Background
==========

I am seeking independent confirmation regarding a debate I am involved in.

The question relates to typical home-style mortgages.


Question
========

If a floating rate mortgage is taken out and the base interest rate
changes, how will the interest and principal changes be affected?

Will the principal payments be unaffected and interest payments
fluctuate, or;

will the total payments remain the same so that the principal is
repaid faster/slower, thereby shortening/lengthening the tenor of the
loan, or;

will the mortgage principal profile be recalculated (allowing p+i to
change) on each period so that the remaining principal is repaid
according to a new mortgage calculation for the remaining term of the
loan, or;

none of the above (please specify)


Deliverables
============

Answer. Sourcing is not strictly necessary if you speak with total
conviction. Otherwise, a source, URL or even book reference would be
helpful.


Pay and Scoring
===============

Pay is $5 flat fee.
Scoring ***** for a quick answer.

Hi asiatechnicals,

Variable rates do the following:

Assuming constant payment amount (this is the standard way that banks
work variable rate mortgages/loans), here's what happens:

Interest rates go UP - ratio of principle to interest goes DOWN. That
means, for example, if you pay $1000 a month, and you HAD been paying
$700 for interest and $300 for principle, and the rates went UP, then
you might be paying $730 for interest and $270 for principle.

Interest rates go DOWN - ratio of principle to interest goes UP. That
means, for example, if you pay $1000 a month, and you HAD been paying
$700 for interest and $300 for principle, and the rates went DOWN,
then you might be paying $670 for interest and $330 for principle.

Rates go down, principle repayment goes up, time to pay off the loan
DECREASES.

Rates go up, principle repayment goes down, time to pay off the loan
INCREASES.

Almost ALL variable rate mortgages operate in this way. Unless you
have a very strange variable mortgage, this is how it works.

Hope that helps!

Legolas-ga

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Request for Answer Clarification by asiatechnicals-ga on 06 Mar 2003 01:45 PST

Thanks for the quick response Legolas-ga.

I am a bit puzzled at your answer. I and my colleague in our project
finance department would be inclined to agree with Xarqi-ga, because
your solution would expose the lender to increasing risk as the loan
is back-ended by a ballooning interest rate environment and in extreme
cases could extend the repayment period close to, or beyond the asset
life.

Xarqi-ga's solution would increase the near-term default risk, if the
borrower cannot service the increased p+i, but that reflects the
changing risk environment and protects the lender, because the
borrower would be forced to refinance the loan on the lender's terms.

Could you therfore, by way of clarification, tell me about your
'typical' mortgage.  For example: What country is it? Is it a home
loan or a project loan? Upon what do you base your opinion?

---

Clarification of Answer by legolas-ga on 06 Mar 2003 08:52 PST

I am a Licenced Mortgage Agent in Alberta (Canada). Given my
assumption of a constant payment amount, it is 100% accurate. If you
allow the payment to vary, then you will pay more or less per month as
the interest goes up or down. However, the ratio of interest/principle
changes in relation to each other..

So, if the rate goes up, then your payment goes up. So, $1000 payment
goes to $1100, and your interest payment goes from $700 to $770 and
your principle goes from $300 to $330.

Legolas-ga

Fivestarts for your quick response and clarification.  I'll have a
think about your response.  I think xarqi-ga and I were thrown by the
statement about the tenor changing, which is not what we had expected.
Nevertheless, you are a licenced professional in this field and it
answers the question asked.

The third option - generally, but of course, it depends on the
specific contract.
That is - the constant amount per period at the new rate to repay the
loan in the remaining time is calculated and this is the new payment.

Thanks xarqi-ga. Nevertheless, I'll leave the question open for a
Researcher to answer.

Having read legolas-ga's answer I can only assume that what is "usual"
differs from place to place.  Where I am, it is usual for the term of
a mortgage to be fixed, so that if the interest rate changes, the
periodic payments change.  It must be that in legolas-land, the term
of the mortgage is considered more flexible than the amount of the
regular payment.

As always, "your mileage may vary" and it's best to read the fine
print.

I know that in most, if not all, states in the U.S. the answer given
is incorrect. A 30 year mortgage lasts for 30 years. If you have a
variable rate mortgage and the rate changes, your payment also
changes. This is why you must determine if you can afford the payments
in the "worst case scenario." Under the terms given in the answer, the
mortgage could theoretically go on forever as the payments may not
cover any principal and may not even cover the total interest which
would mean the balance outstanding would be increasing over the life
of the loan, not decreasing (a bank would obviously never allow this
to happen.)

I would respectfully suggest that you request a refund because the
"official" answer is incorrect. My comment and that given in another
comment are correct.

Researcher says: "I am a Licenced Mortgage Agent in Alberta (Canada).
Given my
assumption of a constant payment amount, it is 100% accurate." 
However, that assumption is wrong in most home mortgage loans in the
U.S. which would make the answer somewhat less than 100% accurate,
more like 0% accurate. Note that in the answer clarification, he goes
on the assumption that payments are constant, but then uses numbers
that show otherwise.

Researcher wrote: "Rates go up, principle repayment goes down, time to
pay off the loan INCREASES. Almost ALL variable rate mortgages operate
in this way.", but then he changed his mind in the clarification.
Perhaps the answerer is not knowledgeable in home mortgages?