Business Glossary

residential mortgage in which the interest rate floats up or down according to changes in an index rate. Adjustable-rate mortgages usually have lower initial interest rates than fixed-rate mortgages, so there is an opportunity for substantial interest savings over the life of the loan if rates remain steady or decline. Adjustable-rate mortgages first appeared in the 1960s but did not gain wide popularity until the 1980s, when lenders began promoting ARM loans as a low-cost alternative to thirty-year, fixed-rate mortgage loans. ARMs are structured with built-in limits, called interest-rate caps, to cushion the impact of interest-rate fluctuations on loan payments in any year or over the life of the loan. An adjustablerate mortgage with an initial rate of 41/2%, an annual cap of 1%, and a lifetime cap of 4% will have an interest rate no higher than 91/2%. ARM rates are usually adjusted every six months or once a year, depending on the type of loan. Loan payment caps do not limit the amount of interest the lender is earning, which means an ATM loan may cause negative amortization if the accrued loan interest exceeds the interest actually paid.

When computing the loan interest rate, the lender adds a margin to an index rate selected as the benchmark, or base rate. The most common indexes are the Constant Maturity Treasury (CMT) index of Treasury issues with the same final maturity; the Treasury Bill index,based on the current auction yield of 3-month, 6-month or 1-year Treasury bills; the 12-month Moving Treasury Average, computed from the Treasury CMT index for the previous 12 months; the 11th District Cost of Funds Index, the weighted average cost of savings accounts, Federal Home Loan Bank advances, and other sources of funds paid by savings institutions in the 11th Federal Home Loan Bank district; the London Interbank Offered Rate (LIBOR), the rate major London banks charge each other for borrowings; the certificate of deposit (CD) index, the average rate earned by nationally traded certificates of deposit; and the bank prime rate, the rate banks charge their prime business borrowers. The most popular are the Treasury indexes, the 11th District Cost of Funds Index, and the LIBOR index. A popular variation of the adjustable-rate mortgage is the HYBRID ARM, in which the loan has a fixed interest rate for 3 to 10 years and thereafter adjusts according to market conditions.

residential loan with a Fixed Interest Rate set below market rates, with the lender entitled to a specified share of appreciation in property value over a specified time interval.

fixed rate mortgage with low payments in the early years, and higher payments later on, designed to meet the financing needs of young home owners with growing incomes. Also known in the trade as a "Jeep" mortgage. The most popular versions of the GPM are 30-year mortgages with payments that rise by a fixed amount each year for the first five to ten years and then level off. Lenders usually charge a slightly higher rate on a GPM than a conventional mortgage, because part of the interest due is deferred until the later years. Even though borrowers ultimately pay more for a GPM, the lower initial payments make this kind of mortgage more affordable to home buyers whose incomes could not support a conventional mortgage loan. A variation is the adjustable rate graduated payment mortgage, which has an interest rate that is adjusted every three to five years.

mortgage loan in which the payment is increased by a specific amount each year, with the additional payment amount applied to principal retirement. As a result of the added principal retirement, the maturity of the loan is significantly shorter than for a comparable level-payment mortgage.

a type of mortgage loan, commonly used in Canada, in which the amortization of principal is based on a long term but the interest rate is established for a much shorter term. The loan may be extended, or rolled over, at the end of the shorter term atthe current market interest rate.

Example: Abel obtains a rollover loan. The amortization term is 30 years. The interest rate is 9% for 2 years. After 2 years, Abel mustrenew the loan at the going interest rate or refinance with a new loan.

fixed-rate mortgage with loan payments every two weeks, rather than monthly as with most residential mortgages. The loan payment is one-half that of a regular 30-year mortgage, but the accelerated repayment allows the borrower to pay off the mortgage much faster than the mortgage with monthly amortization. The borrower makes 26 half-payments a year or one extra full-month payment. The result is accelerated buildup of equity and lower interest expense over the loan term. A biweekly 30-year mortgage, if held to maturity, is retired in approximately 20 years, yielding a savings of more than $142,000 in interest for every $100,000 borrowed.

