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1 Printable Lesson Materials Print these materials as a study guide These printable materials allow you to study away from your computer, which many students find beneficial. These materials consist of two parts: graphic summaries of the content and a multiple choice quiz. Graphic Summaries This portion of your printable materials consists of dozens of frames that summarize the content in this lesson. The frames are arranged on the page to make it easy for you to study the material and add your own notes from your textbook or the online course. Quizzes Many students learn best from sets of questions, and this multiple choice quiz allows you to focus your review of the material to important topics Rockwell Institute NE 20th Street Bellevue, WA

2 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.

3 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 Fully amortized loan 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. Amortization Fully amortized loan 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.

4 Amortization Fully amortized loan 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. Amortization Partially amortized loan 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. Amortization Interest-only loan 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.

5 Amortization Interest-only loan If payments are interest-only during entire term, whole amount originally borrowed is due at end. Amortization Interest-only loan 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. Repayment Period Repayment period: number of years borrower has to repay loan. Also called the loan term.

6 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.

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

8 Repayment Period Total interest 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. Repayment Period Interest rate Lenders generally charge lower interest rates for shorter-term loans. Repayment Period 15-year loan compared to 30-year loan 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

9 Repayment Period 20-year loans 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. Repayment Period 40-year loans 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. 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

10 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.

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

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

13 Loan-to-Value Ratio Maximum LTV 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. Loan-to-Value Ratio Maximum LTV 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. Loan-to-Value Ratio Maximum LTV In recent years, loans with higher LTVs widely available. With higher maximum LTVs, people who don t have much cash can buy homes.

14 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).

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

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

17 Mortgage Insurance/Loan Guaranty Loan guaranty Guarantor might be: private party, nonprofit organization, or governmental agency. Mortgage Insurance/Loan Guaranty 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. Secondary Financing Secondary financing: Second loan obtained to pay part of downpayment or closing costs required for main loan (primary loan).

18 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.

19 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 Fixed-rate mortgages 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.

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

21 Fixed or Adjustable Interest Rate Adjustable-rate mortgages 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 How an ARM works Borrower s interest rate first determined by market rates at time loan is made. Adjustable-Rate Mortgages How an ARM works 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.

22 Adjustable-Rate Mortgages How an ARM works 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. Adjustable-Rate Mortgages ARM features ARM may have all or only some of these features: Note rate Index Margin Rate adjustment period Payment adjustment period Lookback period Interest rate cap Payment cap Negative amortization cap Conversion option ARM Features Note rate ARM s note rate is its initial interest rate, as stated in promissory note.

23 ARM Features Note rate 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. ARM Features Index 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 ARM Features Margin 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.

24 ARM Features Margin 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 ARM Features Margin 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. ARM Features Rate adjustment period ARM s interest rate adjusted only at specified intervals. For example, every 6 months, once a year, or every 3 years. This is loan s rate adjustment period. One-year adjustment period most common.

25 ARM Features Rate adjustment period At end of period, lender: checks index for increase or decrease, and raises or lowers loan s rate based on change in index rate. ARM Features Rate adjustment period 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 fixed rate for first three years annual adjustments for rest of loan term ARM Features Mortgage payment adjustment period ARM s mortgage payment adjustment period determines when lender changes amount of principal and interest payment to reflect change in interest rate. Most ARMs provide for payment to be adjusted at same time as interest rate. But with some loans, payment is adjusted less frequently than interest rate.

26 ARM Features Lookback period Typical lookback period is 45 days. Loan s rate and payment adjustments are determined by what index was 45 days before end of adjustment period. ARM Features Interest rate cap When ARM s payment amount is adjusted, borrower may experience payment shock. Payment shock occurs when: market rates (and ARM s index) have risen dramatically since last adjustment, which causes sharp increase in loan s interest rate, which causes payment amount to increase so much that borrower can t afford it. ARM Features Interest rate cap To protect borrower from payment shock, most ARMs have interest rate cap. Interest rate cap limits how much the loan s interest rate can increase, regardless of increases in index. Prevents monthly payment from increasing too much.

27 ARM Features Interest rate cap ARM rate caps limit how much interest rate can increase: per adjustment period, and over the life of the loan. ARM Features Mortgage payment cap A payment cap directly limits how much the loan s payment amount can increase. Cap applies only to principal and interest payment, not to tax and insurance portion of PITI payment. Many ARMS have only interest rate cap, with no payment cap. ARM Features Negative amortization Negative amortization occurs when unpaid interest is added to loan s principal balance, increasing amount owed. Normally, balance goes down steadily (if gradually) as principal is paid off. Negative amortization causes principal balance to go up instead of down.

28 Negative Amortization Features causing negative amortization ARM features that can lead to negative amortization: Payment cap without rate cap. Payments adjusted less often than interest rate. Negative Amortization Features causing negative amortization Example: W borrows $190,000 to buy home. Loan is one-year ARM. 7.5% annual payment cap No interest rate cap Initial interest rate: 4.5% Initial monthly payment: $ Negative Amortization Features causing negative amortization Example: W borrows $190,000 to buy home. Loan is one-year ARM. 7.5% annual payment cap No interest rate cap Initial interest rate: 4.5% Initial monthly payment: $ By end of first year, index has risen 2%, and lender increases interest rate on loan by 2%, to 6.5%.

