Copyright 2016 by Diane S. Docking

Lesson Objectives: What Are Mortgages?
Characteristics of Residential Mortgages Types of Mortgage Loans Borrower Qualifications Copyright 2016 by Diane S. Docking

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 2016 by Diane S. Docking

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 2016 by Diane S. Docking

Types of Mortgage Loans
Copyright 2016 by Diane S. Docking

Residential Mortgage: Mortgage Interest Rates
30-Year FRM, 1971 – July 2016: Above is a graph of historical trends in mortgage interest rates. Historical mortgage interest rates Copyright 2016 by Diane S. Docking

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%. Must the Johnson’s pay PMI? What are their monthly mortgage (P&I) payments? 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 2016 by Diane S. Docking

Solution to Example 1: FRM
Must the Johnson's pay PMI? No. 70,000/330,000 = 21.21% > 20% 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/y = 7% / 12 = % Compute Pmt = $1, per month Copyright 2016 by Diane S. Docking

What is the payoff amount after 5 years? 2nd Amort: P1 = 1 and P2 = 60, ↓ Balance = $244,742.13 OR PV = $260,000 n = 5 yrs. x 12 = 60 pmts made i/y = 7% / 12 = % Pmt = $1, per month Compute FVEOY5 =payoff amount = $244,742.13 Copyright 2016 by Diane S. Docking

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%. What is the monthly payment? What is the principal repayment for the first year? How much interest is paid the first year? What is the total amount of interest paid over the lifetime this loan? Copyright 2016 by Diane S. Docking

What is the principal repayment for the first year? Given the inputs from #1, use the 2nd Amort function to find the solution: PV = $100,000 FV = 0 n = 30 x 12 = 360 i/y = 10% / 12 = % Cpt Pmt = $ per month How much interest is paid the first year? 2nd Amort: P1 = 1; P2 = 12 ↓ BAL = $99,444.12 ↓ PRN = $555.88 ↓ INT = $9,974.98 2nd Amort: P1 = 1; P2 = 12 ↓ BAL = $99,444.12 ↓ PRN = $555.88 ↓ INT = $9,974.98 Copyright 2016 by Diane S. Docking

What is the total amount of interest paid over the lifetime this loan? Given the inputs from #1, use the 2nd 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, Less loan amount $215, = total interest paid over 30 yrs. 2nd Amort: P1 = 1; P2 = 360 ↓ BAL = $0 ↓ PRN = $100,000 ↓ INT = $215,925.77 Copyright 2016 by Diane S. Docking

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/y= 5.75% / 12 = % Cpt Pmt = $1, per month Copyright 2016 by Diane S. Docking

Mortgage Amortization Schedule (1)
Copyright 2016 by Diane S. Docking

Mortgage Amortization Schedule (2)
. Copyright 2016 by Diane S. Docking

Adjustable Rate Mortgages (ARM)
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%. Copyright 2016 by Diane S. Docking

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%. What is the monthly payment in year 1? Year 2? What is the principal repayment and interest paid for the first year? For the second year? 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 2016 by Diane S. Docking

Solution to Example: ARM
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 2nd Amort: P1 = 1; P2 = 12; ↓ BAL = $98,771.99 2) Interest rate for year 2 = 3-month T-Bill rate + 2% = 6% + 2% = 8%. 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 FVEOY1= $98,771.99 PVBOY2 = 98,771.99 FV = 0 n = 29 yrs. left x 12 = 348 i = 6% + 2% = 8%/ 12 = 0.666% Pmt = $ per month in year 2 Copyright 2016 by Diane S. Docking

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 2nd Amort: P1 = 1; P2 = 12; ↓ BAL = $98,771.99 ↓ PRN = $1, principal reduction in year 1 ↓ INT = $5, interest paid in year 1 Using 2nd Amort: P1 = 1; P2 = 12; ↓ BAL = $97,870.87 ↓ PRN = $ principal reduction in year 2 ↓ INT = $7, interest paid in year 2 PVBOY2 = 98,771.99 FV = 0 n = 29 yrs. left x 12 = 348 i = 6% + 2% = 8%/ 12 = 0.666% Pmt = $ per month in year 2 Copyright 2016 by Diane S. Docking

