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Financing Residential Real Estate

Lesson 6:

Basic Features of a Residential Loan

Introduction

In this lesson we will cover:

lamortization

lrepayment periods

lloan-to-value ratios

lmortgage insurance and loan guaranties

lsecondary financing

lfixed and adjustable interest rates

Amortization

Loan amortization refers to how principal and interest are paid to lender during loan term.

Amortization

Loan amortization refers to how principal and interest are paid to lender during loan term.

Amortized loan

Borrower required to make regular installment payments that include principal as well as interest.

Amortization

Payments for a fully amortized loan are enough to pay off all principal and interest by end of loan term.

lPayment amount is same throughout term.

Fully amortized loan

Amortization



lEvery month, interest portion of payment is smaller, and principal portion is larger.


Amortization



lEvery month, interest portion of payment is smaller, and principal portion is larger.

�Interest portion gets smaller because it’s based on remaining principal balance.

�Balance is steadily reduced by principal portion of payments.


Amortization

Partially amortized loan also requires regular payments that include principal as well as interest.

lBut payments aren’t enough to pay off debt by end of loan term.

lBalloon payment is required to pay remainder of principal.

Partially amortized loan

Amortization

Interest-only loan calls for regular payments that cover only the interest accruing, without paying any of the principal, either:

�during entire loan term, or

�during specified interest-only period at beginning of term.

Interest-only loan

Amortization

If payments are interest-only during entire term, whole amount originally borrowed is due at end.

Interest-only loan

Amortization

If payments are interest-only during limited period:

lAt end of that period, borrower must start making amortized payments that will pay off all principal and interest by end of term.

lPayment may increase sharply at end of interest-only period.

Interest-only loan

Repayment Period

Repayment period: number of years borrower has to repay loan.

lAlso called the loan term.

Repayment Period

lUntil 1930s, typical repayment period for mortgage loan was 5 years.

�If lender didn’t renew loan, balloonpayment required.

Repayment Period



lNow 30 years is standard repayment period.

Repayment Period



lNow 30 years is standard repayment period.

l15-year, 20-year, and 40-year loans also available.

Repayment Period

Length of repayment period affects:

1. amount of monthly payment, and

2. total amount of interest paid over life of loan.

May also affect interest rate charged.

Repayment Period

Longer repayment period reduces amount of monthly payment.

�Makes 30-year loan more affordablethan 15-year loan.

Monthly payment amount

Repayment Period

Shorter repayment period:

�higher payment amount

�equity builds faster

�more difficult to qualify for

Monthly payment amount

Repayment Period

Shorter repayment period substantially decreases total amount of interest paid on loan.

lTotal interest for a 15-year loan is less than half the total interest for a 30-year loan.

Total interest

Repayment Period

Lenders generally charge lower interest rates for shorter-term loans.

Interest rate

Repayment Period

Advantages of 15-year loan:

¡ lower interest rate

¡ total interest much less

¡clear ownership in half the time

Disadvantages of 15-year loan:

¡higher monthly payments

¡ tax deduction lost sooner

15-year loan compared to 30-year loan

Repayment Period

20-year loan is compromise between 15-year loan and 30-year loan.

�Monthly payments higher than paymentsfor 30-year loan.

�But not as high as payments for 15-year loan.

20-year loans

Repayment Period

Some lenders offer 40-year loans, but they aren’t common.

�Monthly payments even more affordable than payments for 30-year loan.

�But equity builds even more slowly and borrower pays even more total interest.

�Most likely to be used in areas with very high housing costs.

40-year loans

Summary

Amortization and Repayment PeriodÄAmortizationÄFully amortizedÄPartially amortizedÄBalloon paymentÄInterest-only loanÄLoan termÄ30-year loanÄ15-year loanÄ20-year loanÄ40-year loan

Loan-to-Value Ratio

Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased.

Loan-to-Value Ratio


lFor example, if LTV is 80%, loan amount is 80% of sales price or appraised value, whichever is less.

Loan-to-Value Ratio


lFor example, if LTV is 80%, loan amount is 80% of sales price or appraised value, whichever is less.

