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Survey the different residential mortgage products.

FRM® Part I · Financial Markets and Products · Mortgages and Mortgage-Backed Securities · FRM1.FM.18.a

The idea

A residential mortgage is a loan secured by a home, and the products differ in how the rate and balance behave. A fixed-rate fully amortizing loan has a constant payment. An adjustable-rate mortgage resets to an index plus a margin, subject to initial, periodic and lifetime caps. A 5/1 hybrid is fixed for five years and then adjusts yearly. An interest-only loan pays no principal for an initial period and then recasts over the remaining term, so the payment jumps. An option ARM allows payments below the interest due, which causes negative amortization. A balloon loan leaves a large balance due at maturity. Credit tiers are prime, Alt-A (limited documentation) and subprime. FHA-insured and VA-guaranteed loans back Ginnie Mae pools. Conforming loans back Fannie Mae and Freddie Mac pools, and jumbo loans go to the non-agency market. The exam point is to link each product to its cash-flow risk.

A practice question

From the question bank, with the reason each wrong option is wrong.

A borrower takes out a 5/1 hybrid adjustable-rate mortgage. Which description is correct?

  1. The rate is fixed for five years and then resets annually to an index plus a margin. - correct
  2. The rate resets every year for five years and is then fixed for the remaining term.Why not: Reverses the order: the first number is the initial fixed period, not a period of adjustments.
  3. The rate is fixed for one year and then resets every five years to an index plus a margin.Why not: Swaps the two numbers: the 5 is the fixed period and the 1 is the reset interval.
  4. The loan pays interest only for five years and carries a one-year balloon at the end.Why not: Confuses a hybrid ARM with interest-only and balloon loans; a hybrid still amortizes and simply reprices.

In X/Y hybrid notation the first number is the initial fixed period in years and the second is the reset frequency afterwards. A 5/1 is fixed for five years and then adjusts annually.

A harder one

A borrower has an option ARM with a balance of USD 300,000 and a rate of 6.00% per year paid monthly. This month she chooses the minimum payment option of USD 1,200. The balance after this payment is closest to:

  1. USD 298,800Why not: Subtracts the whole payment from the balance as if it were all principal, ignoring that interest accrues first.
  2. USD 299,700Why not: Sign error: subtracts the 300 interest shortfall instead of adding it to the balance.
  3. USD 300,300 - correct
  4. USD 301,500Why not: Adds the full month of interest to the balance and ignores the payment made.

Interest due is 300,000 x 0.06 / 12 = 1,500. The payment of 1,200 is short by 300, and the unpaid interest is added to the balance: 300,000 + 300 = 300,300. This is negative amortization.

The hardest tier

A borrower takes a 30-year, USD 400,000 interest-only mortgage at a fixed 6.00% per year with monthly payments. It is interest-only for the first 10 years and then amortizes with level payments over the remaining term at the same rate. The monthly payment immediately after the interest-only period is closest to:

  1. USD 2,398Why not: Amortizes the balance over the full 360 months instead of the remaining 240.
  2. USD 2,866 - correct
  3. USD 2,000Why not: Keeps the interest-only payment; the loan must start repaying principal at recast.
  4. USD 3,667Why not: Adds straight-line principal (400,000 / 240) to interest on the original balance; a level payment needs the annuity formula.

During the IO period the payment is 400,000 x 0.005 = 2,000. At recast the full balance amortizes over the remaining 240 months: 400,000 x 0.005 / (1 - 1.005^-240) = 2,866, a payment shock of about 43%.

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