1. © 2010 Rockwell Publishing Financing Residential Real Estate Lesson 6: Basic Features of a Residential Loan

2. © 2010 Rockwell Publishing Introduction This lesson will cover: amortization repayment periods loan-to-value ratios mortgage insurance and loan guaranties secondary financing fixed and adjustable interest rates

3. © 2010 Rockwell Publishing 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.

4. © 2010 Rockwell Publishing Amortization Payments for fully amortized loan are enough to pay off all principal and interest by end of loan term. Payment amount same throughout term. Every month, interest portion of payment gets smaller, principal portion gets larger. Fully amortized loan

5. © 2010 Rockwell Publishing Amortization Partially amortized loan: requires regular payments including principal and interest. But payments not enough to pay off debt by end of loan term. Balloon payment required to pay remainder of principal. Partially amortized loan

6. © 2010 Rockwell Publishing Amortization Interest-only loan: calls for regular payments that cover only interest accruing, without paying any of principal, either: during entire loan term, or during specified interest-only period at beginning of term. Interest-only loan

7. © 2010 Rockwell Publishing Amortization If payments interest-only during limited period: at end of that period, amortized payments must begin payment may increase sharply at end of interest-only period Interest-only loan

8. © 2010 Rockwell Publishing Repayment Period Number of years borrower has to repay loan. Also called loan term.

9. © 2010 Rockwell Publishing Repayment Period Until 1930s, typical repayment period for mortgage was 5 years. If lender didn’t renew loan, balloon payment required. Now 30 years is standard repayment period. 15, 20, and 40-year loans also available.

10. © 2010 Rockwell Publishing Repayment Period Length of repayment period affects: amount of monthly payment total amount of interest paid over life of loan May also affect interest rate charged.

11. © 2010 Rockwell Publishing Repayment Period Longer repayment period reduces amount of monthly payment. 30-year loan more affordable than 15. Shorter repayment period: higher payment amount equity builds faster more difficult to qualify for Monthly payment amount

12. © 2010 Rockwell Publishing Repayment Period Shorter repayment period substantially decreases total amount of interest paid on loan. Total interest for 15-year loan less than half total interest for 30-year loan. Total interest

13. © 2010 Rockwell Publishing 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 vs. 30-year loan

14. © 2010 Rockwell Publishing Repayment Period 20-year loan is compromise between 15-year and 30-year loan. Monthly payments higher than 30-year loan. But not as high as 15-year loan. 20-year loans

15. © 2010 Rockwell Publishing Repayment Period Some lenders offer 40-year loans, but they aren’t common. Monthly payments even more affordable than 30-year loan. Most commonly used in areas with very high housing costs. 40-year loans

16. © 2010 Rockwell Publishing Summary Amortization & Repayment Period Amortization Fully amortized Partially amortized Balloon payment Interest-only loan Loan term

17. © 2010 Rockwell Publishing Loan-to-Value Ratio Loan-to-value ratio (LTV): expresses relationship between loan amount and value of home being purchased. With 80% LT V, loan amount is 80% of home’s value. Higher LTV = smaller downpayment

18. © 2010 Rockwell Publishing Loan-to-Value Ratio Because downpayment is smaller, higher LTV loans riskier than lower LTV loans. Borrower has less money invested, won’t try as hard to avoid default. If foreclosure necessary, property may not sell for enough to pay off debt and costs. Higher LTV = higher risk

19. © 2010 Rockwell Publishing Loan-to-Value Ratio Lenders set maximum LTV for particular loan program or loan type. In transaction, maximum LTV determines: maximum loan amount minimum downpayment Key factor in determining “how much house” borrower can buy. Maximum LTV

20. © 2010 Rockwell Publishing Loan-to-Value Ratio Lenders traditionally protected themselves by setting low LTV limits. Traditional maximum: 80% Higher LTVs allowed only in special programs (FHA, VA). Maximum LTV

21. © 2010 Rockwell Publishing Loan-to-Value Ratio In recent years, loans with higher LTVs widely available. With higher maximum LTVs, people without much cash can buy homes. Maximum LTV

22. © 2010 Rockwell Publishing 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.

23. © 2010 Rockwell Publishing Mortgage Insurance/Guaranty Mortgage insurance works like other insurance: policyholder pays premiums insurer provides coverage for certain losses, up to policy limit Mortgage insurance

24. © 2010 Rockwell Publishing Mortgage Insurance/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 difference. Mortgage insurance

25. © 2010 Rockwell Publishing Mortgage Insurance/Guaranty With loan guaranty, third party (guarantor) takes on secondary legal responsibility for borrower’s obligation to lender. If borrower defaults, guarantor must reimburse lender for losses. Loan guaranty

26. © 2010 Rockwell Publishing Secondary Financing Secondary financing: second loan obtained to pay part of downpayment or closing costs required for primary loan. May be provided by institutional lender, private third party, or property seller.

