IO Hybrid ARMs

[Hend Abuenein]

Hello David,

When trying to calculate the monthly payment in a mid term month for an IO hybrid ARM I don't know when to apply the repayment factor, or how to calculate IO payments.

Suppose there exited such a mortgage with principal of 1 million. First 5 years fixed rate period, then 10 years of IO payments, then adjustable rate period for the rest of 30 year term.

1-How do I calculate payments of 5 years?

2-If it's assuming repayment factor * principal, do I count months of 5 years or of whole term?

3-How are the IO payments calculated?

4-If rate changes within the last 15 years, how are the payments reset from rate to rate? I can't treat this as a fixed rate fully amortizing separate mortgage.

Thanks

 

[Hend Abuenein]

And...
5- what is the difference between resetting a loan, and recasting a loan?

 

[Hend Abuenein]

6- If put like this :

The opening principal balance of a loan was $250,000 with a five-year fixed rate period, a ten-year interest-only period (interest is paid monthly), and a 30-year term.

Should I always conclude that the ten year IO overlap the 5 year fixed rate, so that they both end after the 10th year of the loan's term? or not ?

 

[David Harper CFA FRM]

Hend - Do you have a model you can share, these sound like questions associated with model construction?

Otherwise, I'll have to bookmark this and input into my model (I am recording videos and writing mock exam questions, so I can't get too distracted in low testability minutiae ...) when I get a chance, it's the only way i can efficiently answer six questions ... if you don't have a model, I'll just input your assumptions into mine and upload as soon as i can. I think a model is the best way to handle this? Thanks,

 

[Hend Abuenein]

I was working with this question:

The opening principal balance was $250,000 with a five-year fixed rate period, a ten-year interest-only period (interest is paid monthly), and a 30-year term. The initial fixed rate was 4% and five years later, the interest rate increased to 5%. Another five years passed and the interest rate increased to 6% for the remainder of the term. Based on the information provided, which of the following amounts represents the total increase in monthly mortgage payments up to the first point the mortgage is recast?

Kaplan's SchweserPro 2012 Q ID # 143161

I understand the importance of what you're doing now. It's ok if you delay your reply.

Thank you

 

[David Harper CFA FRM]

Oh, thank you!, It's so much better to see the question itself I have a totally different perspective, phew. Okay, well, first, it's really not a good question, how exactly shall we interpret the question: "Based on the information provided [unnecessary, always implicit], which of the following amounts represents the total increase in monthly mortgage payments up to the first point the mortgage is recast [i can think of three definitions??]?"

1. [first 5 years] interest-only: monthly payment = 4%/12 * 250,000 = $833.33
2. [next 5 years] interest-only: monthly payment 5%/12 * 250,000 = $1,041.67
3. [next 20 years] fully amortize: monthly payment: n=20*12, I/Y = 6/12, PV = -250,000, 0 = FV, CPT PMT = 1,791.08 per month

that looks to be the scenario, I consider the question itself a bit unclear. Recast suggests T+10 years, but "up to the first point" is unclear. The weakness in this question is the wording, we shouldn't need to struggle with the language of what the question is asking, that's not healthy challenge. It appears the question wants either:

• $1,791.08 - $1,041.67 = $749.41, or more likely
• 1,791.08 - $833.33 = $957.41, the "total increase" ... the question should not be challenging due to imprecise language but due to substantive concept

do i need to consider your six questions above, is it productive for me to try and address those (later in a model)?

 

[Hend Abuenein]

Thanks David,
Only about the difference between the reset and recast. I'm still not clear.

About the ambiguous wording, GARP does a better job at that than Kaplan.
I know you wouldn't do the same in your questions by way of preparing us for it , but that doesn't change the fact that a candidate has this kind of challenge to worry about in the exam Like FRM in itself is not hard enough!

And the answer they wanted in the question was the total increase $957.

Thanks again

 

[David Harper CFA FRM]

Thanks for closing the loop. Interesting. Great points. And I do agree, btw, with your suggestion that GARP would give you a better question than this. "Recast" to my knowledge, is not formally covered (it's when you re-amortize, not necessarily just reset the rate). So, while GARP suffers some imprecisions, it is not in their nature to serve up "recast" without some further specificity, as it's pretty obvious that it could be interpreted as the 5-year mark. That difference is a little sneaky and GARP actually doesn't try to trick you, IMO. Thanks,