The higher the LTV, the smaller the downpayment.

Loan-to-Value Ratio

Because downpayment is smaller, loan with higher LTV is generally riskier than loan with lower LTV.

Higher LTV = higher risk

Loan-to-Value Ratio


lBorrower has less money invested in home, won’t try as hard to avoid default.


Loan-to-Value Ratio


lBorrower has less money invested in home, won’t try as hard to avoid default.

lIf foreclosure necessary, greater chance that property won’t sell for enough to fully pay off debt and costs.


Loan-to-Value Ratio

Lenders set maximum LTV limit for particular loan program or type of loan.

Maximum LTV

Loan-to-Value Ratio

Lenders set maximum LTV limit for particular loan program or type of loan.

lIn a transaction, maximum LTV determines:

�maximum loan amount

�minimum downpayment

Maximum LTV

Loan-to-Value Ratio

lFor example, if maximum LTV for loan program is 95% and sales price is $200,000:

�Maximum loan amount = $190,000

�Minimum downpayment (5%) = $10,000

Maximum LTV

Loan-to-Value Ratio

lFor example, if maximum LTV for loan program is 95% and sales price is $200,000:

�Maximum loan amount = $190,000

�Minimum downpayment (5%) = $10,000

lMaximum LTV is key factor in determining “how much house” borrower can buy.

Maximum LTV

Loan-to-Value Ratio

lLenders traditionally protected themselves by setting low LTV limits.

�Traditional maximum: 80%

�Higher LTVs allowed only in special programs like FHA and VA loan programs.

Maximum LTV

Loan-to-Value Ratio

lIn recent years, loans with higher LTVs widely available.

lWith higher maximum LTVs, people who don’t have much cash can buy homes.

Maximum LTV

Mortgage Insurance/Loan Guaranty

Purpose of mortgage insurance or guaranty: to protect lender from foreclosure loss.


Purpose of mortgage insurance or guaranty:to protect lender from foreclosure loss.

Also encourages lenders to make loans that would otherwise be too risky.


Purpose of mortgage insurance or guaranty:to protect lender from foreclosure loss.

Also encourages lenders to make loans that would otherwise be too risky.

Insurance or guaranty may be:

�required by lender, or

�feature of loan program (e.g., VA guaranty).


Mortgage insurance works like other types of insurance:

�policyholder pays premiums, and

�insurer provides coverage for certain types of losses, up to policy limit.

Mortgage insurance


Policy protects lender against losses from borrower default and foreclosure.

Mortgage insurance



lMortgage insurance company agrees to indemnify lender.

�If foreclosure sale proceeds fall short, insurer will make up the difference.

Mortgage insurance



lMortgage insurance company agrees to indemnify lender.

�If foreclosure sale proceeds fall short, insurer will make up the difference.

lBorrower must meet underwriting standards of insurer as well as lender’s standards.

Mortgage insurance


With loan guaranty, third party (the guarantor) agrees to take on secondary legal responsibility for borrower’s obligation to lender.

Loan guaranty


With loan guaranty, third party (the guarantor) agrees to take on secondary legal responsibility for borrower’s obligation to lender.

�If borrower defaults, guarantor must reimburse lender for resulting losses.

Loan guaranty


Guarantor might be:

çprivate party,

çnonprofit organization, or

çgovernmental agency.

Loan guaranty


Guarantor might be:

çprivate party,

çnonprofit organization, or

çgovernmental agency.

Guarantor may have its own underwriting standards that borrower must meet, in addition to meeting lender’s standards.

Loan guaranty

Secondary Financing

Secondary financing: Second loan obtained to pay part of downpayment or closing costs required for main loan (primary loan).

Secondary Financing

Secondary financing: Second loan obtained to pay part of downpayment or closing costs required for main loan (primary loan).

May be provided by institutional lender, private third party, or property seller.

Secondary Financing

Lender making primary loan usually places some restrictions on type of secondary financing borrower can use.

lRestrictions intended to prevent secondary loan from increasing risk of default on primary loan.

