Copyright 2014 by Diane S. Docking 1 The Mortgage Market

Copyright 2014 by Diane S. Docking 2 Lesson Objectives:  What Are Mortgages?  Characteristics of Residential Mortgages  Types of Mortgage Loans  Mortgage-Lending Institutions  Borrower Qualifications  Loan Servicing  Secondary Mortgage Market  Securitization of Mortgages

Copyright 2014 by Diane S. Docking 3 What Are Mortgages? A long term loan secured by real estate. An amortized loan whereby a fixed payment pays both principal and interest each month Major types:  Fixed Rate (FR)  Adjustable Rate (ARM)  Balloon

Copyright 2014 by Diane S. Docking 4 Types of Mortgage Loans Other Types Interest Only Mortgages (IO) Reverse Annuity Mortgages (RAM) Construction to Permanent Mortgages Second Mortgages Home Equity Lines of Credit Graduated-Payment Mortgages (GPM) Rollover Mortgages (ROM) Renegotiated Rate Mortgages (RRM) Growing Equity Mortgages (GEM) Shared-Appreciation Mortgages (SAM) Equity Participation Mortgages

Copyright 2014 by Diane S. Docking 12-5 Types of Mortgage Loans

Copyright 2014 by Diane S. Docking 6 Mortgage Terminology 1) Mortgage Interest Rates 2) Loan Terms 3) Note 4) Mortgage Loan Amortization 5) Discount Points

Copyright 2014 by Diane S. Docking 7 Mortgage Terminology 6) Collateral 7) Down Payments 8) Insurance 9) Escrow 10) Borrower Qualification

Copyright 2014 by Diane S. Docking 8 Fixed rate - a constant, unchanging rate Monthly payments amortized over time. Usually 30, 20 or 15 years. Fixed Rate Mortgages

Residential Mortgage: Mortgage Interest Rates Historical mortgage interest rates 9 Copyright 2014 by Diane S. Docking Historical Graphs For Mortgage Rates: Long-Term Trends 30-Year FRM, 15-Year FRM, 1-Year ARM Rates, :

Residential Mortgage: Mortgage Interest Rates Historical mortgage interest rates 10 Copyright 2014 by Diane S. Docking Historical Graphs For Mortgage Rates: Long-Term Trends 30-Year FRM, 1-Year ARM Rates, :

Copyright 2014 by Diane S. Docking 11 Example 1: FRM The Johnson’s are buying a home. The purchase price is $330,000. They plan on putting $70,000 down on the home and financing the balance over 30 years at a fixed rate of 7%. 1. Must the Johnson’s pay PMI? 2. What are their monthly mortgage (P&I) payments? 3. Suppose the Johnson’s win the lottery in 5 years and decide to pay off the loan early. What is the payoff amount after 5 years?

Copyright 2014 by Diane S. Docking 12 Solution to Example 1: FRM 1. Must the Johnson’s pay PMI? ______________________________ 2. What are their monthly mortgage (P&I) payments? PV = 330,000 – 70,000 = $260,000 loan amount FV = 0 n = 30 x 12 = 360 i = 7% / 12 = %  Pmt = _______________________

Copyright 2014 by Diane S. Docking 13 Solution to Example 1: FRM 3. What is the payoff amount after 5 years? PV = $260,000 n = 5 yrs. x 12 = 60 pmts made i/y = 7% / 12 = % Pmt = $1, per month Compute FV EOY5 =payoff amount = ________________ Or 2 nd Amort: P1 = 1 and P2 = 60, ↓ Balance = ___________

Copyright 2014 by Diane S. Docking 14 Example 2: FRM Assume a house costs $125,000. The purchasers put 20% down and borrow the balance negotiating a fixed-rate constant-payment 30-year 10%. 1. What is the monthly payment? 2. What is the principal repayment for the first year? 3. How much interest is paid the first year? 4. What is the total amount of interest paid over the lifetime this loan?

