Chapter 6:Chapter 6:Residential Financial Residential Financial AnalysisAnalysis

Incremental Borrowing CostIncremental Borrowing Cost– Two loans, one for a greater sum Two loans, one for a greater sum

than the other. How should than the other. How should borrower compare the alternatives? borrower compare the alternatives? Calculate marginal or incremental Calculate marginal or incremental cost of borrowing.cost of borrowing.

Loan 1: $80,000, 12%, 25 years = $ Loan 1: $80,000, 12%, 25 years = $ 842.58/mo. 842.58/mo.

Loan 2: Loan 2: $90,000$90,000, 13%, 25 years= , 13%, 25 years= $ $ 1,015.05/mo.1,015.05/mo. $10,000 $10,000 $ $ 172.47172.47

IRR? -10000=PVIRR? -10000=PV 172.47=PMT172.47=PMT 300 = n 300 = n

IRR = 20.57% = IRR = 20.57% = incremental cost of extraincremental cost of extra $10,000$10,000

What if loan is repaid early What if loan is repaid early (say after 5 years)?(say after 5 years)?

Loan 1: OLB after 5 years = 76,523Loan 1: OLB after 5 years = 76,523 Loan 2: OLB Loan 2: OLB = = 86,64086,640

10,117 10,117 IRR? IRR? -10,000=PV-10,000=PV

172.47=pmt172.47=pmt 10,117=FV 10,117=FV=OLB Differential=OLB Differential 60 =n 60 =n IRR = 20.83% IRR = 20.83%

If there were origination If there were origination fees?fees?

Loan 1:Loan 1: 1,600 Fees1,600 Fees Loan 2:Loan 2: 2,700 Fees2,700 Fees IRR? 8,900=PV= IRR? 8,900=PV= {(90,000-80,000)-{(90,000-80,000)-

(2,700-1,600)}(2,700-1,600)} 172.47=pmt172.47=pmt 300=n 300=n

IRR = 23.18%IRR = 23.18%

LOAN REFINANCINGLOAN REFINANCING

If interest rates fall, should loan be If interest rates fall, should loan be refinanced?refinanced?

Compare costs of refinancing to benefits Compare costs of refinancing to benefits or savings. Calculate IRR or NPV.or savings. Calculate IRR or NPV.

Five year old loan ($80,000 orig., 30 Five year old loan ($80,000 orig., 30 years, 15%) vs. new loan of $78,976.50 years, 15%) vs. new loan of $78,976.50 (OLB of old loan) 25 years, 14%.(OLB of old loan) 25 years, 14%.

Loan Refinancing (con’t)Loan Refinancing (con’t)

Costs = $4,105Costs = $4,105 Benefits = pmtBenefits = pmtoldold - pmt - pmtnewnew

(1011.56 - 950.69= 60.87)(1011.56 - 950.69= 60.87) IRR? : 4,105=PVIRR? : 4,105=PV

60.87=pmt 60.87=pmt 300=n 300=n

IRR = 17.57%IRR = 17.57% NPV = ? depends on borrower’s req’d NPV = ? depends on borrower’s req’d

rate of return.rate of return.

What happens if loan is What happens if loan is repaid early?repaid early?

Assume loans were prepaid after 15 Assume loans were prepaid after 15 years (old loan) or 10 years after years (old loan) or 10 years after refinancing.refinancing. IRR? :IRR? :4,105 = PV 4,105 = PV 60.87 = pmt60.87 = pmt 889 = FV 889 = FV (OLB(OLBoldold-OLB-OLBnewnew)=(72,275-71,387) )=(72,275-71,387)

120 =n 120 =n IRR = IRR = 14.21%14.21%

What if refinancing costs can What if refinancing costs can be financed?be financed?1 Simply compare new payments (based on OLB Simply compare new payments (based on OLB

& refinancing costs) to old payment. If new & refinancing costs) to old payment. If new payment is lower, refinance.payment is lower, refinance.

2 Alternatively, calculate the effective cost of Alternatively, calculate the effective cost of refinancing.refinancing.

IRR?:IRR?: 78,976.50 = PV 78,976.50 = PV (loan disbursment)(loan disbursment)

1,000.101,000.10= = pmt pmt (OLB &Financed (OLB &Financed refinance refinance cost)=(78,976.50+4105)cost)=(78,976.50+4105)

300 = n300 = n

IRR = 14.81%IRR = 14.81%

What if the borrower wanted to What if the borrower wanted to refinance for a lower interest refinance for a lower interest rate, but wishes to continue rate, but wishes to continue making their current monthly making their current monthly payment? The impact of this payment? The impact of this approach would be to shorten approach would be to shorten the payback period. Let’s revisit the payback period. Let’s revisit the first refi example. The the first refi example. The interest rate drops from 15% to interest rate drops from 15% to 14%, and a refi fee of $4105 is 14%, and a refi fee of $4105 is charged. The original loan had charged. The original loan had 25 more years (300 months) until 25 more years (300 months) until maturity. How long would it take maturity. How long would it take to amortize the outstanding loan to amortize the outstanding loan balance at the 14% rate?balance at the 14% rate?

