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

Introduction In this lesson we will cover: amortization repayment periods loan-to-value ratios mortgage insurance and loan guaranties 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 as well as interest.

Amortization Payments for a fully amortized loan are enough to pay off all principal and interest by end of loan term. Payment amount is same throughout term. Fully amortized loan

Amortization Payments for a fully amortized loan are enough to pay off all principal and interest by end of loan term. Payment amount is same throughout term. Every month, interest portion of payment is smaller, and principal portion is larger. Fully amortized loan

Amortization Payments for a fully amortized loan are enough to pay off all principal and interest by end of loan term. Payment amount is same throughout term. Every month, interest portion of payment is smaller, and principal portion is larger.  Interest portion gets smaller because it’s based on remaining principal balance.  Balance is steadily reduced by principal portion of payments. Fully amortized loan

Amortization Partially amortized loan also requires regular payments that include principal as well as 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 regular payments that cover only the interest accruing, without paying any of the principal, either:  during entire loan term, or  during specified interest-only period at beginning of term. Interest-only loan

Amortization If payments are interest-only during entire term, whole amount originally borrowed is due at end. Interest-only loan

Amortization If payments are interest-only during limited period: At end of that period, borrower must start making amortized payments that will pay off all principal and interest by end of term. Payment may increase sharply at end of interest-only period. Interest-only loan

Repayment Period Repayment period: number of years borrower has to repay loan. Also called the loan term.

Repayment Period Until 1930s, typical repayment period for mortgage loan was 5 years.  If lender didn’t renew loan, balloon payment required.

Repayment Period Until 1930s, typical repayment period for mortgage loan was 5 years.  If lender didn’t renew loan, balloon payment required. Now 30 years is standard repayment period.

Repayment Period Until 1930s, typical repayment period for mortgage loan was 5 years.  If lender didn’t renew loan, balloon payment required. Now 30 years is standard repayment period. 15-year, 20-year, and 40-year loans also available.

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

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

Repayment Period Shorter repayment period:  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 for a 15-year loan is less than half the total interest for a 30-year loan. Total interest

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

Repayment Period 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 15-year loan compared to 30-year loan

Repayment Period 20-year loan is compromise between 15-year loan and 30-year loan.  Monthly payments higher than payments for 30-year loan.  But not as high as payments for 15-year loan. 20-year loans

Repayment Period Some lenders offer 40-year loans, but they aren’t common.  Monthly payments even more affordable than payments for 30-year loan.  But equity builds even more slowly and borrower pays even more total interest.  Most likely to be used in areas with very high housing costs. 40-year loans

Summary Amortization and Repayment Period  Amortization  Fully amortized  Partially amortized  Balloon payment  Interest-only loan  Loan term  30-year loan  15-year loan  20-year loan  40-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. For example, if LTV is 80%, loan amount is 80% of sales price or appraised value, whichever is less.

Loan-to-Value Ratio Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased. For example, if LTV is 80%, loan amount is 80% of sales price or appraised value, whichever is less. The higher the LTV, the smaller the downpayment.

Loan-to-Value Ratio Because downpayment is smaller, loan with higher LTV is generally riskier than loan with lower LTV. Higher LTV = higher risk

Loan-to-Value Ratio Because downpayment is smaller, loan with higher LTV is generally riskier than loan with lower LTV. Borrower has less money invested in home, won’t try as hard to avoid default. Higher LTV = higher risk

Loan-to-Value Ratio Because downpayment is smaller, loan with higher LTV is generally riskier than loan with lower LTV. Borrower has less money invested in home, won’t try as hard to avoid default. If foreclosure necessary, greater chance that property won’t sell for enough to fully pay off debt and costs. Higher LTV = higher risk

Loan-to-Value Ratio Lenders set maximum LTV limit for particular loan program or type of loan. Maximum LTV

Loan-to-Value Ratio Lenders set maximum LTV limit for particular loan program or type of loan. In a transaction, maximum LTV determines:  maximum loan amount  minimum downpayment Maximum LTV

Loan-to-Value Ratio For example, if maximum LTV for loan program is 95% and sales price is $200,000:  Maximum loan amount = $190,000  Minimum downpayment (5%) = $10,000 Maximum LTV

Loan-to-Value Ratio For example, if maximum LTV for loan program is 95% and sales price is $200,000:  Maximum loan amount = $190,000  Minimum downpayment (5%) = $10,000 Maximum LTV is key factor in determining “how much house” borrower can buy. Maximum LTV

Loan-to-Value Ratio Lenders traditionally protected themselves by setting low LTV limits.  Traditional maximum: 80%  Higher LTVs allowed only in special programs like FHA and VA loan programs. Maximum LTV

Loan-to-Value Ratio In recent years, loans with higher LTVs widely available. With higher maximum LTVs, people who don’t have much cash can buy homes. Maximum LTV

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

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

Mortgage Insurance/Loan Guaranty Purpose of mortgage insurance or guaranty: to protect lender from foreclosure loss. Also encourages lenders to make loans that would otherwise be too risky. Insurance or guaranty may be:  required by lender, or  feature of loan program (e.g., VA guaranty).

