© 2010 Rockwell Publishing Financing Residential Real Estate Lesson 6: Basic Features of a...

© 2010 Rockwell Publishing

Financing Residential Real Estate

Lesson 6:

Basic Features of a Residential Loan


Introduction

This lesson will cover:amortizationrepayment periodsloan-to-value ratiosmortgage insurance and loan guarantiessecondary financingfixed and adjustable interest rates


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

Payment amount same throughout term.Every month, interest portion of payment

gets smaller, principal portion gets larger.

Fully amortized loan


Amortization

Partially amortized loan: requires regular payments including principal and interest.

But payments not enough to pay off debt by end of loan term.

Balloon payment required to pay remainder of principal.

Partially amortized loan


Amortization

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

during entire loan term, orduring specified interest-only period at

beginning of term.

Interest-only loan


Amortization

If payments interest-only during limited period:

at end of that period, amortized payments must begin

payment may increase sharply at end of interest-only period

Interest-only loan


Repayment Period

Number of years borrower has to repay loan.Also called loan term.


Repayment Period

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

If lender didn’t renew loan, balloonpayment required.

Now 30 years is standard repayment period.15, 20, and 40-year loans also available.


Repayment Period

Length of repayment period affects: amount of monthly payment 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.

30-year loan more affordable than 15.

Shorter repayment period:higher payment amountequity builds fastermore difficult to qualify for

Monthly payment amount


Repayment Period

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

Total interest for 15-year loan less than half total interest for 30-year loan.

Total interest


Repayment Period

Advantages of 15-year loan:lower interest ratetotal interest much lessclear ownership in half the time

Disadvantages of 15-year loan:higher monthly paymentstax deduction lost sooner

15-year vs. 30-year loan


Repayment Period

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

Monthly payments higher than 30-year loan.

But not as high as 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 30-year loan.

Most commonly used in areas with very high housing costs.

40-year loans


SummaryAmortization & Repayment Period

• Amortization

• Fully amortized

• Partially amortized

• Balloon payment

• Interest-only loan

• Loan term


Loan-to-Value Ratio

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

With 80% LT V, loan amount is 80% of home’s value.

Higher LTV = smaller downpayment


Loan-to-Value Ratio

Because downpayment is smaller, higher LTV loans riskier than lower LTV loans.

Borrower has less money invested, won’t try as hard to avoid default.

If foreclosure necessary, property may not sell for enough to pay off debt and costs.

Higher LTV = higher risk


Loan-to-Value Ratio

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

In transaction, maximum LTV determines:maximum loan amountminimum downpayment

Key factor in determining “how much house” borrower can buy.

Maximum LTV


Loan-to-Value Ratio

Lenders traditionally protected themselves by setting low LTV limits.

Traditional maximum: 80%Higher LTVs allowed only in special

programs (FHA, VA).

Maximum LTV


Loan-to-Value Ratio

In recent years, loans with higher LTVs widely available.

With higher maximum LTVs, people without much cash can buy homes.

Maximum LTV


Mortgage Insurance/Loan Guaranty

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

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


Mortgage Insurance/Guaranty

Mortgage insurance works like other insurance:

policyholder pays premiumsinsurer provides coverage for certain

losses, up to policy limit

Mortgage insurance



Policy protects lender against losses from borrower default and foreclosure.

Mortgage insurance company agrees to indemnify lender.

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

Mortgage insurance



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

If borrower defaults, guarantor must reimburse lender for losses.

Loan guaranty


Secondary Financing

Secondary financing: second loan obtained to pay part of downpayment or closing costs required for primary loan.

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


Secondary Financing

Lender of primary loan often restricts type of secondary financing borrower can use.

Intended to prevent secondary loan from increasing default risk.

Borrower must qualify for combined payment on both loans.

Borrower still required to make small downpayment from own funds.


SummaryLTV Ratio and Other Features

• Loan-to-value ratio

• Maximum loan amount

• Minimum downpayment

• Mortgage insurance

• Indemnify

• Loan guaranty

• Guarantor

• Secondary financing


Fixed or Adjustable Interest Rate

Fixed-rate mortgage: interest rate charged on loan remains constant throughout loan term.

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

Considered standard.

Fixed-rate mortgages


Fixed or Adjustable Interest Rate

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

Transfers rate fluctuation risk to borrower.

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

Adjustable-rate mortgages


Adjustable-Rate Mortgages

Borrower’s initial rate determined by market rates at time loan is made.

Interest rate on loan tied to index.Index: published statistical report used

as indicator of changes in cost of money.Lender chooses index when loan is

made.

How ARM works



Loan’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 lowers interest rate charged on loan.

How ARM works



note rateindexmarginrate adjustment

periodpayment adjustment

periodlookback period

interest rate cappayment capnegative

amortization capconversion option

ARM features

ARM may have some/all of these features:


ARM Features

Note rate: ARM’s 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

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

Treasury securities index11th District cost of funds indexLIBOR index

Index


ARM Features

Margin: difference between index rate and interest rate lender charges borrower.

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

Margin stays same throughout loan term,

even when interest rate changes.

Margin


ARM Features

ARM’s interest rate adjusted only at specified intervals.

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

One-year adjustment period most common.

Rate adjustment period


ARM Features

At end of period, lender:checks index for increase or decreaseraises or lowers loan’s rate based on

change in index rate



ARM Features

Hybrid ARM: combination of ARM and fixed-rate loan, with two-tiered adjustment structure.

Longer initial period, with more frequent adjustments after that.

Example: 3/1 hybrid ARM.



ARM Features

Determines when lender changes payment amount to reflect change in interest rate.

Most ARMs have payment adjustment at same time as rate adjustment.

With some loans, payment adjustedless frequently than interest rate.

Mortgage payment adjustment period


ARM Features

Typical lookback period is 45 days. Loan’s rate and payment adjustments

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.

Occurs when:market rates/index rise dramaticallysharp increase in loan’s interest ratepayment amount increases drastically

Interest rate cap


ARM Features

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

limits how much loan’s interest rate can increase per adjustment period and over life of loan

Interest rate cap


ARM Features

Payment cap: directly limits how much loan’s payment amount can increase.

Cap applies only to principal and interest payment, not tax and insurance portion.

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

Mortgage payment cap


ARM Features

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

Normally, balance goes down steadily as principal is paid off.

Negative amortization causes principal balance to go up.

Negative amortization


Negative Amortization

ARM features that can lead to negative amortization:

payment cap without rate cappayments adjusted less often than

interest rate

Features causing NA



Many ARMs structured to prevent negative amortization.

But if NA is possible, loan may have 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



Each month, borrower chooses payment option:

P&I payment based on 15-year amortization

P&I payment based on 30-year amortization

interest-only paymentminimum (limited) payment

Option ARMs



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

After negative amortization limit reached and loan recast, many borrowers default.

Option ARMs no longer widely available.

Option ARMs


ARM Features

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

Conversion typically can take place only:on annual rate adjustment dateduring limited period

Lender usually charges conversion fee.

Conversion option


SummaryFixed or Adjustable Interest Rate

• Fixed-rate mortgage• Adjustable-rate mortgage• Index• Note rate• Margin• Rate and payment adjustment periods• Lookback period• Interest rate and mortgage payment caps• Negative amortization• Option ARM• Conversion option

© 2010 Rockwell Publishing Financing Residential Real Estate Lesson 6: Basic Features of a...

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