Copyright 2014 by Diane S. Docking 15 Solution to Example 2: FRM 1. What is the monthly payment? PV = 125,000 – 25,000 = $100,000 loan amount FV = 0 n = 30 x 12 = 360 i = 10% / 12 = %  Pmt = ______________________

Copyright 2014 by Diane S. Docking 16 Solution to Example 2: FRM 2. What is the principal repayment for the first year? Given the inputs from #1, use the 2 nd Amort function to find the solution: PV = $100,000 FV = 0 n = 30 x 12 = 360 i/y = 10% / 12 = % Cpt Pmt = $ per month 3. How much interest is paid the first year? 2 nd Amort: P1 = 1; P2 = 12 ↓ BAL = $99, ↓ PRN = __________ ↓ INT = $9, nd Amort: P1 = 1; P2 = 12 ↓ BAL = $99, ↓ PRN = $ ↓ INT = _____________

Copyright 2014 by Diane S. Docking 17 Solution to Example 2: FRM 4. What is the total amount of interest paid over the lifetime this loan? Given the inputs from #1, use the 2 nd Amort function to find the solution: PV = $100,000 FV = 0 n = 30 x 12 = 360 i/y = 10% / 12 = % Cpt Pmt = $ per month OR $ x 360 = $315, total P&I payments - $100,000.00Less loan amount __________= total interest paid over 30 yrs. 2 nd Amort: P1 = 1; P2 = 360 ↓ BAL = $0 ↓ PRN = $100,000 ↓ INT = _____________

Example 3: Amortization A borrower agrees to a $200,000, 30-year fixed-rate mortgage with a 5.75% (or % per month) quoted interest rate. What is the payment amount and how much of each payment goes to principle and interest? PV = $200,000 loan amount FV = 0 n = 30 x 12 = 360 i = 5.75% / 12 = %  Pmt = _________________________ A borrower agrees to a $200,000, 30-year fixed-rate mortgage with a 5.75% (or % per month) quoted interest rate. What is the payment amount and how much of each payment goes to principle and interest? PV = $200,000 loan amount FV = 0 n = 30 x 12 = 360 i = 5.75% / 12 = %  Pmt = _________________________ 18 Copyright 2014 by Diane S. Docking

Mortgage Amortization Schedule (1) 19 Copyright 2014 by Diane S. Docking

Mortgage Amortization Schedule (2) 20 Copyright 2014 by Diane S. Docking

21 Interest rate is adjusted periodically.  Cumulative vs. noncumulative Initial teaser rate. 1, 3, 5, and 7-year ARMs common Common rate indices include Treasury rates, fixed rate mortgage indices, prime rate, and the LIBOR rate. Interest rate caps limit the size of the increase in the loan rate in any year and over the loan’s life.  Typically, the annual cap is 1-2%, and the lifetime cap is 5-6%. Adjustable Rate Mortgages (ARM)

Copyright 2014 by Diane S. Docking 22 Example: ARM Assume a house costs $125,000. The purchasers put 20% down and borrow the balance negotiating a 1 year convertible ARM. The initial rate is 6%, after that the interest rate may be adjusted annually and the rate is 2% plus the 3-month T-Bill rate. Suppose at the end of the first year the 3-month T-Bill rate is 6%. Amortization is done on a 30-year basis. The conversion rate is 9%. 1. What is the monthly payment in year 1? Year 2? 2. What is the principal repayment and interest paid for the first year? For the second year? 3. Suppose at the end of the second year, the purchasers decide to convert to a fixed rate mortgage. What is their new monthly payment?

Copyright 2014 by Diane S. Docking 23 Solution to Example: ARM 1. What is the monthly payment in year 1? What is the monthly payment in year 2? 1) Find balance at end of year 1. Using 2 nd Amort: P1 = 1; P2 = 12; ↓ BAL = $98, ) Interest rate for year 2 = 3-month T-Bill rate + 2% = 6% + 2% = 8%.  FV EOY1 = $98, PV = 125,000 – 25,000 = $100,000 loan amount FV = 0 n = 30 x 12 = 360 i/y = 6% / 12 = 0.5% Cpt Pmt = _________per month in year 1 PV BOY2 = 98, FV = 0 n = 29 yrs. left x 12 = 348 i = 6% + 2% = 8%/ 12 = 0.666%  Pmt = per month in year 2

