Fixed Rate Mortgage Loans Chapter 4 Fixed Rate Mortgage Loans

Overview Mortgage Interest Rates Components of the Mortgage Interest Rate Constant Amortization Mortgage (CAM) Constant Payment Mortgage (CPM) CAM and CPM Payment Patterns Computing a Loan Balance Loan Closing Costs Pricing a Loan Other Loan Patterns Partially Amortizing Loan Negative Amortization Option Mortgages Reverse Annuity Mortgage (RAM)

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

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

Components of the Mortgage Interest Rate – Continued Default Risk Interest Rate Risk Anticipated Inflation and Unanticipated Inflation Prepayment Risk Liquidity Risk Legislative Risk

Components of the Mortgage Interest Rate – Continued r = Real Rate f1 = Inflation Rate p1 = Risk Premiums

Constant Amortization Mortgage (CAM) Amortization = Original Loan Balance / Number of Payments Opening Balance = Previous Period Ending Balance Ending Balance = Opening Balance – Amortization Periodic Rate = Annual Rate / Payment per Year Interest = Opening Balance × Periodic Rate Monthly Payment = Interest + Amortization

Constant Payment Mortgage (CPM) FRM payments are structured as an ordinary annuity PV of the annuity is the amount borrowed The monthly payment on a 30-year, 12%, $60,000 loan is: Notes: To get the answer press CPT and then what you are trying to get To clear the calculator memory use 2nd CLR TVM To change P/Y, press 2nd P/Y, enter the amount and press ENTER. To get out of this mode use 2nd QUIT Annuity due setting is BGN (for beginning): 2nd BGN, 2nd SET, 2nd QUIT N I/Y P/Y PV PMT FV MODE 360 12 -60,000 617.17

Constant Payment Mortgage (CPM) – Continued Monthly Payment = Determined using Excel’s PMT function Beginning Loan Balance = Previous Period Ending Balance Interest = Beginning Loan Balance × Periodic Rate Ending Loan Balance = Beginning Loan Balance – Amortization Periodic Rate = Annual Rate / Payment per Year Amortization = Monthly Payment – Interest

CAM and CPM 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

Computing a Loan Balance The outstanding loan balance is the PV of the remaining loan payments discounted at the original loan rate After computing the PMT of the original loan just change N to number of remaining payments then CPT PV Alternatively, to determine the outstanding balance of the loan in the previous example after 10 years: Compute PMT (617.17) 2nd AMORT 120 ENTER 120 ENTER This will allow you to see loan information (self explanatory) at that point in time You can change P1 and P2 to get the data for the specified payment range

Computing Payment Components How much interest do you pay during the second year? $7,160.67 How much principal do you pay during the second year? $245.34 What is the interest component of 72nd payment? $582.37

Loan Closing Costs There are three categories of loan closing costs: Statutory Costs: These charges are associated with the legal transfer of title and other fees. They are paid for services by governmental agencies Third Party Charges: Payments for legal fees, appraisals, surveys, inspection, and title insurance Additional Finance Charges: These charges provide additional income to the lender and therefore should be included as a part of cost of borrowing 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

Loan Closing Costs – Continued 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

Loan Closing Costs – Continued If there are fees and points, then the effective interest cost is higher If the previous loan has 3 points, then the lender will disburse: [60,000 – (60,000 X 0.03)] = –58,200 Loan payments are based on $60,000 and the borrower receives less, increasing the return to lender Note that fees and points work the same way We also assume that the loan is not prepaid Lenders are required to disclose by law (Truth-in-Lending Act) an annual percentage rate (APR) computed in a similar manner The effective interest cost is N I/Y P/Y PV PMT FV MODE 360 12.41 12 -58,200 617.17

Loan Closing Costs and Prepayment What would be effective interest cost if the loan is paid early Assume that after 5 years (60 payments), the loan is paid off We need to determine the outstanding balance of the loan after 60 payments Make sure that calculator has the original loan data without fees and points 2nd AMORT 60 ENTER 60 ENTER This will allow you to see loan information at that point in time (58,598.16) Loan balance becomes an entry for future value N I/Y P/Y PV PMT FV MODE 60 12.82 12 -58,200 617.17 58,598.16