27. © 2010 Rockwell Publishing Secondary Financing Lender of primary loan often restricts type of secondary financing borrower can use. Intended to prevent secondary loan from increasing default risk. Borrower must qualify for combined payment on both loans. Borrower still required to make small downpayment from own funds.

28. © 2010 Rockwell Publishing Summary LTV Ratio and Other Features Loan-to-value ratio Maximum loan amount Minimum downpayment Mortgage insurance Indemnify Loan guaranty Guarantor Secondary financing

29. © 2010 Rockwell Publishing Fixed or Adjustable Interest Rate 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

30. © 2010 Rockwell Publishing Fixed or Adjustable Interest Rate Adjustable-rate mortgage (ARM): allows lender to adjust loan’s interest rate to reflect changes in cost of money. Transfers rate fluctuation risk to borrower. ARM’s initial interest rate often lower than market rate for fixed-rate loan. Adjustable-rate mortgages

31. © 2010 Rockwell Publishing Adjustable-Rate Mortgages Borrower’s initial rate determined by market rates at time loan is made. Interest rate on loan tied to index. Index: published statistical report used as indicator of changes in cost of money. Lender chooses index when loan is made. How ARM works

32. © 2010 Rockwell Publishing 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 ARM works

33. © 2010 Rockwell Publishing 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 some/all of these features:

34. © 2010 Rockwell Publishing ARM Features Note rate: ARM’s 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

35. © 2010 Rockwell Publishing ARM Features When loan is made, lender chooses one of several published indexes, such as: Treasury securities index 11 th District cost of funds index LIBOR index Index

36. © 2010 Rockwell Publishing ARM Features Margin: difference between index rate and interest rate lender charges borrower. Lender adds margin to index to cover administrative expenses and provide profit. Margin stays same throughout loan term, even when interest rate changes. Margin

37. © 2010 Rockwell Publishing ARM Features ARM’s interest rate adjusted only at specified intervals. For example, every 6 months, once a year, or every 3 years. One-year adjustment period most common. Rate adjustment period

38. © 2010 Rockwell Publishing ARM Features At end of period, lender: checks index for increase or decrease raises or lowers loan’s rate based on change in index rate Rate adjustment period

39. © 2010 Rockwell Publishing ARM Features Hybrid ARM: combination of ARM and fixed- rate loan, with two-tiered adjustment structure. Longer initial period, with more frequent adjustments after that. Example: 3/1 hybrid ARM. Rate adjustment period

40. © 2010 Rockwell Publishing ARM Features Determines when lender changes payment amount to reflect change in interest rate. Most ARMs have payment adjustment at same time as rate adjustment. With some loans, payment adjusted less frequently than interest rate. Mortgage payment adjustment period

41. © 2010 Rockwell Publishing ARM Features Typical lookback period is 45 days. Loan’s rate and payment adjustments determined by what index was 45 days before end of adjustment period. Lookback period

42. © 2010 Rockwell Publishing ARM Features When ARM’s payment amount is adjusted, borrower may experience payment shock. Occurs when: market rates/index rise dramatically sharp increase in loan’s interest rate payment amount increases drastically Interest rate cap

43. © 2010 Rockwell Publishing ARM Features To protect borrower from payment shock, most ARMs have interest rate cap: limits how much loan’s interest rate can increase per adjustment period and over life of loan Interest rate cap

44. © 2010 Rockwell Publishing ARM Features Payment cap: directly limits how much loan’s payment amount can increase. Cap applies only to principal and interest payment, not tax and insurance portion. Many ARMS have only interest rate cap, with no payment cap. Mortgage payment cap

45. © 2010 Rockwell Publishing ARM Features Negative amortization: when unpaid interest is added to loan’s principal balance, increasing amount owed. Normally, balance goes down steadily as principal is paid off. Negative amortization causes principal balance to go up. Negative amortization

46. © 2010 Rockwell Publishing Negative Amortization ARM features that can lead to negative amortization: payment cap without rate cap payments adjusted less often than interest rate Features causing NA

47. © 2010 Rockwell Publishing Negative Amortization Many ARMs structured to prevent negative amortization. But if NA is possible, loan may have negative amortization cap. Limits amount of unpaid interest that can be added to principal balance. When limit is reached, loan must be recast. Negative amortization cap

48. © 2010 Rockwell Publishing Negative Amortization Each month, borrower chooses payment option: P&I payment based on 15-year amortization P&I payment based on 30-year amortization interest-only payment minimum (limited) payment Option ARMs

49. © 2010 Rockwell Publishing Negative Amortization Minimum payment option doesn’t cover interest, resulting in negative amortization. After negative amortization limit reached and loan recast, many borrowers default. Option ARMs no longer widely available. Option ARMs

50. © 2010 Rockwell Publishing ARM Features If ARM has conversion option, borrower allowed to convert loan to fixed-rate mortgage. Conversion typically can take place only: on annual rate adjustment date during limited period Lender usually charges conversion fee. Conversion option

51. © 2010 Rockwell Publishing 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