Financing Residential Real Estate Lesson 6: Basic Features of a Residential Loan

Introduction In this lesson we will cover: how a loan is amortized length of repayment period loan-to-value ratio mortgage insurance and loan guaranty secondary financing fixed 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 and interest.

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

Amortization Payments of fully amortized loan are enough to pay off all principal and interest by end of loan term.  Payments include both principal and interest. Fully amortized loan

Amortization Payments of fully amortized loan are enough to pay off all principal and interest by end of loan term.  Payments include both principal and interest.  Every month the interest portion of the payment is smaller. Fully amortized loan

Amortization Partially amortized loan requires regular payments of principal and interest. Partially amortized loan

Amortization Partially amortized loan requires regular payments of principal and interest.  Payments insufficient to pay off debt by end of loan term. Partially amortized loan

Amortization Partially amortized loan requires regular payments of principal and interest.  But payments aren’t enough to pay off debt by end of loan term.  Balloon payment is required to pay remainder of principal. Partially amortized loan

Amortization Interest-only loan calls for only interest payments during loan term.  At end of term, entire principal amount is due and must be paid off. Interest-only loan

Amortization Interest-only loan calls for only interest payments during loan term.  At end of term, entire principal amount is due and must be paid off.  No principal is paid off by monthly payments. Interest-only loan

Repayment Period Repayment period is number of years borrower has to repay loan.

Repayment Period Repayment period is number of years borrower has to repay loan.  Until 1930s, typical repayment period was 5 years, with balloon payment of principal due at end.

Repayment Period Repayment period is number of years borrower has to repay loan.  Until 1930s, typical repayment period was 5 years, with balloon payment of principal due at end.  Now, loan terms are generally 30 years, although lenders offer 15-year and 20-year loans.

Repayment Period Length of repayment period affects: 1.amount of monthly payment, and 2.total amount of interest paid over life of loan.

Repayment Period Longer repayment period reduces amount of monthly payment.  30-year loan thus more affordable than 15-year loan. Monthly payment amount

Repayment Period Shorter loan term:  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

Repayment Period Lenders generally charge lower interest rates for short-term loans. Interest rate

Advantages of 15-year loan:  lower interest rate  total interest much less  clear ownership in half the time

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

Repayment Period 20-year loan is compromise between 15-year and 30-year loan.  Monthly payments are higher than 30- year loan payments. 20-year loans

Summary Amortization and Repayment Period  Fully amortized  Partially amortized  Balloon payment  Interest-only loan  Loan term  Interest rate  15-year loan  30-year loan  20-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 Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased.  The higher the LTV ratio, the smaller the downpayment.

Loan-to-Value Ratio Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased.  The higher the LTV ratio, the smaller the downpayment.  Loan with lower LTV is generally less risky than one with high LTV.

Loan-to-Value Ratio Lenders use loan-to-value ratios to establish maximum loan amounts.  LTV is key factor in determining what borrower can afford to buy.

Loan-to-Value Ratio Lenders use loan-to-value ratios to establish maximum loan amounts.  LTV is key factor in determining what borrower can afford to buy.  Many lenders allow LTVs no higher than 80%.

Loan-to-Value Ratio Lenders use loan-to-value ratios to establish maximum loan amounts.  LTV is key factor in determining what borrower can afford to buy.  Many lenders allow LTVs no higher than 80%.  High LTVs help people who don’t have money for large downpayments.

Mortgage Insurance/Loan Guaranty Purpose of mortgage insurance or guaranty is to protect lender from foreclosure loss.

Mortgage Insurance/Loan Guaranty Purpose of mortgage insurance or guaranty is to protect lender from foreclosure loss. Also provides incentive for lenders to make loans that would otherwise be too risky.