PV= OLB= $78,976.50PV= OLB= $78,976.50PMT= $1011.56PMT= $1011.56I= 14%I= 14%N=?= 208.43months vs. the 300 N=?= 208.43months vs. the 300

months remaining on the original loanmonths remaining on the original loan

What would the lender’s yield be on the What would the lender’s yield be on the refi loan?refi loan?

PV= $74,871.50 = (78976.50 OLB – PV= $74,871.50 = (78976.50 OLB – 4105 refi fee)4105 refi fee)

PMT= $1101.56PMT= $1101.56N= 208.43 monthsN= 208.43 monthsI= ? = 14.99%I= ? = 14.99%

Early Loan RepaymentEarly Loan Repayment: : Lender InducementsLender Inducements

If interest rates rise, lenders would If interest rates rise, lenders would like to retire old loans. Lender might like to retire old loans. Lender might offer to discount loan if prepaid.offer to discount loan if prepaid.

Old loan $75,000; 8%; 15 years. 10 Old loan $75,000; 8%; 15 years. 10 years later OLB is $35,348. If current years later OLB is $35,348. If current rates are 12% and lender offers to rates are 12% and lender offers to accept repayment of only $33,348.accept repayment of only $33,348.

What is the return to the borrower?What is the return to the borrower?

IRR?: 33,348 = PV (OLB - 2000 IRR?: 33,348 = PV (OLB - 2000 discount)discount)

716.74 = pmt (orig. loan pmt)716.74 = pmt (orig. loan pmt)

60 = n60 = n

IRR = 10.50% = return on IRR = 10.50% = return on “investment” to “investment” to buy buy back the loan.back the loan.

Market Value of a LoanMarket Value of a Loan

Simple Simple - compute the present - compute the present value of the remaining payments value of the remaining payments at the market interest rate.at the market interest rate.

Old Loan of $80,000; 10%; 20 Old Loan of $80,000; 10%; 20 years. Five years later, the OLB is years. Five years later, the OLB is $71,842. If market rates were $71,842. If market rates were 15% today, what is the loan 15% today, what is the loan value?value?

PV = ?:PV = ?: 772.02 = pmt772.02 = pmt

180 = n 180 = n

15% = i15% = i

PV = $55,161 is the “discounted” PV = $55,161 is the “discounted” value of value of the loan. the loan.

Makes sense if the borrower has Makes sense if the borrower has the $$ to pay off loan and the IRR the $$ to pay off loan and the IRR represents on attractive yield to represents on attractive yield to alternative investmentsalternative investments

Effective Cost of Two or Effective Cost of Two or more loans:more loans: Situations exist when borrower takes a second Situations exist when borrower takes a second

mortgage or perhaps assumes a loan and mortgage or perhaps assumes a loan and needs additional funds.needs additional funds.

You wish to buy a property priced at $115,000. You wish to buy a property priced at $115,000. An existing mortgage can be assumed An existing mortgage can be assumed (OLB=$75,331), payments are $726.96 and the (OLB=$75,331), payments are $726.96 and the loan will mature in 20 years. A second loan will mature in 20 years. A second mortgage for $16,669 ($115,000 x .80 - mortgage for $16,669 ($115,000 x .80 - $75,331) can be obtained at 14% for 20 years. $75,331) can be obtained at 14% for 20 years. Alternatively, the purchase can be made with Alternatively, the purchase can be made with an 80% LTV loan ($115,000 x .80) at 12% for an 80% LTV loan ($115,000 x .80) at 12% for 20 years.20 years.

Is the assumption attractive? IRR of Is the assumption attractive? IRR of combined assumption plus second combined assumption plus second mortgage?mortgage?

IRR?:IRR?: 726.96 + 207.28 = 934.24 = 726.96 + 207.28 = 934.24 = pmtpmt

240 = n240 = n

92,000 = PV92,000 = PV

IRR = 10.75%, which is lower than IRR = 10.75%, which is lower than cost of cost of First mortgage First mortgage financing financing (12%) (12%)

Usually second mortgages have short Usually second mortgages have short maturities. If the above situation called for a 5 maturities. If the above situation called for a 5 year second mortgage, would the assumption year second mortgage, would the assumption make sense?make sense?

