Real estate finance 5

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Financing Residential Real Estate

Lesson 6:

Basic Features of a Residential Loan

Introduction

This lesson will cover:

amortization
repayment periods
loan-to-value ratios
mortgage insurance and loan guaranties
secondary financing
fixed 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, or
during 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, balloon
payment 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-year loan.

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.

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 rate
total interest much less
clear ownership in half the time

Disadvantages of 15-year loan:

higher monthly payments

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

Summary
Amortization & 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% LTV, 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 amount
minimum 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 premiums
insurer provides coverage for certain
losses, up to policy limit

Mortgage insurance

Mortgage Insurance/Guaranty

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

Mortgage Insurance/Guaranty

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.

Summary
LTV 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

Adjustable-Rate Mortgages

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

If index rate has increased, lender
raises interest rate charged on loan.
If index rate has decreased, lender lowers interest rate charged on loan.

How ARM works

Adjustable-Rate Mortgages

note rate
index
margin
rate adjustment period
payment adjustment period
lookback period

interest rate cap
payment cap
negative amortization cap
conversion 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 doesn’t include the margin typically added to the index rate.

Note rate

ARM Features

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

Treasury securities index
11th District cost of funds index
LIBOR 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 decrease
raises or lowers loan’s rate based on
change in index rate

Rate adjustment period

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

Rate adjustment period

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 adjusted
less 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 dramatically
sharp increase in loan’s interest rate
payment 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 cap
payments adjusted less often than interest rate

Features causing NA

Negative Amortization

Many ARMs structured to prevent negative amortization.

But if NA is possible, loan may have negative amortization cap.

Limits amount of unpaid interest that
can be added to principal balance.
When limit is reached, loan must be recast.

Negative amortization cap

Negative Amortization

Each month, borrower chooses payment option:

P&I payment based on 15-year amortization
P&I payment based on 30-year amortization
interest-only payment
minimum (limited) payment

Option ARMs

Negative Amortization

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 during limited period
Lender usually charges conversion fee.

Conversion option

Summary
Fixed 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