Copyright 2014 by Diane S. Docking 24 Solution to Example: ARM 2. What is the principal repayment and interest paid for the first year? For the second year? PV = $100,000 loan amount FV = 0 n = 30 x 12 = 360 i/y = 6% / 12 = 0.5% Cpt Pmt = $ per month in year 1 Using 2 nd Amort: P1 = 1; P2 = 12; ↓ BAL = $98, ↓ PRN = __________principal reduction in year 1 ↓ INT = _________interest paid in year 1 PV BOY2 = 98, FV = 0 n = 29 yrs. left x 12 = 348 i = 6% + 2% = 8%/ 12 = 0.666%  Pmt = $ per month in year 2 Using 2 nd Amort: P1 = 1; P2 = 12; ↓ BAL = $97, ↓ PRN = __________principal reduction in year 2 ↓ INT = ________interest paid in year 2

Copyright 2014 by Diane S. Docking 25 Solution to Example: ARM 3. Suppose at the end of the second year, the purchasers decide to convert to a fixed rate mortgage. What is their new monthly payment? PV BOY3 = 97, FV = 0 n = 28 yrs. left x 12 = 336 i = 9%/ 12 = 0.75%  Pmt = _________________________________ PV BOY2 = $98, n = 12 payments i = 8% / 12 = 0.666% Pmt = $ per month  FV EOY2 = $97,870.86

Copyright 2014 by Diane S. Docking 26 Example: Annual and Lifetime Caps on ARMs The loan is a 1-year ARM on which the interest rate is set at 2% above the prevailing T-bill rate. There is an annual and lifetime cap of 2% and 6%, respectively on the loan, non-cumulative. The teaser rate is 5%. T-bill rates are as follows: Beginning of year 2=6% Beginning of year 3=7% Beginning of year 4=5.5% Beginning of year 5=8% Beginning of year 6=9.5% Beginning of year 7=10.5% What is the interest rate at the beginning of each year?

Copyright 2014 by Diane S. Docking 27 Solution to Example: Annual and Lifetime Caps on ARMs What is the interest rate at the beginning of each year? Year 1:The teaser rate = _____ T-Bill rate BOY + 2% Year 2=6% +2% = 8% but ltd to ___________cap = ______ Year 3=7% +2% = 9% but ltd to ___________ cap = ______ Year 4=5.5%+2% = 7.5% but ltd to _________cap = _______ Year 5=8% +2% = 10% but ltd to __________cap = ______ Year 6=9.5%+2% = 11.5% but ltd to ________________ Year 7=10.5% +2% = 12.5% but ltd to _______________

Copyright 2014 by Diane S. Docking 28 Rate is fixed over the contract term. Terms can be 3, 5 or 7 year balloons. Loan is amortized over 15 or 30 year period  monthly payments are no different than a FRM of equal maturity. Remaining principal due at end of balloon period. Popular with borrowers who may either sell or refinance prior to maturity. Balloon Payment Mortgages

Copyright 2014 by Diane S. Docking 29 Low payments in initial years (10 to 15 years) – only includes interest on borrowed amount. After initial period, payments increase such that entire loan amount is amortized by the end of 30 years. Borrower pays interest for a considerable period on the entire loan balance, but avoids having to pay down balance in initial years. Interest Only Mortgages

Copyright 2014 by Diane S. Docking 30  Payment stream is "reversed." Instead of making monthly payments to a lender, a lender makes payments to you.  RAMs allow homeowners to borrow against the equity on their homes at low rates.  Used by older Americans (> 62 yrs.) to convert the equity in their homes into cash.  Typical term is no more than 20 years and could be for borrower’s lifetime as an annuity.  Homeowners’ equity declines by amount borrowed.  While a reverse mortgage loan is outstanding, you continue to own the home and hold title to it.  The money from a reverse mortgage can be used for ANYTHING: daily living expenses; home repairs and home modifications; medical bills and prescription drugs; pay-off of existing debts; continuing education; travel; long-term health care; prevention of foreclosure; and other needs.  Idea is when you die, no value in your home. Reverse Annuity Mortgages (RAMs)

Copyright 2014 by Diane S. Docking 31  extended at time of purchase or later as equity is borrowed from property.  used in conjunction with first or primary mortgage  shorter maturity typically for 2nd mortgage  1st mortgage paid first if default occurs so 2nd mortgage has a higher rate Second Mortgage

Copyright 2014 by Diane S. Docking 32 Became popular after the 1986 federal tax law. Home equity loans and lines of credit allow home owners to borrow against the equity built up in their homes because of paying down the loan and/or because of the appreciation of the property. Home equity lines of credit

