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 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

4-3 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 Option-adjusted spread

4-4 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/spread

4-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Three Relationships for Fixed- income Securities Applicable to all fixed-income securities  Interest payment at time t = loan balance at time t-1 X period interest rate  Total payment = interest payment + principal (amortization) payment  Principal payment at time t = Principal at time t-1 minus payment toward principal at time t Different debt security has different requirement for principal payment

4-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Computing a Loan Balance Three methods  “Rolling” principal balance period by period Convenient if principal payment is constant  Compute the present value of the remaining payments More convenient if the payments are constant  Compute the future value of the amortized loan amount, given initial loan value Convenient if total payment is constant

4-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Mortgage Payment Patterns Interest-only Mortgage (IO)  Monthly payment constant  Total principal stays constant as well Constant Amortization Mortgage (CAM)  Loan Amortization Remains the Same  Monthly Payment Changes Constant Payment Mortgage (CPM)  Loan Amortization Changes  Monthly Payment Remains the Same

4-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns I 1.Short-term interest-only mortgage with large down payment requirement Interests paid based on constant principal amount No intermediate amortization

4-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns I Example 1: you are interested in a $75K house. The bank is willing to lend you at 12% 5-year interest only loan if you can put 50% down. What is the monthly payment and mortgage balance at the end of 5 th year?

4-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns II 2. Constant amortization mortgage (CAM)  Constant amortization amount Amort = total loan amount / number of months  Interest computed on the loan balance at the end of previous month Int(t) = OLB (t -1) * (mortgage rate / 12)  Total pmt = constant amortization amount + monthly interest pmt  OLB(t) = OLB(t-1) – amort(t) Note: total payment will decrease over time

4-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns II Example 2: if you only need to put down 20% for the $75K property to qualify for a 30- year CAM, at 12% annual interest rate, Q: what is mortgage balance by the end of 5 th year? Q: What is your 61 st payment? Q: How much of your 61 st payment goes to principal?

4-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns III 3. Constant payment mortgage (CPM)  Constant total monthly payment Can be calculated using annuity PV formula  Interest computed based on loan balance at the end of previous month int(t) = OLB (t -1) * (mortgage rate / 12)  Amount of amortization can be backed out by taking difference b/w total payment and its interest component amort(t) = pmt(t) – int(t)

4-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns III 3. Constant payment mortgage (CPM)  Remaining balance can be calculated by deducting previous balance by payment toward principal in the current period (backward looking) Can also be calculated by discounting remaining payments at the mortgage interest rate Or follow a PV/PMT/FV calculation

4-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns III Example What is the monthly payment for a 30-year $60K CPM at 12%? 2. What is the loan balance by the end of 5 th year? 3. How much does your 61 st payment will go towards principal payment? 4. Over the life of the mortgage, what is the total amount of interest paid? 5. If inflation is 6%, what is the real value of the 60 th payment today? 6. How much interest will you be paying in the 6 th year?

4-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Other Loan Patterns Partially Amortizing  Balloon Mortgage Negative Amortization  Graduated Payment Mortgage (GPM) Reverse Annuity Mortgages

4-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Development of Mortgage Payment Patterns IV 4. Graduated payment mortgage (GPM)  Mortgage payments are lower in the initial years of the loan  GPM payments are gradually increased at predetermined rates for initial years, and then stay constant until maturity

4-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved GPM Example Loan amount $60,000 Maturity30 years Interest rate (yield)12% Graduation time5 years Graduation rate7.5% Q: What is the initial payment? Q: What is the balance after 5 years?

4-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Reverse Annuity Mortgage Residential property value $500,000 Loan amount to be disbursed in monthly installments $250,000 Term 10 years 120 months Interest Rate 10% Q: How much payment will the homeowner receive?

4-19 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Reverse Annuity Mortgage Example Continued Calculator solution:  FV=-250,000  i=10%/ 12  PMT= ?  n=120  Solve for payment $

4-20 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective Interest Cost Fees and points are part of loan financing charges  Should be taken into account in comparing loan cost or true interest costs Regulation - Truth in Lending Act  What is the borrowing cost, called Annual Percentage Rate (APR, in %) if the loan is paid off at maturity?

4-21 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective Interest Cost Example 1: APR Contractual loan amount $ 60,000 Less organization fee (3%) $ 1,800 Net cash disbursed by lender $ 58,200 Interest rate= 12% Term 30 years

4-22 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective Interest Cost Examples 1: APR Continued Calculator solution  n=360  PMT=  PV= 58,200  FV= 0  i= (12.41% annualized)

4-23 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective Interest Cost Example 2: Early Termination Contractual loan amount $ 60,000 Less organization fee(3%) $ 1,800 Net cash disbursed by lender $ 58,200 Interest rate= 12% Term 30 years Loan paid off in 5 years Q: What is the true effective cost to the borrower/effective yield to the lender?

4-24 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective Interest Cost Example 2: Early Termination 1. Find out loan balance after 5 years 2. Find out initial net cash outlay 3. Find out the interest rate that sets the present value of loan balance in 5 years (minus possible penalty/fess) and the mortgage payments in first 5 years to the initial net cash outlay (OLB0-Fees and points)