Loan Closing Costs and Prepayment Penalty What would be effective interest cost if the loan is paid early Assume that after 5 years (60 payments), the loan is paid off We need to determine the outstanding balance of the loan after 60 payments Make sure that calculator has the original loan data without fees and points 2nd AMORT 60 ENTER 60 ENTER This will allow you to see loan information at that point in time (58,598.16) Apply 3% prepayment penalty [58,598.16 × (1 + 0.03) = 60,356] Loan balance becomes an entry for future value N I/Y P/Y PV PMT FV MODE 60 13.25 12 -58,200 617.17 60,356

Yield and Prepayment Time

Pricing a Loan How can a lender earn 13% return on a 12% interest rate, 30-year fixed rate mortgage that is expected to prepay in 10 years? This is same as asking for points to be charged to achieve the desired yield Payment on the loan: Balance of the loan after 120 payments: 0.934180 PV of payments to lender at the desired return: The fees should total 100% - 94.53% = 5.47% N I/Y P/Y PV PMT FV MODE 360 12 -1 0.010286 N I/Y P/Y PV PMT FV MODE 120 13 12 -0.9453 0.010286 0.934180

Partially Amortizing Loan What is the payment on a $60,000 loan with 12% interest rate, 30-year term, monthly payments, and $40,000 balloon payment at maturity? N I/Y P/Y PV PMT FV MODE 360 12 -60,000 605.72 40,000

Negative Amortization What is the payment on a $60,000 loan with 12% interest rate, 30-year term, and monthly payments? What is the balance of this loan if the lender and borrower agree on a monthly payment of $400 rather than $617.17 after 5 years? N I/Y P/Y PV PMT FV MODE 360 12 -60,000 617.17 N I/Y P/Y PV PMT FV MODE 60 12 -60,000 400.00 76,334

Option Mortgages In a simple case, a borrower pays interest only for a certain period and then converts the loan into a fixed rate fully amortizing loan What is the interest only payment for the first ten years on a $60,000 loan with 12% interest rate, 30-year term, and monthly payments? What is the monthly payment when the loan converts into a fixed rate fully amortizing loan? N I/Y P/Y PV PMT FV MODE 120 12 -60,000 600.00 60,000 N I/Y P/Y PV PMT FV MODE 240 12 -60,000 660.65

Reverse Annuity Mortgage (RAM) A RAM is a raising debt falling equity mortgage It requires large payment later in its life It is designed for retired home owners who have little debt on their home It allows owners to take out equity What is the payment on a $250,000 RAM with 10% interest rate, 10-year term, monthly payments? N I/Y P/Y PV PMT FV MODE 120 10 12 1,220.44 -250,000

Three Loans when LTV < 20% 1. Conventional loan with PMI 2. First and second loan 3. FHA insurance

Not So Special Specials A land developer purchases land, or purchases on option on land, with the intention of developing or enhancing the value of the property through improvements With an option the developer ties up less cash than with an outright purchase. A developer may be able to “control” property worth many millions of dollars with an option that may cost only in the thousands The developer makes a profit not through the appreciation in the value of the land but through the value added from the improvements

Not So Special Specials – Continued Zoning compliance – making sure that there are no legal restrictions to the type of development that is contemplated. If there are, then efforts must be made to have the zoning changed if possible, or the development modified to meet the existing zoning regulations Engineering and surveying – specialists in this field must be employed to make sure that the types of structures that are contemplated can be built on the land. The land may have to be modified to accommodate certain types of structures. In extreme cases it may be impossible to build certain types of structures on the available land Subdividing – the large land parcel is divided into smaller parcels. The smaller parcels are sold to other developers or to the final consumer who, in turn, constructs a structure Physical work – the actual grading of the land, landscaping, installation of utilities, and so forth

Authority to Assess Specially Why a city would get into this type of an activity?

Specials Example and Computations

Specials Computations