Mortgage Insurance/Loan Guaranty Mortgage insurance works like other types of insurance:  policyholder pays premiums, and  insurer provides coverage for certain types of losses. Mortgage insurance

Mortgage Insurance/Loan Guaranty Policy protects the lender against losses from borrower default and foreclosure. Insurer agrees to indemnify lender.  Insurer will make up any deficiency after foreclosure. Mortgage insurance

Mortgage Insurance/Loan Guaranty Policy protects the lender against losses from borrower default and foreclosure. Insurer agrees to indemnify lender.  Insurer will make up any deficiency after foreclosure.  Insurer also underwrites loan. Mortgage insurance

Mortgage Insurance/Loan Guaranty In loan guaranty, a third party (guarantor) agrees to take on secondary legal responsibility for borrower’s obligation to lender.  Guarantor reimburses lender for losses from borrower default. Loan guaranty

Mortgage Insurance/Loan Guaranty Guarantor might be:  private party, Loan guaranty

Mortgage Insurance/Loan Guaranty Guarantor might be:  private party,  nonprofit organization, Loan guaranty

Mortgage Insurance/Loan Guaranty Guarantor might be:  private party,  nonprofit organization, or  governmental agency. Loan guaranty

Mortgage Insurance/Loan Guaranty Guarantor might be:  private party,  nonprofit organization, or  governmental agency. Guarantor may also underwrite the loan. Loan guaranty

Secondary Financing Secondary financing Second loan obtained to pay part of downpayment or closing costs for a home.

Secondary Financing Lender making primary loan usually restricts type of secondary financing a borrower can use.  Buyer must qualify for combined payments on both loans.

Secondary Financing Lender making primary loan usually restricts type of secondary financing a borrower can use.  Buyer must qualify for combined payments on both loans.  Restrictions intended to minimize risk of default on second loan.

Summary LTV, Insurance or Loan Guaranty  Loan-to-value ratio  Mortgage insurance  Indemnify  Loan guaranty  Secondary financing

Fixed or Adjustable Interest Rate Fixed-rate mortgage Interest rate charged on loan remains constant through loan term.  Considered industry standard. Fixed-rate loan

Fixed or Adjustable Interest Rate Fixed-rate mortgage Interest rate charged on loan remains constant through loan term.  Considered industry standard.  When market rates rise or fall, loan rate stays the same. Fixed-rate loan

Fixed or Adjustable Interest Rate Adjustable-rate mortgage ARM allows lender to adjust loan’s interest rate to reflect changes in cost of money. Adjustable-rate loan

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 risk of rate fluctuations to borrower. Adjustable-rate loan

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 risk of rate fluctuations to borrower.  Generally lower interest rate than fixed- rate loans. Adjustable-rate loan

Fixed or Adjustable Interest Rate 1.Borrower’s interest rate first determined by market interest rates at time loan is made. How ARMs work

Fixed or Adjustable Interest Rate 1.Borrower’s interest rate first determined by market interest rates at time loan is made. 2.After loan made, interest rate tied to an index and adjusted accordingly. How ARMs work

Fixed or Adjustable Interest Rate 1.Borrower’s interest rate first determined by market interest rates at time loan is made. 2.After loan made, interest rate tied to an index and adjusted accordingly.  Index chosen by lender when loan made. How ARMs work

Summary Fixed or Adjustable-rate Mortgages  Fixed-rate loan  Adjustable-rate mortgage  Index

ARM Features ARM may have all or some of these elements:  note rate  index  margin  rate adjustment period

 mortgage payment adjustment period  lookback period  interest rate cap  mortgage payment cap  negative amortization cap  conversion option

ARM Features A loan’s note rate is its initial interest rate, as stated in promissory note. Note rate

ARM Features A loan’s note rate is its initial interest rate, as stated in promissory note. Lenders used to attract borrowers by offering discounted initial rate lower than index rate. Note rate

ARM Features An index is a statistical report used as an indicator of changes in cost of money. Index

ARM Features An index is a statistical report used as an indicator of changes in cost of money. Several published indexes used by lenders:  Treasury securities indexes,  11 th District cost of funds index, and  LIBOR index. Index

ARM Features ARM’s margin is difference between index rate and interest rate lender charges borrower.  Lenders add margin to index to cover administrative expenses and provide profit. Margin

ARM Features ARM’s interest rate is adjusted only at specified intervals.  Such as every 6 months, once a year, or every 3 years. Rate adjustment period

ARM Features ARM’s interest rate is adjusted only at specified intervals.  Such as every 6 months, once a year, or every 3 years.  One-year adjustment period most common. Rate adjustment period

