Presentation on theme: "CHAPTER 4 FIXED RATE MORTGAGES"— Presentation transcript:
1CHAPTER 4 FIXED RATE MORTGAGES DETERMINANTS OF MORTGAGE INTEREST RATES:MORTGAGE INTEREST RATES ARE BASED ON A “DERIVED DEMAND” -- THE DEMAND FOR HOUSING AND ALSO SUPPLY SIDE FACTORS.THE MORTGAGE MARKET IS PART OF A LARGER CAPITAL MARKET - i.e., THE SUPPLY OF MORTGAGE MONEY IS IN COMPETITION WITH OTHER TYPE OF LOANS/INVESTMENTS (CAPITAL MARKETS)
2INTEREST RATESREAL RATE OF INTEREST - MINIMUM RATE REQUIRED TO DIVERT FUNDS FROM PRESENT CONSUMPTION TO FUTURE CONSUMPTIONUSUALLY MEASURED AS A SHORT-TERM INTEREST RATEA NOMINAL (CURRENT DOLLARS) RATE CORRECTED FOR ACTUAL (OR ANTICIPATED) CHANGES IN INFLATION Continued
3INTEREST RATES USUALLY THOUGHT OF AS A “RISKLESS” RATE HISTORICALLY ABOUT 3 PERCENTNOMINAL RATE - INFLATION RATE = REAL RATE
5NOMINAL INTEREST RATE (CONTRACT RATE) PRICING DECISIONS BY LENDERS ARE RENDERED COMPLEX BECAUSE MOST MORTGAGE LOANS ARE MADE AT FIXED INTEREST RATES FOR LONG PERIODS OF TIME.
6NOMINAL INTEREST RATE (CONTRACT RATE) IF LENDERS FORMED EXPECTATIONS OF WHAT INTEREST RATES WOOULD BE ON A SERIES OF ONE-YEAR LOANS OVER THE MATURITY OF A GIVEN LOAN - THEY WOULD CALCULATE IT AS FOLLOWS:(1+it)n = (1+i1)(1+i2)(1+i3) … (1+in)
7NOMINAL INTEREST RATE (CONTRACT RATE) EXAMPLE: IF YOU FORECASTED THE FOLLOWING SERIES OF INTEREST RATES(8%, 9%, 9%, 10%, 8%)(1+it) = (1+.08)(1+.09)(1+.09)(1+.10)(1+.08)= (1.5244)
9NOMINAL INTEREST RATE (CONTRACT RATE) THIS IS THE CONTRACT RATE THAT WOULD BE CHARGED IF THE FUTURE ANTICIPATED WERE AS FORECASTED ABOVE.IT IS ALSO THE COMPOUND ANNUAL RATE NECESSARY TO GROW $1 TO $ IN 5 YEARS
10MORTGAGE PAYMENT PATTERNS PRIOR TO GREAT DEPRESSION:HIGH DOWN PAYMENTS (50%)SHORT MATURITY (5 YEARS)INTEREST ONLY LOANSBALLOON PAYMENTS
11MORTGAGE PAYMENT PATTERNS THEREFORE,FEW COULD AFFORD HOME PURCHASESHORT MATURITY/ BALLOON PAYMENT CREATED REPAYMENT DANGERR.E. AS COLLATERAL WAS NOT HIGHLY REGARDED
13SELF - AMORTIZING LOANS AMORITIZATION - THE PROCESS OF LOAN REPAYMENT OVER TIME1. CONSTANT AMORTIZATION MORTGAGE (CAM)MONTHLY PAYMENT = CONSTANT AMORTIZATION OF PRINCIPAL + INTEREST DUE ON OUTSTATNDING LOAN BALANCE (OLB)
15SELF - AMORTIZING LOANS MONTH 2 PAYMENT= ((100, )(.10/12)== $1,105.47BORROWERS DIDN’T CARE FOR CHANGING MONTHLY PAYMENTS
16SELF - AMORTIZING LOANS 2. CONSTANT PAYMENT MORTGAGE (CPM)MONTHLY PAYMENT IS CONSTANT OVER LIFE OF LOANLOAN IS FULLY AMORTIZED AT MATURITYPORTION OF PAYMENT THAT IS PRINCIPAL VERSUS INTEREST CHANGES IN EVERY PAYMENTEASIER TO QUALIFY FOR THAN CAM BECAUSE INTIAL PAYMENT IS LOWERMORE INTEREST IS PAID OVER LIFE OF LOAN
25CLOSING COSTSEXPENSES IN ADDITION TO THE PURCHASE PRICE OF THE PROPERTY WHICH MUST BE PAID BY THE PURCHASER OR DEDUCTED FROM THE PROCEEDS OF THE SALE TO THE SELLER AT THE TIME OF CLOSING. THESE COSTS CAN GENERALLY BE PLACED IN ONE OF THREE CATEGORIES: STATUTORY COSTS, THIRD-PARTY CHARGES, AND ADDITIONAL FINANCE CHARGES.