mortgage in which the borrower receives a below-market rate of interest in return for agreeing to share part of the appreciation in the value of the underlying property with the lender in a specified number of years. If the borrower does not want to sell at that time, he or she must pay the lender its share of the appreciation in cash. If the borrower does not have that amount of cash on hand, the lender may force the borrower to sell the property to satisfy their claim.

variation of an adjustable-rate mortgage (ARM)l oan that has a fixed rate of interest in the early years of the loan. The initial fixed-rate period in a hybrid ARM can be set for 3 years, 5 years, 7 years or 10 years, after which the loan converts to an adjustable-rate mortgage and the interest rate is adjusted once a year according to changes in market conditions for the remaining term of the loan. Hybrid ARMs are ideal for borrowers who plan to live in their homes for a relatively short period, want a lower monthly payment, or would like to qualify for a larger mortgage. The 5/1 hybrid ARM, a popular choice, has a fixed rate of interest for the first five years; in subsequent years the rate is adjusted annually.

residential mortgage combining a first lien mortgage financing 80% of the home's value and a second lien mortgage "piggybacked" onto the original mortgage. Both loans are closed at the same time and by the same lender. Piggyback mortgages have their advantages, but there are offsetting costs. Taking out a second lien mortgage (normally for 10 to 15% of the house value) enables the borrower to avoid paying private mortgage insurance. The biggest disadvantage is the second lien mortgage often has an interest rate one to two percentage points higher than the first lien mortgage. Also called a combination mortgage, 80/10/10 mortgage, or 80/15/5 mortgage, depending on the size of the borrower's initial down payment.

form of Graduated Payment Mortgage in which the rate of interest paid remains fixed, but the outstanding balance is adjusted for inflation according to an appropriate price index. Periodically, according to a time schedule approved by both borrower and lender, the outstanding balance owed is revised for appreciation in property values and monthly payments are revised accordingly.

popular variation of the fixed-rate mortgage that pays off a home mortgage over a 15-year period. The monthly payments are slightly higher than those in a regular 30-year mortgage, but a greater portion of each loan payment is applied to the principal, so the interest actually paid is significantly less than with a regular 30-year loan at the same interest rate and amount borrowed. Adisadvantage for borrowers with growing incomes is the 15-year mortgage lowers the amount of tax-deductible interest paid over the life of the loan.

arrangement whereby a homeowner borrows against home equity and receives regular payments (tax-free) from the lender until the accumulated principal and interest reach the credit limit of equity; at that time, the lender either gets repayment in a lump sum or takes the house. Reverse mortgages are available privately and through the Federal Housing Administration (FHA). They are appropriate for cash-poor but house-rich older borrowers who want to stay in their homes and expect to live long enough to amortize high up-front fees but not so long that the lender winds up with the house. Lower income but greater security is provided by a variation, the Reverse Annuity Mortgage (RAM).

type of fixed-rate, 30-year mortgage, that adjusts the borrower's interest rate after an initial five or seven year period. The borrower pays less principal in the early years of the mortgage. After five years have passed (seven years in some loans), the mortgage interest rate is adjusted to the prevailing fixed-rate mortgage for the remainder of the mortgage.

mortgage that does not fully repay principal and interest by the maturity date. A balloon mortgage, also known as a nonamortizing mortgage, has a lower debt repayment than a conventional fixed rate mortgage loan, and thus is attractive to new home buyers whose incomes may be expected to increase, or to people who expect to sell their property and pay off the loan in a much shorter period than if they had borrowed with a conventional, fully-amortized mortgage. The two types of balloon mortgages are the interest-only loan -a mortgage with payments that cover only the interest owed and the partially amortizing mortgage, also known as a rollover mortgage-a short-term mortgage that must be refinanced at the end of a stated term, usually three to five years.

mortgage with a fixed interest rate and growing payments. This technique allows the homeowner to build equity in the underlying home faster than if they made the same mortgage payment for the life of the loan. Borrowers who take on GEM loans should be confident in their ability to make higher payments over time based on their prospects for rising income.