Most mortgages that homebuyers use offer adjustable interest rates that vary based on certain market indices or fixed interest rates. With these mortgages, the balance remains fixed unless the homeowner uses an interest-only loan or reverse mortgage and capitalizes the interest payment. With a less commonly used mortgage, the price level-adjusted mortgage, the interest rate remains fixed, but the outstanding principal balance fluctuates.
Price level-adjusted mortgages, often referred to as PLAMs, are mortgages with payments that vary due to a fixed interest rate and an adjustable principal balance. Because they adjust with inflation or deflation -- typically calculated using the consumer price index -- PLAM payments retain their real purchasing power. Whereas most traditional mortgages have fixed payments with price levels that remain constant, PLAMs have payments that fluctuate with price levels that fluctuate.
Say a homeowner has a traditional 30-year, $500,000 mortgage at a 5 percent fixed rate. Her monthly payment on the mortgage will equal approximately $2,684.11 per month for the term of the mortgage. If the homeowner instead used a PLAM, the lender may initially offer a significantly lower rate of 1.25 percent. Therefore, the initial monthly payment would equal $1,666.26. However, the PLAM’s monthly mortgage payments will change based on inflation adjustments made to the outstanding principal. Therefore, the $1,666.26 payment will likely change each month. The homeowner and her lender specify in the loan agreements how often the lender will make inflation adjustments to the principal, typically once monthly.
According to proponents of PLAMs, they eliminate the affordability problem. Lenders that offer price level-adjusted mortgages structure deals with borrowers that provide the borrower with a consistent, low interest rate over the life of the mortgage loan. The borrower benefits from lower interest rates because the lender does not need to factor inflation increases into the mortgage,. The lender indirectly benefits from the home's rising value, which protects it against the eating away by inflation of the mortgage payments it receives.
The balance on a price level-adjusted mortgage fluctuates regularly, resulting in monthly payments that often change each month. This can make it difficult to set aside specific funds for mortgage payments. In addition, many individuals may have difficulty understanding the principal changes attributed to equity and those attributed to price level adjustments. Those on fixed incomes may be poor candidates for PLAMs in economic environments with rising inflation because their monthly payments will rise.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.