1. © 2012 Rockwell Publishing Financing Residential Real Estate Lesson 1: Finance and Investment

2. © 2012 Rockwell Publishing Introduction This lesson will cover: mortgage financing investments and returns types of investments investment risks market interest rates

3. © 2012 Rockwell Publishing Borrowing for Home Purchase Buyer’s ability to afford a home depends on: housing prices income level tax considerations mortgage financing available many other factors

4. © 2012 Rockwell Publishing Borrowing for Home Purchase Typical loan transaction: Lender loans buyer portion of purchase price. Buyer makes down payment. Buyer executes security instrument (mortgage or deed of trust), creating lien. Lien released when loan paid off.

5. © 2012 Rockwell Publishing Borrowing for Home Purchase Buyers pay back loan with monthly payments over specified period. Loan term: period of loan repayment. Principal: amount borrowed. Interest: cost of borrowing money.

6. © 2012 Rockwell Publishing Borrowing for Home Purchase Lender sees loan as an investment. Interest paid by buyer is lender’s profit from investment.

7. © 2012 Rockwell Publishing Investments and Returns National economy is driven in part by investment capital: money used to fund business enterprises, ventures, projects.

8. © 2012 Rockwell Publishing Investments and Returns Investor’s return takes various forms: Return on investment: profit over and above the amount originally invested. Return of investment: getting full amount originally invested back (also called recapture).

9. © 2012 Rockwell Publishing Types of Investments Two general categories of investments: ownership investments debt investments

10. © 2012 Rockwell Publishing Types of Investments Ownership investment: asset (or property interest in an asset) purchased by investor: generates income, and/or appreciates in value over time. Return in the form of appreciation ordinarily not realized by investor until asset is sold. Ownership investments

11. © 2012 Rockwell Publishing Ownership Investments Real estate is example of ownership investment. It may: produce income (rent), and/or appreciate in value. Real estate

12. © 2012 Rockwell Publishing Ownership Investments Corporate stock another example of ownership investment. Shares = ownership interest in corporation. Stockholder’s return may take form of: dividends, and/or appreciation of stock value. Corporate stock

13. © 2012 Rockwell Publishing Types of Investments Debt investment: investor provides money to individual or company that will repay money along with interest. Examples: loans, bonds, savings accounts. Debt investments

14. © 2012 Rockwell Publishing Debt Investments Loan that earns interest for lender is debt investment. Includes residential mortgage loans. Bank makes debt investment by loaning money to home buyers. Home buyers make ownership investment by investing money to purchase asset. Loans

15. © 2012 Rockwell Publishing Debt Investments Bond: certificate of indebtedness issued by governmental body or business entity. Coupon rate: interest rate paid on bond. Principal: face amount of bond. Bonds

16. © 2012 Rockwell Publishing Debt Investments Funds deposited into savings accounts are used by bank to make loans to other borrowers. Depositor loans money to bank and receives interest in return. Bank makes another debt investment (loan to another customer). Savings accounts

17. © 2012 Rockwell Publishing Debt Investments Certificates of deposit (CDs): similar to savings accounts. Depositor agrees to keep funds on deposit for certain time period in return for interest payments. Bank can charge penalty for early withdrawal of funds. Certificates of deposit

18. © 2012 Rockwell Publishing Types of Investments Securities: investment instruments that grant holder interest or right to payment, but no managerial control. May be ownership or debt investments. Liquid assets = quickly converted to cash. Traded in established financial markets. Examples: stocks, bonds. Securities

19. © 2012 Rockwell Publishing Securities Mutual fund: company that buys and sells stocks, bonds on behalf of investors. Investors purchase shares in company. Company uses capital to invest in securities. Fund managers choose which securities to buy and sell. Mutual funds

20. © 2012 Rockwell Publishing Securities Issuance and trading of securities regulated by federal Securities and Exchange Commission (SEC). Requires companies to disclose financial information to public. Enforces insider trading rules. Regulation of securities

21. © 2012 Rockwell Publishing Securities Securities trading affects mortgage lending in two ways: Mortgage lending competes with other investments for funds. Mortgages can be pooled together and “securitized” for sale to investors as mortgage-backed securities. Securities and the mortgage industry

22. © 2012 Rockwell Publishing Key Investment Characteristics Investors look at three potential investment advantages: safety liquidity yield

23. © 2012 Rockwell Publishing Key Investment Characteristics Investment is safe if there’s little risk that investor will actually lose money. Investor can count on return of investment, if not return on investment. Safety

24. © 2012 Rockwell Publishing Key Investment Characteristics A liquid investment can be converted into cash (liquidated) quickly. Illiquid investments “lock up” investor funds, making them unavailable for other purposes. Liquidity

25. © 2012 Rockwell Publishing Key Investment Characteristics Investment’s yield is its rate of return. Low yield = safe and liquid investments. High yield = high risk/illiquid investments. Yield isn’t necessarily fixed when investment is made. Yield

26. © 2012 Rockwell Publishing Key Investment Characteristics Investor diversifies portfolio by putting money into variety of different investments. Portfolio: a mix of investments and cash reserves. Diversification

27. © 2012 Rockwell Publishing Investment Risk From lender’s point of view, risks involved in mortgage lending include: risk of default risk of loss interest rate risk prepayment risk Lending risks

28. © 2012 Rockwell Publishing Lending Risks Degree of risk for loan depends on likelihood of borrower default. Underwriting process screens loan applicants for risk. Lender may charge borrower more to compensate for extra risk. Risk of default

29. © 2012 Rockwell Publishing Lending Risks Lenders take steps to limit risk of financial loss in event of default/foreclosure or damage to collateral property. Steps include: appraising property requiring borrower to maintain hazard insurance requiring mortgage insurance for some loans Risk of loss

30. © 2012 Rockwell Publishing Lending Risks If market rates rise after loan is made at a certain interest rate, lender can’t reinvest money at higher rate. Risk increases with length of loan term. Lenders deal with risk by: using adjustable-rate mortgages selling loans on secondary market Interest rate risk

31. © 2012 Rockwell Publishing Lending Risks Prepayment: borrower repays all or part of principal before it’s due. Decline in interest rates = borrowers refinance and prepay existing loans. Prepayment = lender’s yield is less. Lenders compensate for reduced yield by charging prepayment penalty. Prepayment risk

32. © 2012 Rockwell Publishing Investment Risk Investors who underestimate risk of particular investment may get lower yield than expected or even lose money. Poor investment decisions may result from: inaccurate information deception bad judgment Misjudging risk

33. © 2012 Rockwell Publishing Market Interest Rates Market interest rates: typical rates lenders are currently charging borrowers for loans. Can be influenced by: size of loan whether rate fixed or adjustable loan term borrower’s credit score

34. © 2012 Rockwell Publishing Market Interest Rates Mortgage rates have considerable impact on real estate activity. High rates cause slowdowns in real estate activity. Low rates spur market. Mortgage rates also respond to changes in supply and demand.

35. © 2012 Rockwell Publishing Discussion Chapter 1: Finance & Investment Break into small groups Read discussion questions Choose your group’s question Discuss Present groups conclusions to class