Secondary Financing



lBorrower must qualify for combined payment on both loans.

Secondary Financing



lBorrower must qualify for combined payment on both loans.

lIn many cases, primary lender still requires borrower to make small downpayment from own funds.

Summary

Loan-to-value Ratio and Other FeaturesÄLoan-to-value ratio

ÄMaximum loan amountÄMinimum downpaymentÄMortgage insurance

ÄIndemnifyÄLoan guarantyÄGuarantor

ÄSecondary financing

Fixed or Adjustable Interest Rate

With a fixed-rate mortgage, interest rate charged on loan remains constant throughout loan term.

lWhen market rates rise or fall, loan rate stays the same.

Fixed-rate mortgages


With a fixed-rate mortgage, interest rate charged on loan remains constant throughout loan term.

lWhen market rates rise or fall, loan rate stays the same.

lConsidered standard.

Fixed-rate mortgages


An adjustable-rate mortgage (ARM) allows lender to adjust loan’s interest rate to reflect changes in cost of money.

Adjustable-rate mortgages



lTransfers risk of rate fluctuations to borrower.




lTransfers risk of rate fluctuations to borrower.

lARM’s initial interest rate often lower than market rate for a fixed-rate loan.

�Not true under all market conditions, however.


Adjustable-Rate Mortgages

lBorrower’s interest rate first determined by market rates at time loan is made.

How an ARM works


lBorrower’s interest rate first determined by market rates at time loan is made.

lInterest rate on loan is tied to an index.

�Index = Published statistical report usedas indicator of changes in cost of money.

�Lender chooses index when loan is made.

How an ARM works


lLoan’s interest rate periodically adjusted to reflect changes in index rate.

�If index rate has increased, lenderraises interest rate charged on loan.

�If index rate has decreased, lender lowersinterest rate charged on loan.

How an ARM works


lNote rate

lIndex

lMargin

lRate adjustment period

lPayment adjustment period

lLookback period

lInterest rate cap

lPayment cap

lNegative amortization cap

lConversion option

ARM featuresARM may have all or only some of these features:

ARM Features

ARM’s note rate is its initial interest rate, as stated in promissory note.

Note rate

ARM Features

ARM’s note rate is its initial interest rate, as stated in promissory note.

Some ARMs have teaser rate: discounted initial rate that is lower than initial rate indicated by index.

Note rate

ARM Features

ARM’s index is the statistical report indicating changes in market interest rates that the loan’s interest rate is tied to.

When loan is made, lender chooses one of several published indexes, such as:

¡Treasury securities indexes

¡11th District cost of funds index

¡LIBOR index

Index

ARM Features

ARM’s margin is the difference between index rate and interest rate lender charges borrower.

lLender adds margin to index to cover administrative expenses and provide profit.

Margin

ARM Features



�Example: 3.25% Current index rate+ 2.00% Margin

5.25% Interest rate charged

Margin

ARM Features



�Example: 3.25% Current index rate+ 2.00% Margin

5.25% Interest rate charged

lMargin stays same throughout loan term, even when interest rate changes.

Margin

ARM Features

ARM’s interest rate adjusted only at specified intervals.

lFor example, every 6 months, once a year,or every 3 years.

lThis is loan’s rate adjustment period.

One-year adjustment period most common.

Rate adjustment period

ARM Features

At end of period, lender:

�checks index for increase or decrease, and

�raises or lowers loan’s rate based onchange in index rate.


ARM Features

Hybrid ARM

Combination of ARM and fixed-rate loan, with two-tiered adjustment structure.

lLonger initial period, with more frequent adjustments after that.

lExample: 3/1 hybrid ARM

�fixed rate for first three years

�annual adjustments for rest ofloan term


ARM Features

ARM’s mortgage payment adjustment perioddetermines when lender changes amount of principal and interest payment to reflect change in interest rate.

�Most ARMs provide for payment to be adjusted at same time as interest rate.

�But with some loans, payment is adjustedless frequently than interest rate.