IRR?:IRR?: 726.96 + 387.86* =1,114.82 = pmt726.96 + 387.86* =1,114.82 = pmt

*pmt. On 2nd mtg.,i=14% ,N=5YRS*pmt. On 2nd mtg.,i=14% ,N=5YRS

1-5 for 1,114.82 = n 1-5 for 1,114.82 = n

6-20 for 726.96 = n6-20 for 726.96 = n

92,000 = PV92,000 = PV

IRR = 10.29%IRR = 10.29%

Wraparound LoansWraparound Loans

Used to keep an old (low interest rate) Used to keep an old (low interest rate) loan in place. Wrap lender makes loan loan in place. Wrap lender makes loan for an amount equal to existing loan for an amount equal to existing loan balance plus the additional financing balance plus the additional financing required. Wrap lender pays off old note required. Wrap lender pays off old note and borrower pays off wraparound loan. and borrower pays off wraparound loan. Can be used in lieu of assumption and Can be used in lieu of assumption and second mortgage in an acquisition or as a second mortgage in an acquisition or as a means to borrow against equity in a means to borrow against equity in a property.property.

$90,000 = OLB old loan $90,000 = OLB old loan (8%, 15 years remaining)(8%, 15 years remaining)

$860.09 = old pmt.$860.09 = old pmt.

$150,000 = property value$150,000 = property value

$30,000 = desired new financing$30,000 = desired new financing

Options:Options:

1. New first mortgage $120,000 at 11.5% for 15 1. New first mortgage $120,000 at 11.5% for 15 years. years.

2. Second mortgage of $30,000 at 15.5% for 15 2. Second mortgage of $30,000 at 15.5% for 15 years.years.

3. Wrap loan of $120,000 at 10% for 15 years. 3. Wrap loan of $120,000 at 10% for 15 years.

Obviously the wrap rate of 10% is favorable Obviously the wrap rate of 10% is favorable compared to a new first mortgage at 11.5%. Is the compared to a new first mortgage at 11.5%. Is the wrap better than adding a second mortgage? wrap better than adding a second mortgage? Calculate the incremental cost on the additional Calculate the incremental cost on the additional $30,000 acquired via wrap financing. Compare this $30,000 acquired via wrap financing. Compare this rate to the second.rate to the second.

IRR?:IRR?: 30,000 = PV30,000 = PV429.44 = pmt429.44 = pmt (1289.53 wrap loan(1289.53 wrap loan

180 = n 180 = n pmt-860 old loan pmt)pmt-860 old loan pmt)

IRR = 15.46% which is slightly lower than IRR = 15.46% which is slightly lower than rate on the second. rate on the second.

* Original mortgagee gets Original mortgagee gets screwed. That is why the screwed. That is why the original mortgage probably original mortgage probably disallows further disallows further encumbrances or includes a encumbrances or includes a due-on-sale clause.due-on-sale clause.

BUYDOWNSBUYDOWNS

Seller (often builder) helps buyer Seller (often builder) helps buyer (borrower) qualify for mortgage (borrower) qualify for mortgage financing by “buying down” early financing by “buying down” early mortgage payments. Used most mortgage payments. Used most often when interest rates are often when interest rates are very high. Often buydowns are very high. Often buydowns are executed with graduated executed with graduated payments for 3-5 years.payments for 3-5 years.

Assume buyer seeks a $75,000 Assume buyer seeks a $75,000 mortgage and current rates are 15%. mortgage and current rates are 15%. If loan maturity were 30 years, If loan maturity were 30 years, payments would equal $948.33. payments would equal $948.33. Borrower can’t qualify at this Borrower can’t qualify at this payment, but if rate were 13% payment, but if rate were 13% ($829.65 pmt) they could qualify. ($829.65 pmt) they could qualify. Builder/Seller offers to “buy down” Builder/Seller offers to “buy down” the interest rate from 15% to 13% for the interest rate from 15% to 13% for the first five years of the loan.the first five years of the loan.

How much would builder pay lender to How much would builder pay lender to buydown the loan? Calculate present buydown the loan? Calculate present value of payment short fall $118.68 value of payment short fall $118.68 (948.33 - 829.65) at 15% over 5 years.(948.33 - 829.65) at 15% over 5 years.

PV = ?PV = ? 118.68118.68 = pmt = pmt

15% = i15% = i

6060 = n = n

PV = $4,988.67PV = $4,988.67