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

Mortgage Insurance/Loan Guaranty Policy protects lender against losses from borrower default and foreclosure. Mortgage insurance

Mortgage Insurance/Loan Guaranty Policy protects lender against losses from borrower default and foreclosure. Mortgage insurance company agrees to indemnify lender.  If foreclosure sale proceeds fall short, insurer will make up the difference. Mortgage insurance

Mortgage Insurance/Loan Guaranty Policy protects lender against losses from borrower default and foreclosure. Mortgage insurance company agrees to indemnify lender.  If foreclosure sale proceeds fall short, insurer will make up the difference. Borrower must meet underwriting standards of insurer as well as lender’s standards. Mortgage insurance

Mortgage Insurance/Loan Guaranty With loan guaranty, third party (the guarantor) agrees to take on secondary legal responsibility for borrower’s obligation to lender. Loan guaranty

Mortgage Insurance/Loan Guaranty With loan guaranty, third party (the guarantor) agrees to take on secondary legal responsibility for borrower’s obligation to lender.  If borrower defaults, guarantor must reimburse lender for resulting losses. 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 have its own underwriting standards that borrower must meet, in addition to meeting lender’s standards. Loan guaranty

Secondary Financing Secondary financing: Second loan obtained to pay part of downpayment or closing costs required for main loan (primary loan).

Secondary Financing Secondary financing: Second loan obtained to pay part of downpayment or closing costs required for main loan (primary loan). May be provided by institutional lender, private third party, or property seller.

Secondary Financing Lender making primary loan usually places some restrictions on type of secondary financing borrower can use. Restrictions intended to prevent secondary loan from increasing risk of default on primary loan.

Secondary Financing Lender making primary loan usually places some restrictions on type of secondary financing borrower can use. Restrictions intended to prevent secondary loan from increasing risk of default on primary loan. Borrower must qualify for combined payment on both loans.

Secondary Financing Lender making primary loan usually places some restrictions on type of secondary financing borrower can use. Restrictions intended to prevent secondary loan from increasing risk of default on primary loan. Borrower must qualify for combined payment on both loans. In many cases, primary lender still requires borrower to make small downpayment from own funds.

Summary Loan-to-value Ratio and Other Features  Loan-to-value ratio  Maximum loan amount  Minimum downpayment  Mortgage insurance  Indemnify  Loan guaranty  Guarantor  Secondary financing

Fixed or Adjustable Interest Rate With a fixed-rate mortgage, interest rate charged on loan remains constant throughout loan term. When market rates rise or fall, loan rate stays the same. Fixed-rate mortgages

Fixed or Adjustable Interest Rate With a fixed-rate mortgage, interest rate charged on loan remains constant throughout loan term. When market rates rise or fall, loan rate stays the same. Considered standard. Fixed-rate mortgages

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

Fixed or Adjustable Interest Rate An 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 mortgages

Fixed or Adjustable Interest Rate An 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. ARM’s initial interest rate often lower than market rate for a fixed-rate loan.  Not true under all market conditions, however. Adjustable-rate mortgages

Adjustable-Rate Mortgages Borrower’s interest rate first determined by market rates at time loan is made. How an ARM works

Adjustable-Rate Mortgages Borrower’s interest rate first determined by market rates at time loan is made. Interest rate on loan is tied to an index.  Index = Published statistical report used as indicator of changes in cost of money.  Lender chooses index when loan is made. How an ARM works

Adjustable-Rate Mortgages Loan’s interest rate periodically adjusted to reflect changes in index rate.  If index rate has increased, lender raises interest rate charged on loan.  If index rate has decreased, lender lowers interest rate charged on loan. How an ARM works

Adjustable-Rate Mortgages Note rate Index Margin Rate adjustment period Payment adjustment period Lookback period Interest rate cap Payment cap Negative amortization cap Conversion option ARM features ARM may have all or only some of these features:

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

ARM Features ARM’s note rate is its initial interest rate, as stated in promissory note. Some ARMs have teaser rate: discounted initial rate that is lower than initial rate indicated by index. Note rate

ARM Features ARM’s index is the statistical report indicating changes in market interest rates that the loan’s interest rate is tied to. When loan is made, lender chooses one of several published indexes, such as:  Treasury securities indexes  11 th District cost of funds index  LIBOR index Index

ARM Features ARM’s margin is the difference between index rate and interest rate lender charges borrower. Lender adds margin to index to cover administrative expenses and provide profit. Margin

ARM Features ARM’s margin is the difference between index rate and interest rate lender charges borrower. Lender adds margin to index to cover administrative expenses and provide profit.  Example: 3.25% Current index rate % Margin 5.25% Interest rate charged Margin

ARM Features ARM’s margin is the difference between index rate and interest rate lender charges borrower. Lender adds margin to index to cover administrative expenses and provide profit.  Example: 3.25% Current index rate % Margin 5.25% Interest rate charged Margin stays same throughout loan term, even when interest rate changes. Margin

ARM Features If ARM has conversion option, borrower allowed to convert loan to fixed-rate mortgage. Conversion typically can only take place:  on annual rate adjustment date;  during a limited period (for example, only after first year and no later than fifth year). Lender charges conversion fee. Conversion option

Summary Fixed or Adjustable Interest Rate  Fixed-rate mortgage  Adjustable-rate mortgage  Index  Note rate  Margin  Rate and payment adjustment periods  Lookback period  Interest rate and mortgage payment caps  Negative amortization  Option ARM  Conversion option