Mortgage payment adjustment period

ARM Features

Typical lookback period is 45 days.

lLoan’s rate and payment adjustments are determined by what index was 45 days before end of adjustment period.

Lookback period

ARM Features

When ARM’s payment amount is adjusted, borrower may experience payment shock.

Payment shock occurs when:

�market rates (and ARM’s index) haverisen dramatically since last adjustment,

�which causes sharp increase in loan’sinterest rate,

�which causes payment amount toincrease so much that borrowercan’t afford it.

Interest rate cap

ARM Features

To protect borrower from payment shock, most ARMs have interest rate cap.

Interest rate cap limits how much the loan’s interest rate can increase, regardless of increases in index.

�Prevents monthly payment from increasing too much.

Interest rate cap

ARM Features

ARM rate caps limit how much interest rate can increase:

¡per adjustment period, and

¡over the life of the loan.

Interest rate cap

ARM Features

A payment cap directly limits how much the loan’s payment amount can increase.

�Cap applies only to principal and interest payment, not to tax and insurance portionof PITI payment.

�Many ARMS have only interest rate cap,with no payment cap.

Mortgage payment cap

ARM Features

Negative amortization occurs when unpaid interest is added to loan’s principal balance, increasing amount owed.

�Normally, balance goes down steadily (if gradually) as principal is paid off.

�Negative amortization causes principal balance to go up instead of down.

Negative amortization

Negative Amortization

ARM features that can lead to negative amortization:

¡Payment cap without rate cap.

¡Payments adjusted less often than interest rate.

Features causing negative amortization


Example: W borrows $190,000 to buy home. Loan is one-year ARM.

�7.5% annual payment cap�No interest rate cap�Initial interest rate: 4.5%�Initial monthly payment: $962.70



Example: W borrows $190,000 to buy home. Loan is one-year ARM.

�7.5% annual payment cap�No interest rate cap�Initial interest rate: 4.5%�Initial monthly payment: $962.70

lBy end of first year, index has risen 2%, and lender increases interest rate on loan by 2%,to 6.5%.



(Example, continued)

lWithout payment cap, rate increase would cause payment to increase by $238.23, to $1,200.93.

�But payment cap limits increase to $72.20.



(Example, continued)

lWithout payment cap, rate increase would cause payment to increase by $238.23, to $1,200.93.

�But payment cap limits increase to $72.20.

lNew payment ($1,034.90) doesn’t cover all of the interest accruing on the loan.

�Lender adds unpaid interest to loan balance.�Balance goes up, not down, which

is negative amortization.



Many ARMs are structured to prevent negative amortization.

But if it is a possibility, loan may have a negative amortization cap.

�Limits amount of unpaid interest thatcan be added to principal balance.

�When limit is reached, loan must be recast.

Negative amortization cap


Option ARMs, popular during subprime boom, were designed to allow negative amortization.

Each month, borrower chooses payment option:

�P&I payment based on 15-yearamortization,

�P&I payment based on 30-yearamortization,

�interest-only payment, or

�minimum (limited) payment.

Option ARMs


lMinimum payment option doesn’t cover interest, resulting in negative amortization.

Option ARMs



�Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month.

Option ARMs




�After negative amortization limit reached and loan was recast, borrowers defaulted.

Option ARMs




�After negative amortization limit reached and loan was recast, borrowers defaulted.

lOption ARMs no longer widely available.

Option ARMs

ARM Features

If ARM has conversion option, borrower allowed to convert loan to fixed-rate mortgage.

lConversion typically can only take place:

�on annual rate adjustment date;

�during a limited period (for example, only after first year and no later than fifth year).

lLender charges conversion fee.