Copyright 2014 by Diane S. Docking 33 What Does it Take to Buy a Home? Several factors influence a home buyer’s ability to secure a mortgage loans.  Borrower Income Payment-To-Income Ratio  Down Payment. Generally 20% Loan-To-Value Ratio  Private Mortgage Insurance is necessary for borrowers who are unable to come up with a 20 percent down payment. PMI premiums are added to mortgage payments until the value of the mortgage is less than 80% of the value of the house.  Commitment Letter form Lender

Copyright 2014 by Diane S. Docking 34 Example: Borrower Qualifications John and Mary want to buy a home. Their combined monthly gross income (GI) is $6,000. They currently have monthly car payments of $500 and a student loan payment of $275. Assume they will include in their monthly mortgage payment an escrow amount = $400 for real estate taxes (T) and homeowners insurance (HI). The bank requires the following income and loan ratios:  a minimum down payment of 20%,  a P&I ratio ≤ 25% of GI,  a P,I,T, & HI ratio ≤ 28% of GI,  a P,I,T,HI,& other debt service ratio ≤ 33% of GI,  and a LTV ratio of 80% or less. What is the maximum monthly P&I (principal and interest) they can afford? What is the maximum market value of a home that John and Mary could purchase given current market rates on a 30-year fixed rate loan = 6.0%? How much must they have for the down payment?

Copyright 2014 by Diane S. Docking 35 Solution to Example: Borrower Qualifications What is the maximum market value of a home that John and Mary could purchase given current market rates on a 30-year fixed rate loan = 6.0%? Given:Y = $6,000 Debt= = $775 T + HI= $400 Required: DP >.20 x FMV (P+I) / Y <.25 (P+I+T+HI) / Y <.28 (P+I+T+HI +Debt) / Y <.33 Loan / FMV <.80 3 bounds

Copyright 2014 by Diane S. Docking 36 Solution to Example: Borrower Qualifications (cont) What is the maximum market value of a home that John and Mary could purchase given current market rates on a 30-year fixed rate loan = 6.0%? I. Find maximum P+I they can afford: Bound 1: (P+I) / Y <.25 (P+I) / 6,000 <.25 → P+I < 1,500 Bound 2: (P+I+T+HI) / Y <.28 (P+I+400) / 6,000 <.28 → P+I < 1,280 Bound 3: (P+I+T+HI +Debt) / Y <.33 (P+I ) / 6,000 <.33 → P+I < 805 Choose Minimum P&I of ________________

Copyright 2014 by Diane S. Docking 37 Solution to Example: Borrower Qualifications (cont) What is the maximum market value of a home that John and Mary could purchase given current market rates on a 30-year fixed rate loan = 6.0%? II. Find PV = Loan value, given P+I = $805 III. Find FMV Loan / FMV < ,267 / FMV <.80 → FMV < $167, = ___________ How much must they have for the down payment? DP >.20 x FMV →.20 x $167,833 = ________________ FV = 0 n = 30 x 12 = 360 i = 6% / 12 = 0.5% Pmt = P+I = $805  PV = ___________= maximum loan amount

Copyright 2014 by Diane S. Docking 38 A variety of fun mortgage calculators Example: Whether or not to Pay Points A difficult decision when getting a mortgage is whether to pay points (cash) upfront in exchange for a lower interest rate on the mortgage. Suppose you had to choose between a 12% 30- year mortgage or an 11.5% mortgage with 2 discount points. Which should you choose? Assume you wished to borrow $100,000.

Copyright 2014 by Diane S. Docking 39 Solution to Example: Whether or not to Pay Points I. First, examine the 12% mortgage. II. Now, examine the 11.5% mortgage. So, paying the points will save you $38.32 each month. However, you have to pay $2,000 upfront in points ($100,000 x.02) PV = $100,000 loan amount FV = 0 n = 30 x 12 = 360 i = 12% / 12 = 1%  Pmt = ________________________ PV = $100,000 loan amount FV = 0 n = 30 x 12 = 360 i = 11.5% / 12 = %  Pmt = _____________________

Copyright 2014 by Diane S. Docking 40 Solution to Example: Whether or not to Pay Points (cont.) The decision depends on how long you want to live in the house, keeping the same mortgage. Suppose you want to live there forever, is the $2,000 upfront cost worth the monthly savings? How do I figure this? You need to determine when the present value of the savings ($38.32) and compare them to the $2,000 upfront costs. Pmt = savings = $38.32 FV = 0 i = 11.5%/ 12 = % n = 30 x 12 = 360  PV = _______________ Since PV of savings > points paid, you should pay the points and accept the 11.5% loan.

