alternative option for the Steady ARM borrower is to reduce his or her monthly payment each year the Steady ARM does not hit its cap. Suppose, for example, the value of the underlying index (in this case, one-year constant maturity Treasury securities) for the Steady ARM does not change from year one to year two. In effect, the rate caps for the Steady ARM have been pushed forward by one year. Thus, the Steady ARM, like the standard ARM, could still march upward to its caps, but now, starting one year later.

Even if the Steady ARM were to march to its caps, the borrower can reduce his monthly payment to $983.53. If the Steady ARM's index stayed constant until the third year, the borrower could then reduce his or her monthly payment to $936.15. Table 5 compares a Steady ARM with a standard ARM under the assumption that the index stays constant for five years and then rises dramatically for the remaining 25 years. The Steady ARM borrower has seen the monthly payment drop to $848.23. [Tabular Data Omitted]

Even with the drop in monthly payment, the Steady ARM borrower has repaid nearly $19,000 of the principal and has the comfort of knowing that the payment will never rise above $848.23 a month. By contrast, the standard ARM borrower has repaid less than $3,800 of principal and still faces the prospect of a monthly payment as high as $1,136.49.

No matter what interest rate scenario you choose, the Steady ARM borrower draws down the principal faster and is better protected against interest rate increases than is the standard ARM borrower.

The Steady ARM market

What kind of borrowers can benefit from a Steady ARM? There are many groups who could enjoy real savings: * Apartment owners renting under contract

to city, state or federal housing assistance

programs - For example, the

HUD Section 8 rental program specifies

maximum contract rents owners

may charge. If capital costs exceed

maximum contract rents, the owner's

cash flow suffers. With the Steady

ARM, an apartment owner can calculate

maximum capital costs and determine

if they will be below maximum

rent guidelines. In addition, if interest

rates do not rise to the Steady ARM's

caps, the owner may actually be able

to lower rents in the future. * Office building developers - The

surety of a fixed, monthly payment

combined with the prospect of either

reduced monthly payments in

future years or faster write-off of

mortgage principal should be attractive

to developers faced with the ups

and downs of office lease rates. Because

interest charges are less, cash

flow improves, and the developer

can offer more competitive lease

rate in future years. * Residential borrowers - The attraction

of a standard ARM for many homebuyers

is the low initial monthly payment.

The Steady ARM is not for

borrowers who hope to "grow into"

their mortgages. Sadly, those borrowers

may actually "grow out of"

their mortgages. However, the Steady

ARM should be attractive to homeowners

refinancing a high, fixed-rate

mortgage and to borrowers willing to

take some interest rate risk in exchange

for the prospect of lower future

payments or a quicker write-off.

In addition to being attractive to borrowers, the Steady ARM should see greater acceptance in the secondary mortgage markets than standard ARMs. A Steady ARM with fixed payments throughout its life should be much easier to administer (no need to calculate payment adjustments and send out adjustment notices each year) and easier to value by mortgage buyers. The rapid principal amortization and the absence of negative amortization make the Steady ARM a more liquid financial instrument while also reducing default risk.

Steady ARMs pooled to form a collateralized mortgage obligation (CMO) expose the investor to lower prepayment risk because refinancings are less likely than under standard ARMs. And investors purchasing strips of principal only (PO) securities backed by Steady ARMs will experience positive cash flow every period because negative amortization is not possible.

The starting point for negotiating the terms of a Steady ARM involves the same terms offered to the borrower under a standard ARM. In most cases, this involves specifying an initial rate; the yearly caps (and floors, if applicable); the index used for adjusting future payments (the prime rate or a Treasury rate); the margin over the index; and the length of the mortgage in years.

The Steady ARM is a product beneficial to both lenders and borrowers. And, it is easy to explain and to understand. Combining the best features of a fixed-rate mortgage and a standard ARM, the Steady ARM eliminates many of the shortcomings of both these products.

Stephen F. Thode is an associate professor of finance and director of the Murray H. Goodman Center for Real Estate Studies, College of Business and Economics, at Lehigh University in Bethlehem, Pennsylvania.

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Title Annotation: | Mortgage Products; adjustable rate mortgages |
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Author: | Thode, Stephen F. |

Publication: | Mortgage Banking |

Date: | Feb 1, 1991 |

Words: | 3111 |

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