McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER4CHAPTER4 CHAPTER4CHAPTER4 Fixed Rate Mortgage Loans

4-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Interest Rates What will borrowers pay for the use of funds? What are lenders willing to accept for the use of funds? Housing Demand Factors: Income & Demographics Mortgage Funds Supply Factors: Alternative Investments

4-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Components of the Mortgage Interest Rate Real Rate of Interest  Time Preference for Consumption Compensation to delay a purchase  Production Opportunities in the Economy Competition for funds when there are other investment opportunities Inflation Expectation  Retain purchasing power

4-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Components of the Mortgage Interest Rate Default Risk Interest Rate Risk  Anticipated Inflation and Unanticipated Inflation Prepayment Risk Liquidity Risk Legislative Risk

4-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Components of the Mortgage Interest Rate r = Real Rate f 1 = Inflation Rate p 1 = Risk Premiums

4-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Payment Patterns Constant Amortization Mortgage (CAM)  Loan Amortization Remains the Same  Monthly Payment Changes Constant Payment Mortgage (CPM)  Loan Amortization Changes  Monthly Payment Remains the Same

4-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Payment Patterns Example 4-1 Calculating the Payment for a CPM  $100,00 Mortgage  7% Interest  30 Years  Monthly Payments

4-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Payment Patterns = $100,000 = 30 x 12 = 360 = $0 = 7/12 = (or change P/Y to 12 and enter 7) = $ n i CPT FV PMT PV

4-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Payment Patterns Interest paid in the first month  (.07/12) x $100,000 = $ Principal paid in the first month  $ $ = $81.96 Every month, interest portion declines Every month, principal portion increases.

4-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Payment Patterns Comparing the CAM & CPM  Higher initial monthly payments for the CAM  More difficult for a borrower to qualify for a loan Amortization of CPM is slower than CAM. CAM payment declines over time.

4-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Computing a Loan Balance Essentially “removing” the interest that was built into the payment. Two mathematical methods  Compute the present value of the remaining payments.  Compute the future value of the amortized loan amount.

4-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Computing a Loan Balance There are 3 methods to do this with a financial calculator  From Example 4-1, what is the future expected loan balance in 8 years?

4-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Computing a Loan Balance Present Value Method = $ = 22 x 12 = 264 = $0 = 7/12 = = $89,491 n i CPT FV PMT PV

4-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Computing a Loan Balance Future Value Method = $100,000 = 8 x 12 = 96 = $ = 7/12 = = $89,491 n i CPT FV PMT PV

4-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Computing a Loan Balance Amortization Function Method Step 1: Compute Payment = $ Step 2: Press = P1 = 1 = P2 = 96 Balance = $89,491 ENTER AMORT ↓ ENTER ↓

4-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Closing Costs Statutory  Transfer  Recording Fees etc. Third Party Charges  Appraisals  Surveys  Inspections, etc.

4-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Closing Costs Additional Finance Charges  Loan Origination Fees Cover origination expenses  Loan Discount Fees – “Points” Used to raise the yield on the loan Borrower trade-off: points vs. contract rate 1 Point = 1% of the loan amount

4-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Closing Costs Why Points?  Sticky mortgage rates  Price in the risk of a borrower  Early repayment of a loan does not allow recovery of origination costs  Earn a profit on loans sold to investors at a yield equal to the loan interest rate.

4-19 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Fees & Borrowing Costs Calculating the effective interest cost Example 4-2:  $250,000 home  80% LTV Loan  8% Interest  4 Points  30 Years

4-20 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Fees & Borrowing Costs Step 1: Compute payment using the face value of the loan. = $200,000 = 360 = 8 = $ But, with points paid up front, the borrower actually receives less than the face value. n i PMT PV

4-21 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Fees & Borrowing Costs Step 2: Loan Amount = $200,000 - Points Paid = (.04 x $200,000) Amount Received = $192,000 Compute effective interest cost, using the Amount Received from Step 2 & Payment from Step 1.

4-22 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Fees & Borrowing Costs Compute effective interest cost: = $192,000= $ = 360= 8.44% PMTPV nCPT i

4-23 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Fees & Borrowing Costs What is the effective cost if we think this loan might be repaid after 8 years?  Step 1: Compute PMT = $  Step 2: Compute Future Loan Balance P1 = 1 P2 = 96 Balance = $182, ENTER AMORT ↓ ENTER ↓

4-24 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Loan Fees & Borrowing Costs  Step 3: Compute effective interest cost. = ($192,000) = $182, = $ = 96 = 8.72% n i CPT FV PMT PV

4-25 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Other Loan Patterns Partially Amortizing  Balloon Payment Interest Only Loans Negative Amortization Reverse Annuity Mortgages