Copyright 2014 by Diane S. Docking 41 Solution to Example: Whether or not to Pay Points (cont.) The decision depends on how long you want to live in the house, keeping the same mortgage. If you only want to live there 1 year, clearly the $2,000 upfront cost is not worth the monthly savings. How do I figure this? You need to determine when the present value of the savings ($38.32) equals the $2,000 upfront costs. PV = $2,000 points paid upfront FV = 0 i = 11.5% / 12 = % Pmt = $38.32 monthly savings  n = months / 12 = ___________ If you think you will stay in the house and not refinance for at least 6.05 years, pay the points. Otherwise, you should accept the 12% loan.

Copyright 2014 by Diane S. Docking 42 Mortgage Bankers __________ residential and commercial mortgages They ________ mortgages from banks, S&Ls, etc. They ___________ mortgages  collecting fees for origination They ____________ the mortgages into securitized financial instruments They _________ these securitized instruments to institutional investors (thrift institutions, life insurance companies, govt. agency, etc.) They usually continue to ________the mortgage even after it has been packaged and sold.

Copyright 2014 by Diane S. Docking 43 Mortgage Pass-Through/ Mortgage-Backed Security Definition: A security that has the borrower’s mortgage payments (P&I) pass through the trustee before being disbursed to the investors.

Securitization Process BorrowersBanks SPE/Trust MBS IOU Mortgage Loan $ Extend Credit Sell loans $ SPE : pools “like” mortgages, obtains credit rating, may seek guarantee GNMA, FNMA, sells to investors via Securities Dealers P&I payments $ Investors $ to purchase CMO,MBS Investment return and Principal $ $ to make MORE loans 3 Mortgage Pass-Through Security Receive P&I monthly 44 Copyright 2014 by Diane S. Docking

45 Securitized Mortgages Benefits 1. Reduces the problems caused by regional lending institution’s sensitivity to local economic fluctuations. 2. Borrowers have access to a national capital market. 3. Investors have low-risk and long-term investments in mortgages without having to service the loan.

Copyright 2014 by Diane S. Docking 46 Development of a Secondary Market U. S. Congress initiated the development of a secondary market for mortgage loans in 1934 by creating the Federal Housing Administration (FHA). In 1938, the Federal National Mortgage Association (FNMA) which was authorized to buy FHA insured loans. In 1968, FNMA was split up into two entities – FNMA and GNMA (Government National Mortgage Association).  GNMA was authorized by Congress to guarantees mortgage pools insured by FHA, VA and other federal agencies. In 1970, the Federal Home Loan Mortgage Corporation (FHLMC) was created to help create a secondary market for conventional mortgages.

Copyright 2014 by Diane S. Docking 47 Types of Pass-Through Securities Ginnie Mae Pass-Throughs  pools of government insured (VA, FHA) mortgages. Fannie Mae pass-throughs pools of conventional or federally insured mortgages. Freddie Mac Participation Certification  pools of conventional mortgages.  Issued by the Federal Home Loan Mortgage Corporation (FHLMC)  not federally insured.

Copyright 2014 by Diane S. Docking 48 Types of Pass-Through Securities Collateralized Mortgage Obligations (CMOs) - fixed maturity date and interest payments similar to bonds.  CMOs are mostly sold by FHLMC; other GSEs and private issuers can also issue CMOs.  CMOs are like serial bonds.  CMO issues have between 3 and 10 classes.  Investors can choose the class that matches their maturity preference.  CMOs are sometimes split into “interest only” (IO) and “principal only” (PO) classes (similar to stripped treasuries).  CMOs have a major disadvantage because they can create tax problems for the originators.

Copyright 2014 by Diane S. Docking 49 CMO Structure Tranche A: 3.3% 2-yr Tranche C: 3.6% 5-yr Tranche Z: 5% 10-yr All investors receive interest. Tranche A receives Principal first, then Tranche B, etc.