29 Negative Amortization Features causing negative amortization (Example, continued) Without payment cap, rate increase would cause payment to increase by $238.23, to $1, But payment cap limits increase to $ Negative Amortization Features causing negative amortization (Example, continued) Without payment cap, rate increase would cause payment to increase by $238.23, to $1, But payment cap limits increase to $ New payment ($1,034.90) doesn t cover all of the interest accruing on the loan. Lender adds unpaid interest to loan balance. Balance goes up, not down, which is negative amortization. Negative Amortization Negative amortization cap Many ARMs are structured to prevent negative amortization. But if it is a possibility, loan may have a negative amortization cap. Limits amount of unpaid interest that can be added to principal balance. When limit is reached, loan must be recast.

30 Negative Amortization Option ARMs Option ARMs, popular during subprime boom, were designed to allow 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, or minimum (limited) payment. Negative Amortization Option ARMs Minimum payment option doesn t cover interest, resulting in negative amortization. Negative Amortization Option ARMs Minimum payment option doesn t cover interest, resulting in negative amortization. Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month.

31 Negative Amortization Option ARMs Minimum payment option doesn t cover interest, resulting in negative amortization. Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month. After negative amortization limit reached and loan was recast, borrowers defaulted. Negative Amortization Option ARMs Minimum payment option doesn t cover interest, resulting in negative amortization. Instead of using minimum payment option occasionally to manage cash flow, many borrowers used it every month. After negative amortization limit reached and loan was recast, borrowers defaulted. Option ARMs no longer widely available. ARM Features Conversion option 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.

32 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

33 Real Estate Finance Lesson 6 Cumulative Quiz 1. A loan where the entire loan balance will be paid off at the end of the loan term is: A. fully amortized B. interest-only C. nonrecourse D. partially amortized 2. A partially amortized loan: A. includes both interest and principal in each payment B. requires a balloon payment at the end of the loan term C. will be fully paid off at the end of the loan term D. Both A and B 3. A balloon payment will be necessary with a/an: A. interest-only loan B. partially amortized loan C. fully amortized loan D. both A and B 4. Compared with a 30-year loan borrower, a 15-year loan borrower: A. will make larger monthly payments B. will make smaller monthly payments C. will make more monthly payments over the course of the loan D. will pay more total interest over the course of the loan 5. Which loan term would result in the borrower paying the least amount of interest over the life of the loan? A. 15 years B. 20 years C. 30 years D. 40 years 6. A borrower takes out a loan with an 80% LTV to purchase a $400,000 property. What is the loan amount? A. $80,000 B. $320,000 C. $360,000 D. $500, Rockwell Publishing 1

34 7. Which LTV would a lender believe to pose the greatest risk? A. 80% B. 90% C. 95% D. 97% 8. The purpose of mortgage insurance is to reimburse: A. the borrower in the event property improvements are destroyed by natural disaster B. the borrower in the event the lender becomes insolvent C. the lender for losses in the event of the borrower's default D. the lender in the event that title is unmarketable 9. A common restriction on secondary financing is that: A. the borrower must qualify based on combined payments for both loans B. the borrower must still make a downpayment out of her own funds C. the secondary financing must be from an institutional lender D. Both A and B 10. Between the 1930s and 1970s, virtually all loans: A. had adjustable interest rates B. had fixed interest rates C. had interest rates higher than 10% D. had LTVs of 90% or higher 11. A lender compensates for the increased risk to an ARM buyer by: A. charging a lower initial interest rate B. requiring mortgage insurance for any ARM loan C. using a shorter repayment period D. using less strict underwriting standards 12. An ARM begins with a stated interest rate of 5%. The ARM is based on the 11th District cost of funds index, which is currently 3%. The is 5%. A. index B. lookback period C. margin D. note rate 2009 Rockwell Publishing 2

35 13. An ARM's margin is: A. a regularly published report reflecting changes in the cost of money B. the difference between the index and the interest rate charged to the borrower C. the initial rate stated in the promissory note D. the length of time between points at which the lender can change the rate 14. A 5/1 ARM has an initial of five years. A. interest rate cap B. mortgage payment adjustment period C. mortgage payment cap D. rate adjustment period 15. On December 31, an ARM's interest rate is adjusted. It is adjusted based on where the LIBOR index stood on November 15. The loan's is 45 days. A. lookback period B. mortgage payment adjustment period C. mortgage payment cap D. rate adjustment period 16. An ARM borrower's interest rate goes up 2% in a particular year, but the index the loan is based on went up 4% that same year. This loan must have a/an: A. interest rate cap B. lookback period C. mortgage payment cap D. negative amortization cap 17. Before making the monthly payment of $2,000 on his ARM, Alex had a loan balance of $250,000. Alex owed $2,100 in interest, so after making the payment, his balance was $250,100. This is an example of: A. negative amortization B. partial amortization C. payment shock D. usury 18. There is a risk of negative amortization occurring if a loan has a/an but no. A. index rate, interest rate cap B. interest rate cap, mortgage payment cap C. mortgage payment cap, interest rate cap D. mortgage payment cap, lookback period 2009 Rockwell Publishing 3

36 19. A borrower may change an ARM to a fixed-rate loan at designated points if the loan: A. has a conversion option B. has an index rate C. has a negative amortization cap D. is a hybrid ARM 20. An ARM has a 2.5% margin. It is based on the Treasury securities index, which two months ago was running at 4%. The loan has a two-month lookback period. The loan had an initial 'teaser' rate of 4.5%. If today is the day for adjusting the loan's interest rate, what is the new rate that will be charged to the borrower? A. 4% B. 4.5% C. 6.5% D. 7% 2009 Rockwell Publishing 4