26CLOSING COSTSSTATUTORY COSTS - LEGAL REQUIREMENTS PERTAINING TO TITLE TRANSFERS, RECORDING DEEDS, TAX STAMPS, ETC... THESE COSTS SHOULD NOT BE CONSIDERED PART OF FINANCING COSTS.
27CLOSING COSTSTHIRD-PARTY COSTS - ATTORNEY’S FEES, APPRAISALS, SURVEYS, BUILDING INSPECTION, TERMITE INSPECTION, TITLE INSURANCE, BROKER COMMISSIONS. NOT TO BE CONSIDERED PART OF FINANCING COSTS.
28CLOSING COSTSFINANCE COSTS (LOAN FEES) - THESE CHARGES CONSTITUTE ADDITIONAL INCOME TO THE LENDER AND SHOULD BE INCLUDED AS A PART OF THE COST OF BORROWING. TWO TYPES:1. LOAN ORIGINATION FEES - THESE CHARGES COVER THE ADMINISTRATIVE COSTS INCURRED BY THE LENDER AND ARE TYPICALLY STATED AS A PERCENTAGE OF THE LOAN.
29CLOSING COSTS2. LOAN DISCOUNT OR POINTS - A FEE CHARGED BY A LENDER AT CLOSING OR SETTLEMENT THAT RESULTS IN INCREASING THE LENDER’S EFFECTIVE YIELD (IRR) ON THE MONEY LOANED. EACH DISCOUNT POINT REPRESENTS A ONE-TIME CHARGE BY THE LENDER EQUAL TO 1% OF THE LOAN PRINCIPAL.
30EFFECTIVE YIELD (EFFECTIVE BORROWING COSTS) THE INTEREST RATE THE LENDER EARNS.NORMALLY, THE EFFECTIVE YIELD IS THE SAME AS THE CONTRACT RATE OF INTEREST ON WHICH THE LOAN PAYMENTS ARE CALCULATED.CERTAIN MODIFICATIONS TO LOANS ALTER THE “TRUE” RATE OF INTEREST THE LENDER EARNS. THESE MODIFICATIONS ARE LOAN DISCOUNTS, LOAN ORIGINATION FEES, AND PREPAYMENT PENALITIES.
31EFFECTIVE YIELD (EFFECTIVE BORROWING COSTS) TRUTH-IN-LENDING ACT REQUIRES APR (ANNUAL PRECENTAGE RATE) WHICH ACCOUNTS FOR ORIGINATION FEES AND DISCOUNT POINTS. APR CALCULATION ALLOWS COMPARISION OF LOANS WITH DISSIMILAR CONTRACT RATES, FEES, AND MATURITIES. PREPAYMENT EFFECT IS NOT CONSIDERED IN APR CALCULATION.
32Calculating Effective Yield The basic idea:The present value of forecasted streamof income + PV of any reversion amountshould be equal to the disbursement[orig. loan] when discounted at theappropriate rate [Effective Yield/Cost].
33IRR (Internal Rate of Return] = the discount rate that caused thePV of CFs to equal the initial cost= The i that causes NPV = 0Think of a loan disbursement as the lender’s investment.The CFs equal the loan payment.