ARM Features ARM’s interest rate is adjusted only at specified intervals.  Such as every 6 months, once a year, or every 3 years.  One-year adjustment period most common.  Lender checks index at end of period and adjusts interest rate. Rate adjustment period

ARM Features Hybrid ARMs Combination of ARM and fixed-rate loan with two- tiered adjustment structure. Longer initial period, with more frequent adjustments after that. Rate adjustment period

ARM Features A mortgage payment adjustment period determines when lender changes amount of principal and interest payment to reflect change in interest rate. Mortgage payment adjustment period

ARM Features A mortgage payment adjustment period determines when lender changes amount of principal and interest payment to reflect change in interest rate.  Payment usually adjusted at same time as interest rate. Mortgage payment adjustment period

ARM Features A mortgage payment adjustment period determines when lender changes amount of principal and interest payment to reflect change in interest rate.  Payment usually adjusted at same time as interest rate.  But payment amount not always adjusted when interest rate is. Mortgage payment adjustment period

ARM Features Typical lookback period is 45 days. Loan’s rate and payment adjustments are determined by what index was 45 days before end of adjustment period. Lookback period

ARM Features When ARMs were introduced, borrowers experienced payment shock. Interest rate cap

ARM Features When ARMs were introduced, borrowers experienced payment shock. As market interest rates rose, indexes also went up, resulting in sharp increase in monthly payments. Interest rate cap

ARM Features When ARMs were introduced, borrowers experienced payment shock. As market interest rates rose, indexes also went up, resulting in sharp increase in monthly payments. Sharp increase in interest rates meant some borrowers couldn’t afford payments anymore. Interest rate cap

ARM Features Interest rate cap limits how much interest rate on a loan can increase, regardless of 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 a mortgage payment can increase. Mortgage payment cap

ARM Features A payment cap directly limits how much a mortgage payment can increase.  Many ARMS only have interest rate cap, and no payment cap. Mortgage payment cap

ARM Features Negative amortization occurs when unpaid interest is added to principal balance of a loan, increasing amount owed. Negative amortization

ARM Features Negative amortization occurs when unpaid interest is added to principal balance of a loan, increasing amount owed.  Normally, loan balance declines steadily. Negative amortization

ARM Features Negative amortization occurs when unpaid interest is added to principal balance of a loan, increasing amount owed.  Normally, loan balance declines steadily. Negative amortization causes principal balance to go up instead of down. Negative amortization

ARM Features ARM features that can lead to negative amortization:  Payment cap without rate cap.  Payments adjusted less often than interest rate. Negative amortization

ARM Features Today, lenders rarely make ARM loans that allow negative amortization. Negative amortization

ARM Features Today, lenders rarely make ARM loans that allow negative amortization. But if it is a possibility, lenders will include a negative amortization cap.  Limits amount of unpaid interest that can be added to principal balance. Negative amortization

Example: W borrows $190,000 to buy home. Loan is a one- year ARM with 7.5% annual payment cap. No interest rate cap. Initial interest rate: 4.5%. Monthly payment: $

Example: W borrows $190,000 to buy home. Loan is a one- year ARM with 7.5% annual payment cap. No interest rate cap. Initial interest rate: 4.5%. Monthly payment: $ By end of first year, index of ARM has risen 2.75%. Lender adjusts loan by 2.75%. Without payment cap, monthly payment would increase by $325.

Example (cont.): But W’s payment cap limits increase to 7.5% of payment amount per year—preventing payment from increasing enough to cover interest charged for second year. Lender adds unpaid interest to loan balance, which is negative amortization.

ARM Features Many ARMs allow borrower to convert loan to fixed- rate mortgage at certain times during loan term. Conversion option

ARM Features Many ARMs allow borrower to convert loan to fixed- rate mortgage at certain times during loan term.  Usually involves a limited time to convert, and requires a conversion fee. Conversion option

Summary ARM Features  Note rate  Margin  Rate adjustment period  Mortgage payment adjustment period  Lookback period  Interest rate cap  Mortgage payment cap  Negative amortization  Conversion option