Question

Briefly describe 2/28 ARM (or other forms of subprime mortgages that reduce monthly payments e.g. “interest only loans”)

1) identify who might benefit from this kind of mortgage and

2) explain why widespread use of this kind of mortgage might create risks for banks

Answer 1

It shall be noted that a 2/28 ARM is a type of 30-year home loan for which for the initial two-year, the interest rate is fixed and after this 2-year period, the interest rate becomes floating such that it is some index plus a margin. The initial fixed interest rate that lasts for 2 years is below average for conventional mortgages, but the adjustable rate rises significantly overnight at the end of 2nd year. For example, a loan of $300,000 on conventional 30-year mortgage would lead to the homeowner's monthly payments of $1610. But a 2/28 ARM with an initial interest rate of 3-percent would require homeowner's monthly payments of just $1265.

If at the end of 2 year, if the LIBOR is 2.7 and the margin is 1.5, the interest rate would increase by 4.2 percent, to 7.2 percent (given 3% was the interest rate for the first 2 years) and this leads to the homeowner's monthly payment of $2036 (60% increase overnight)

1) In the short-run, the borrowers with poor credit history might benefit from this kind of mortgage as for the first 2 years, borrowers would have to pay monthly installment lower due to interest rate being below average interest rate that exist for conventional mortgage. The objective & plan was to take advantage of the low interest rate for first 2 years, then refinance after two years to either a conventional fixed-interest rate mortgage or to a new adjustable mortgage, if conventional fixed-interest rate mortgage is not within reach.

2) It shall be noted that 2/28 ARM are generally subscribed by people with poor credit rating. In case if the people would not be able to refinance at end of 2 years, they would more likely make their due payments by sell their homes for the value of the outstanding loan. This would increase the risk of defaulting and with increased supply of home for sale, home values may get plummeted and the bank would not be possible to even recover the principal amount of the loan. The non-performing assets of the bank would increase leading to financial crisis.