Suppose at the end of the second year, the purchasers decide to convert to a fixed rate mortgage. What is their new monthly payment? PVBOY2 = $98,771.99 n = 12 payments i = 8% / 12 = 0.666% Pmt = $ per month FVEOY2= $97, Using 2nd AMORT this is the balance at EOY 2 PVBOY3 = 97,870.86 FV = 0 n = 28 yrs. left x 12 = 336 i = 9%/ 12 = 0.75% Pmt = $ per month for years Copyright 2016 by Diane S. Docking

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 2016 by Diane S. Docking

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 = 5% T-Bill rate BOY + 2% Year 2 = 6% +2% = 8% but ltd to 5% + 2% cap = 7% Year 3 = 7% +2% = 9% but ltd to 7% + 2% cap = 9% Year 4 = 5.5%+2% = 7.5% but ltd to 9% - 2% cap = 7% =7.5% Year 5 = 8% +2% = 10% but ltd to 7.5% + 2% cap = 9.5% Year 6 = 9.5%+2% = 11.5% but ltd to 11% lifetime Year 7 = 10.5% +2% = 12.5% but ltd to 11% lifetime Copyright 2016 by Diane S. Docking

Balloon Payment Mortgages
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. Copyright 2016 by Diane S. Docking

Interest Only Mortgages
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. Copyright 2016 by Diane S. Docking

Reverse Annuity Mortgages (RAMs)
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. Copyright 2016 by Diane S. Docking

Second Mortgage 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 Copyright 2016 by Diane S. Docking

Home equity lines of credit
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. Copyright 2016 by Diane S. Docking

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 2016 by Diane S. Docking

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 2016 by Diane S. Docking

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: GI = $6,000 Debt = = $775 T + HI = $400 Required: DP > .20 x FMV (P+I) / GI < .25 (P+I+T+HI) / GI < .28 (P+I+T+HI +Debt) / GI < .33 Loan / FMV < .80 3 bounds Copyright 2016 by Diane S. Docking

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) / GI < .25 (P+I) / 6,000 < .25 → P+I < 1,500 Bound 2: (P+I+T+HI) / GI < .28 (P+I+400) / 6,000 < .28 → P+I < 1,280 Bound 3: (P+I+T+HI +Debt) / GI < .33 (P+I ) / 6,000 < .33 → P+I < 805 Choose Minimum P&I of $805 Copyright 2016 by Diane S. Docking

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 < .80 134,267 / FMV < .80 → FMV < $167, = $167,833 How much must they have for the down payment? DP > .20 x FMV → .20 x $167,833 = $33,567 FV = 0 n = 30 x 12 = 360 i/y = 6% / 12 = 0.5% Pmt = P+I = $805 Cpt PV = $134,267 = maximum loan amount Copyright 2016 by Diane S. Docking

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. A variety of fun mortgage calculators Copyright 2016 by Diane S. Docking

Solution to Example: Whether or not to Pay Points
First, examine the 12% mortgage. 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/y = 12% / 12 = 1% Cpt Pmt = $1, per month PV = $100,000 loan amount FV = 0 n = 30 x 12 = 360 i/y = 11.5% / 12 = % Cpt Pmt = $ per month Copyright 2016 by Diane S. Docking

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. Since PV of savings > points paid, you should pay the points and accept the 11.5% loan. Pmt = savings = $38.32 FV = 0 i/y = 11.5%/ 12 = % n = 30 x 12 = 360 Cpt PV = $3,869.57 Copyright 2016 by Diane S. Docking

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. 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. PV = $2,000 points paid upfront FV = 0 i/y = 11.5%/ 12 = % Pmt = $38.32 monthly savings Cpt n = months / 12 = 6.05 years Copyright 2016 by Diane S. Docking

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