Video Captions: Algebra Applications: What Is an Adjustable Rate Mortgage?
[Music]
Narrator: The mortgage crisis of 2008 was due in part
to an increasing number of sub prime mortgages.
Because these types of mortgages are often given to
those with low credit scores, one consequence of this is an
increase in the number of loan defaults.
Defaulting on a loan means that you stop paying it back.
When a homeowner defaults on a loan the bank takes ownership
of the house.
So before resorting to a loan default a homeowner has
the option of selling their house.
This is almost always the better option since defaulting
on a loan will decrease your credit score even more, making
it all the more difficult to get future loans.
One of the reasons that mortgage defaults increased is
due to the combination of two things: adjustable rate
mortgages and the decrease in the value of real estate.
Let's take a look at adjustable rate mortgages.
We saw that those with a low credit score often pay a
higher interest rate, but this also results in a much higher
monthly higher payment.
All to often these higher payments prevent people from
taking out these loans.
One type of mortgage that helps with this problem is an
adjustable rate mortgage.
This is how they work.
For the first three to five years of the mortgage the
homeowner pays the loan at a lower rate.
The lower rate results in a lower monthly payment.
But after this period of time the interest rate changes to a
higher rate.
The idea is that during this early period the homeowner has
an opportunity to improve his or her credit score.
When this happens then they can refinance their mortgage
to take advantage of lower interest rates.
Otherwise the homeowner will be paying a much higher
mortgage payment every month.
Let's use the TI-Nspire to analyze how the
payments change.
Open the amortization template that you previously created.
Suppose that a homeowner takes out a two hundred thousand
adjustable-rate mortgage.
For the first five years the rate will be four point five
percent, but in the sixth year the rate increases to seven
point five percent.
Change cell B1 to two hundred thousand.
Press ENTER.
Then change cell B2 to four point five.
Press ENTER again.
If a homeowner were to pay this mortgage for thirty
years, then the monthly payment would be one thousand
thirteen dollars and thirty-seven cents
every month.
But keep in mind that this is an adjustable-rate mortgage
that has the rate for five years.
Since five years is equal to sixty months scroll down to
find the sixtieth mortgage payment.
The value in cell C60, one hundred and eighty-two
thousand, six hundred and forty-four is the
loan balance.
This is how much money you still owe the bank on the
original two hundred thousand dollar loan.
Make a note of this number.
From the sixty-first payment on your interest rate changes
to seven point five percent.
Go back to cell B1.
Input the value from cell C60 and press ENTER.
This represents the new mortgage amount.
Input the value of the new interest rate.
You're almost done.
You now need to modify the sequence because it is set up
to calculate three hundred and sixty payments, but after five
years you have three hundred payments left.
Go to the formula line of column C.
Select OK and press ENTER.
You will be asked if you want to replace the data currently
in the column, press ENTER.
The new mortgage payment is one thousand three hundred
forty-nine dollars and seventy-two cents.
So although the mortgage interest went up three
percent, the monthly payment goes up by over
thirty percent.
The extra three hundred and thirty-six dollars a month
turns into more than forty-one thousand dollars over the
entire life of the loan.
So adjustable rate mortgages are good during low interest
periods, but these loans could become very difficult to pay
back during the periods of higher interest.
A common strategy for avoiding the higher monthly payments
was for homeowners to sell their house.
This is a good strategy if the price of the house
has increased.
This graph shows the median price of houses in Los Angeles
County from 1990 to 2008.
Buying a house during the 1990's and selling it before
2006 would have resulted in a profit.
But as you can see from the graph selling a house after
2006 would have resulted in losing money.
Let's take a look at the situation in more detail.
This data table shows the home prices from the graph.
Suppose somebody takes out an adjustable rate mortgage for a
house in 2004 and pays the median price.
Furthermore, suppose that the interest for the first five
years is four percent, and after that the interest rate
adjusts upward to seven point five percent.
Let's investigate.
Go to cell B1 and input the mortgage amount and then input
the interest for the first five years in cell B2.
Go to the formula in the formula row of column C and
change the mortgage period to three hundred and
sixty months.
The monthly payment is two thousand one hundred and
thirty one dollars and nine cents.
Scroll down to see the loan balance after sixty months.
The loan balance is four hundred and four thousand,
five hundred and twenty-two.
Go back to cells B1 and B2 and adjust the loan balance and
the interest rate, then adjust the sequence formula.
In 2008 the new monthly payment would be two thousand
nine hundred and eighty-nine dollars and
thirty-eight cents.
This represents a dramatic increase of about forty
percent in the monthly mortgage payment.
To make matters worse, suppose this homeowner tried selling
the house.
According to the chart the homeowner would get three
hundred and forty thousand dollars.
But according to the amortization table the amount
owed on the loan would be roughly four hundred
thousand dollars.
This means that the owner would still be sixty thousand
dollars in debt.
Between paying forty percent more every month for a
mortgage payment, or selling the house at a loss, the
homeowner is in a difficult position.
Many homeowners in this situation would choose to stop
the mortgage and default on the loan.
Throughout 2006 and 2008 many homeowners found themselves in
this very position, owing more on the house than it was
worth, otherwise known as being under water.
Let's take a step back and see how this affected the
overall economy.
A bank loans money for you to buy a house and in turn you
give money back to the bank.
This cycle of money allows the bank to lend to
other homeowners.
The banks also sell mortgages to larger banks and government
institutions, further allowing banks to lend more money
for mortgages.
The flow of money from homeowners to banking
institution makes up a lot of economic activity.
When foreclosures accelerated from 2006 to 2008 the flow of
money slowed, and in some cases stopped.
This created a credit freeze because not enough money was
flowing through the system.
The reason this became a global crisis is because many
of those mortgages were repackaged and sold to
International banks, and thus a period of great financial
unrest began.
[Music]