During periods of rampant inflation, a fixed rate of interest provides the lender with less yield than
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originally projected. Consequently, mortgagees have devised other methods to insure a satisfactory return on their investments. Lenders who employ these variations from the norm also may charge discount points for making the loan.
1. Alternative Mortgage Instruments
In the 1970s and early 1980s, the Comptroller of the Currency, the Federal Home Loan Bank Board (today the Office of Thrift Supervision), and the National Credit Union Administration authorized the federally-chartered lending institutions under their control to develop alternatives to the traditional mortgage. Moreover, the Alternative Mortgage Transaction Parity Act of 1982, 12 U.S.C.A. § 3801 et seq., preempted state law on the subject and enabled nonfederally-chartered institutions to compete effectively in the residential real estate financing marketplace by authorizing them to offer the same alternative residential mortgage instruments available from similar federally-chartered institutions. The states had three years from the passage of the Act to override this preemption. Some states reinstituted local law by doing so.
As a consequence of these regulatory and legislative measures, several significant alternatives to the traditional mortgage have been developed by institutional lenders.
Those innovative instruments that alter the standard fixed-interest-rate approach are discussed in this section. Newly developed mortgage formats that provide payment alternatives are treated later in this chapter. Neither analysis is
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intended to be exhaustive. Some existing alternative mortgage instruments are not mentioned, and additional variations constantly are being introduced.
a. Adjustable Rate Mortgage
Mortgage lenders now offer adjustable rate mortgages (ARMs) in which the interest rate rises and falls over the term of the loan in accordance with prevailing market conditions.
The market rate of interest is gauged by a predetermined index—some recognized economic indicator reflecting changes in the cost of obtaining mortgage money in the local, regional, or national market. The parties may guard against extreme interest rate fluctuations by establishing floor and ceiling limits.
ARMs, sometimes referred to as variable rate mortgages (VRMs), may be structured in an almost infinite number of ways. Variations exist not only with respect to the index and the use of floors and ceilings, but also as to the frequency and amount of each interest rate adjustment and the way in which interest increases are paid. Moreover, an ARM may be drafted to include other flexibility features such as a graduated payment provision.
Some ARMs include another noteworthy feature. If increases in the interest rate are added to the principal obligation rather than reflected in increased monthly payments or extended maturity, the phenomenon of negative amortization may occur. That is, over time the principal balance of the loan may increase instead of decrease.
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A study conducted by the Federal Home Loan Mortgage Corporation (now Freddie Mac) revealed that ARMs had achieved a prominent position in the mortgage-financing marketplace by the early 1980s. The ARM’s share of the residential mortgage market has varied over the years depending upon inflation and the volatility of interest rates. During periods of moderate inflation and relative interest rate stability, ARMs tend to become less popular with borrowers.
For a time, an unsettling development in the case law made ARMs less attractive to purchasers of mortgage loans on the secondary mortgage market. Several courts concluded that ARM notes were nonnegotiable on the ground the notes did not contain an obligation to pay a “sum certain.” See UCC §§ 3–104(1)(b), 3–106 (pre–1990). Assignees of such nonnegotiable instruments are not eligible to receive the favorable treatment available under Article 3 of the UCC for assignees of negotiable instruments. See Ch. 7, pp. 137–147 (discussing defenses available against assignees and payment problems after assignment). Experts in the field, therefore, called for amendment of the UCC to include ARM notes within the definition of negotiable instruments. In 1990, the UCC was revised to so provide. See UCC § 3–112(b). Consequently, the ARM-negotiability issue has been resolved.
b. Price Level Adjusted Mortgage
A mortgage format often used in other parts of the world to insulate lenders against inflation is the
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price level adjusted mortgage (PLAM), also known as an indexed mortgage (IM). This
instrument deals with the problem of inflation by tying the outstanding principal to an economic index. Thus, the interest rate remains constant over the term of the loan, but the loan principal varies. In this sense, a PLAM is the opposite of an ARM.
An advantage of the PLAM to the mortgagor is that it bears a low interest rate because inflation need not be factored into the rate of return required by the lender. On the other hand, the PLAM’s primary drawback for the borrower is that it produces negative amortization which is usually covered by increased monthly payments.
c. Shared Appreciation Mortgage
Shared appreciation mortgages (SAMs) are designed to insure mortgagees of an adequate return during inflationary times and to provide an alternative form of financing for individuals who otherwise might be unable to obtain a mortgage loan. SAMs combine aspects of the standard fixed-interest-rate mortgage with a novel type of return to the lender. Typically, SAMs bear a fixed-interest-rate well below current market rates thereby enabling a greater number of individuals to qualify for this form of financing than for standard fixed-interest-rate mortgages or ARMs. The SAM instrument also provides that the mortgagee will receive a portion (e.g., one-third) of the amount the mortgaged property appreciates in value. The lender’s fractional share of the appreciation is paid when the property is sold
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or at the end of a certain period (e.g., ten years), whichever comes first. This share is often called contingent interest.
Although the SAM has appeal to both mortgagees and mortgagors, its use raises a myriad of issues: How does one determine the amount of appreciation? How are improvements made by the mortgagor factored into the calculation of appreciation? If the mortgagor does not sell the property before the lender’s share of appreciation must be paid, will satisfactory refinancing be available? These and other questions cloud the SAM picture and lead authorities to draw differing conclusions regarding its future in the residential mortgage marketplace.
2. Buy–Down Mortgage
Mortgagees generally are willing to make belowmarket-interest-rate loans if they receive sufficient upfront money to offset the reduced interest rate of return. A mortgage loan made on this basis is called a “buy-down.” Real estate developers and other sellers may use the buy-down technique to make their residential properties more marketable by paying an institutional lender to offer low-interestrate financing to purchasers. In such case, the interest buy-down is typically for only a short term, such as a year or two;
thereafter the interest rate returns to the market level.
3. Revenue/Equity Participation
As a hedge against inflation, mortgage lenders sometimes demand a portion of the revenue generated
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by the project being financed. When this occurs, the lender is said to receive contingent interest or an “equity kicker.” Under such an arrangement, the lender typically is entitled to a percentage of gross income or net profits in addition to the specified interest.
Mortgagees may go even further and obtain an ownership interest in the project.
Several types of such equity participations exist. The lender may become directly involved by entering a joint venture with the developer or by taking an ownership interest in the entity that controls the project. Equity participation should be distinguished from loan participation discussed earlier. See, Ch. 2, p. 27 (analyzing loan participation).