Lecture 5: Front-end Mortgages by James R. DeLisle, Ph.D. January 19, 2010

Lecture Overview Fixed Rate Mortgages Loans CAM CPM Interest Only Typology of Mortgages Mortgage Regulations Mortgage Mechanics: Introduction

Introduction to Time Value of Money (TVM) Definition of TVM Math of TVM Core Equation: FV = PV * (1 + r)t Types: Lump Sum, Annuity Six Functions of $1 Future Value FV$; what is FV of current lump? FVA; what is FV of annuity? SF; what annuity draw from PV lump? Present Value PV$: what is PV of future lump? PVA; what is PV of FV annuity? PR; what annuity payment to amortize $lump?

Periodic Repayment (PR) Future PV$ PR1/P Interest Principle Present What is the Periodic Payment to amortize $1?

Periodic Repayment (PR): Overview What is the Periodic Payment/Yr that will amortize $1,000 over 5 yr at 7.5%? $1,000 ? $247 $200

Typology of Residential Mortgages

Front-end Mortgage Overview: Part 1 BDM FRM PAM CAM

Front-end Mortgage Overview: Part 2 WRAP PMM

Base Case

Traditional Mortgage Payment Schedule

Traditional Mortgage Amortization Patterns

Traditional Mortgage: Prepayment

Constant Amortization Mortgage Advantages No balloon payment Declining payments may be appropriate to match declining asset or deflation Suited for consumer debt on short-lived assets; not common in real estate Disadvantages High initial payments Declining payment pattern independent from property income to service debt Rapidly declining interest of payments reduces PV of interest tax shield Rapid paydown of principal reduces leverage faster than many borrowers like Constantly changing payment obligation difficult to administer and budget

CAM Pattern

CAM Prepayment

Constant Amortization vs. Constant Payment BI = Borrower’s Income Required

Buydown Mortgage (BDM) Advantages Increase purchasing power Allow borrower to purchase at full price Typically Fixed Rate Disadvantages Lower equity investment may reduce “will to pay” Cooperative Lender and Set-up Fee Reduced interest deduction for taxes Step-up payment risk at end of BDM term

Buydown: Visual Principal Balances Payments

Buydown Mortgage: Base Case

Mechanics of Buydown

Lender Points BDM Yields Lender

Pledged Account Mortgage (PAM) Advantages Increase purchasing power Single lender Fixed Rate Disadvantages Higher LV ratio triggers PMI Set-up Fee Reduced interest deduction for taxes Step-up payment risk at end of PAM term

PAM Visual Principal Balances Cash Flows

PAM Case

Mechanics of PAMs

Lender with Points PAM Yields Lender

WRAP Mortgage: Seller’s Approach Advantages Increase access and speed of closing Lower rate on WRAP vs. new market Hold price for seller Provide arbitrage/spread opportunity Disadvantages Title not as clearly held by buyer Seller retains liability Seller services loan

WRAP Part I: Flows $292,390 $57,561 $276,386 $1878 $ 391 $1416 Excess $71

Wrap Visualization

Wrap Case

WRAP Mechanics

WRAP Details

WRAP Yields

Purchase Money Mortgage: PMM Advantages Allow borrower to qualify Pay more than could afford Hold price for seller Quick approvals Disadvantages Title not as clearly held by buyer Seller retains claim Seller services loan Buyer may not be able to make step

PMM Visual Principal Cash Flows

PMM Case

Mechanics of PMM

Seller PMM Yields Lender

Operating Period Mortgages

Lecture Summary Mortgages Types of Loans Mortgage Process Mortgage Risk Management Mortgage Concepts Mortgage Transfer Foreclosure & Bankruptcy Types of Loans Typology of Mortgages Mortgage Regulations Mortgage Mechanics: Introduction