34Examples:Loan Amount $100,000Interest Rate 8%Maturity Term years- monthly paymentCalculate monthly payment = $733.76Calculate effective yield (YTM or IRR) == 8%
35What if an origination fee or discount points are charged ? Assume same loan term as above, however 2 discount points and 1 origination point are charged .Disbursement = $100,000-3,000 ( .03 X 100,000)$ 97,000CFS = $733.76/mo.IRR = %
36What happens when a loan is prepaid ? 1. Assume no origination fees or discount points. Loan prepaid at end of year 15 (after 180 payments)Calculate OLB = $76,781.55
37CFs Time(100,000) 0,IRR = 8%IRR will equal contract rate at any prepayment date if there are no orig. or discount points, and there is no prepayment penalty.
382. Assume no points, but a prepayment penalty of 3% of OLB 2. Assume no points, but a prepayment penalty of 3% of OLB. Loan prepaid at end of year 15.$76,781.55Calculate prepayment penalty = X.03$ 2,303.45
403. Assume 3 points, 3% prepayment penalty 3. Assume 3 points, 3% prepayment penalty. Loan prepaid at end of year 15.IRR = %4. Assume same as #3, but prepayment occurs at end of year 5.IRR = %The earlier a loan is prepaid that has origination or discount points, or a prepayment penalty, the higher the effective yield.
41Mortgage TiltTilting describes the high nominal mortgage payments required in the early life of a mortgage when interest rates include a large inflation premium. Tilt results because inflation expectations are included in the interest rate and therefore expense estimate but not in the loan applicants’ income estimate.
42Mortgage TiltTilt creates on affordability problem when traditional loan underwriting standards are used. Explains the inability of home buyers to obtain homes whose actual economic costs they could afford.If inflation does occur incomes and home prices should rise, therefore most families should be able to more easily cover the fixed monthly mortgage payment (the payment becomes a smaller portion of their income).
44Graduated Payment Mortgage (GPM) Another approach to the inflation problem. Lower initial payments than on CPMs with same i & n. Payments stabilize after 5-10 years of gradual increases.Combats Tilt EffectMakes initial qualifying easierWhat about GPMs in non inflationary periods ? Yes for homebuyers who have careers that offer future (substantial) wage increases.
45Because GPM payments are lower than those of comparable CPMs in the early years, GPM payments must eventually exceed the level payments of CPMs to “catch up”.OLBS - Since early year GPM payments are lower than similar GPM payments - not enough is being repaid to meet full principle + interest expense required to amortize the loan. Therefore, negative amortization will occur.
46Higher OLBs are not good for lenders - it reduces their “Safety margin”; LTV goes up. Therefore, GPMs is riskier than CPMs. Lenders probably would /should charge slightly higher nominal rates on GPMS.
49What is a reverse mortgage loan? A reverse mortgage is a special type of loan available only to older homeowners with full or nearly full equity in their homes. Such owners can borrow against the equity they have built up over the years, but no repayment is necessary until the borrower sells the property or moves elsewhere. If the borrower dies before the property is sold, the estate repays the loan (plus any interest that has accrued
50Common Features of Reverse Mortgages RMs are rising-debt loans. This means that the interest is added to the principal loan balance each month, because it is not paid on a current basis. Therefore, the total amount of interest you owe increases significantly with time as the interest compounds.All three plans (FHA-insured, lender-insured, and uninsured) charge origination fees and closing costs. Insured plans also charge insurance premiums, and some impose mortgage servicing charges. Your lender may permit you to finance these costs so you will not have to pay for them in cash. But remember these costs will be added to your loan amount
51Common Features of Reverse Mortgages RMs use up some or all of the equity in your home, leaving fewer assets for you and your heirs in the future.You generally can request a loan advance at closing that is substantially larger than the rest of your payments.Your legal obligation to pay back the loan is limited by the value of your home at the time the loan is repaid. This could include increases in the value (appreciation) of your home after your loan begins.
52Common Features of Reverse Mortgages RM loan advances are nontaxable. Further, they do not affect your Social Security or Medicare benefits. If you receive Supplemental Security Income, RM advances do not affect your benefits as long as you spend them within the month you receive them. This is true in most states for Medicaid benefits also. When in doubt, check with a benefits specialist at your local area agency on aging or legal services office .Some plans provide for fixed rate interest. Others involve adjustable rates that change over the loan term based upon market conditions .Interest on RMs is not deductible for income tax purposes until you pay off all or part of your total RM debt.