Conversion option

Summary

Fixed or Adjustable Interest RateÄFixed-rate mortgageÄAdjustable-rate mortgageÄ IndexÄNote rateÄMarginÄRate and payment adjustment periodsÄLookback periodÄ Interest rate and mortgage payment capsÄNegative amortizationÄOption ARMÄConversion option

Real Estate Finance Lesson 6 Cumulative Quiz

1. A loan where the entire loan balance will be paid off at the end of the loan term is:

A. fully amortized B. interest-only C. nonrecourse D. partially amortized

2. A partially amortized loan:

A. includes both interest and principal in each payment B. requires a balloon payment at the end of the loan term C. will be fully paid off at the end of the loan term D. Both A and B

3. A balloon payment will be necessary with a/an:

A. interest-only loan B. partially amortized loan C. fully amortized loan D. both A and B

4. Compared with a 30-year loan borrower, a 15-year loan borrower:

A. will make larger monthly payments B. will make smaller monthly payments C. will make more monthly payments over the course of the loan D. will pay more total interest over the course of the loan

5. Which loan term would result in the borrower paying the least amount of interest over the life of the loan?

A. 15 years B. 20 years C. 30 years D. 40 years

6. A borrower takes out a loan with an 80% LTV to purchase a $400,000 property. What is the loan amount?

A. $80,000 B. $320,000 C. $360,000 D. $500,000

© 2009 Rockwell Publishing 1

7. Which LTV would a lender believe to pose the greatest risk?

A. 80% B. 90% C. 95% D. 97%

8. The purpose of mortgage insurance is to reimburse:

A. the borrower in the event property improvements are destroyed by natural disaster B. the borrower in the event the lender becomes insolvent C. the lender for losses in the event of the borrower's default D. the lender in the event that title is unmarketable

9. A common restriction on secondary financing is that:

A. the borrower must qualify based on combined payments for both loans B. the borrower must still make a downpayment out of her own funds C. the secondary financing must be from an institutional lender D. Both A and B

10. Between the 1930s and 1970s, virtually all loans:

A. had adjustable interest rates B. had fixed interest rates C. had interest rates higher than 10% D. had LTVs of 90% or higher

11. A lender compensates for the increased risk to an ARM buyer by:

A. charging a lower initial interest rate B. requiring mortgage insurance for any ARM loan C. using a shorter repayment period D. using less strict underwriting standards

12. An ARM begins with a stated interest rate of 5%. The ARM is based on the 11th District cost of funds index, which is currently 3%. The _____ is 5%.

A. index B. lookback period C. margin D. note rate


13. An ARM's margin is:

A. a regularly published report reflecting changes in the cost of money B. the difference between the index and the interest rate charged to the borrower C. the initial rate stated in the promissory note D. the length of time between points at which the lender can change the rate

14. A 5/1 ARM has an initial _____ of five years.

A. interest rate cap B. mortgage payment adjustment period C. mortgage payment cap D. rate adjustment period

15. On December 31, an ARM's interest rate is adjusted. It is adjusted based on where the LIBOR index stood on November 15. The loan's _____ is 45 days.

A. lookback period B. mortgage payment adjustment period C. mortgage payment cap D. rate adjustment period

16. An ARM borrower's interest rate goes up 2% in a particular year, but the index the loan is based on went up 4% that same year. This loan must have a/an:

A. interest rate cap B. lookback period C. mortgage payment cap D. negative amortization cap

17. Before making the monthly payment of $2,000 on his ARM, Alex had a loan balance of $250,000. Alex owed $2,100 in interest, so after making the payment, his balance was $250,100. This is an example of:

A. negative amortization B. partial amortization C. payment shock D. usury

18. There is a risk of negative amortization occurring if a loan has a/an _____ but no _____.

A. index rate, interest rate cap B. interest rate cap, mortgage payment cap C. mortgage payment cap, interest rate cap D. mortgage payment cap, lookback period


19. A borrower may change an ARM to a fixed-rate loan at designated points if the loan:

A. has a conversion option B. has an index rate C. has a negative amortization cap D. is a hybrid ARM

20. An ARM has a 2.5% margin. It is based on the Treasury securities index, which two months ago was running at 4%. The loan has a two-month lookback period. The loan had an initial 'teaser' rate of 4.5%. If today is the day for adjusting the loan's interest rate, what is the new rate that will be charged to the borrower?

A. 4% B. 4.5% C. 6.5% D. 7%


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