1. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company1 Why Do People Borrow Money? To enhance returns by using positive financial leverage. To increase the scale of their investments. To purchase assets such as real estate and business assets, for which they currently do not have enough money.

2. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company2 Topics Discussed in this Chapter Financial leverage Margin trading Secured vs. unsecured debt Long-term vs. short-term debt Mortgage loan programs Other mortgage financing alternatives Refinance loans Mortgage (loan) math Mortgage and loan financial planning applications Fixed-rate versus adjustable-rate loans Determining how much home one can afford Leasing

3. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company3 Financial Leverage Financial leverage is the use of borrowed funds to supplement the investor’s own dollar investment (equity) to increase the scale of investment. The keys to leverage are: –Lower interest rate on loan than return on the investment. (Difference is called the Spread.) –The ratio of borrowed funds to one’s own equity.

4. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company4 Leverage Multiplies Gains and Losses In a positive environment, leverage enhances return, BUT, leverage multiplies losses as well as gains. –Consider the person who buys a piece of property for $500,000, borrowing $400,000 on a 6% mortgage. –One year later, if property is worth $600,000, the buyer made $76,000 ($100,000 appreciation - $24,000 interest expense), for a 76% return on the $100,000 invested. –However, if the property’s value declined to $450,000, the buyer lost $50,000 + $24,000 interest, for a 74% loss on his or her $100,000 investment, even though the value of the property declined only 10%!

5. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company5 Margin Trading Margin is borrowing against the market value of securities such as stocks or bonds. The purpose is to enhance the return on investment by using financial leverage. Example: If the margin interest rate is 7%, and you have a security that pays 10%, and you borrow 50% of the value (100,000) so that you can purchase more shares, Then, next slide…

6. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company6 Example of Margin Trade Buyer puts up $50,000 and borrows $50,000 on margin at 7% to buy $100,000 of stock. The investor holds the stock exactly one year, and the price does not change. 10% of $100,000 = $10,000 income. 7% on $50,000 borrowed = $3,500 expense. Net income to investor = $6,500. Return on investor $50,000 investment = 13%. Borrowing to invest gave the investor 30% greater return than if he or she had not used leverage.

7. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company7 Equity Requirements Vary Equity percentage requirements are set by the Federal Reserve: –Stocks listed on FINRA generally require that the investor put up 50%. –U. S. Treasury bonds generally require an equity investment of 10%. –High-grade corporate bonds generally require 30% equity. Note: Investment firms often require more than the Federal Reserve minimums to protect their accounts.

8. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company8 Secured vs. Unsecured Debt Unsecured debt does not have any collateral behind it; examples include credit cards, utility bills, and medical bills. Secured debt is backed up by some form of collateral; examples include mortgage debt and most car loans. A secured creditor is generally in a better position than an unsecured creditor because the secured creditor can take back the property.

9. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company9 Long-Term vs. Short-Term Debt Short-term debt is generally any debt lasting from 90 days to up to 3 years; businesses may use short-term debt to cover accounts payable, pay salaries short-term, or provide for cash until receivables are paid. Long-term debt is generally debt lasting longer than one to three years; generally used to purchase assets that are designed to be used for a longer period of time.

10. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company10 Mortgage Loan Programs Based on how the rate is set there are two types of mortgage : –Fixed Rate Mortgages. –Adjustable Rate Mortgages. Based on payment terms there are also two types: –Self-amortizing loans. –Balloon or interest-only mortgages.

11. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company11 Fixed Rate Mortgage The interest rate is set at the time of the signing of the loan, and does not vary over the life of the loan. For financial planning purposes, fixed rate loans are the best choice when current interest rates are low, and the buyer intends to hold the property for many years.

12. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company12 Features of Fixed Rate Mortgages Very simple, but not very flexible. Available terms are 5, 10, 15, etc. with 15 and 30 years the most popular. Shorter loans usually have lower interest rates. In times of falling interest rates, borrowers may need to refinance several times to take advantage of lower rates. Note: Most, but not all, states now have laws that specify that the borrower may pre-pay the mortgage without any penalty.

13. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company13 Adjustable Rate Mortgage (ARM) The interest rate varies with the market. Rate based on a formula. Typically, the rate will be tied to an index such as the Prime Rate or LIBOR. Possibly a cap on how high the rate can go. Possibly a floor on how low it can go.

14. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company14 ARM Advantages For short term purchases (3 years or less). Initial rate is usually lower than rates on fixed loans. May have a provision that allows conversion to a fixed rate loan. Attractive when interest rates are high. Lenders will sometimes give a free or low-cost refinance to a fixed loan when interest rates fall.

15. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company15 ARM Loan Details ARM periods Index and margin Caps Negative amortization Conversion option Adjustment Process

16. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company16 ARM periods The period is the span of time that a lender must wait before it can readjust the interest rate of the ARM loan. Can range from one month to several years. One-year ARM periods are the most common. Shorter ARM periods usually imply a lower interest rate.

17. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company17 Standard ARM Periods Rates adjust every TermAmortization 3-month ARM3 months30 years 6-month ARM6months30 years 1-Year ARM1 year30 years 2-Year ARM3years30 years

18. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company18 Balloon or Two-step ARM Programs Rates Adjust everyTermInitial Amortization 3/1 ARM1 year, after the 3 rd year30 years 5/1 ARM1 year, after the 5 th year30 years 7/1 ARM1 year after the 7 th year30 years 10/1 ARM1 year after the 10 th year30 years 2-year/6-month ARM 6 months after the 2 nd year 30 years

19. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company19 Index and Margin The ARM agreement specifies how interest rate is to be adjusted by a formula - usually an index plus a margin. The Index is based on rates of securities, financial papers, or a basket of indicators that adequately reflect market conditions. The margin is a constant amount that is added to the index to determine the new interest rate. For conforming loans, the usual margin is 2.75% to 3.25%

20. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company20 Common Indexes U.S. Treasury Bills - usually the one year rate. Prime rate – The prime rate is the rate that banks charge to their best customers, usually commercial. Cost-of-Funds index (COFI) – The COFI index is calculated by each of the Federal Reserves' regional districts, the most popular of which is the 11th District. The Cost-of-Funds index is a monthly survey of the cost to the banks of the money they have at their disposal. London InterBank Offered Rate (LIBOR) – The LIBOR index has become the index of choice for non-conforming lenders, especially with sub-prime (B/C/D/E) credit loans. The LIBOR rate tends to remain close to – though slightly higher – than the T-Bill rate.

21. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company21 Caps Caps restrict the amount that the lender can change the rate on the specified anniversary date and thus protect the borrower from unforeseen rises in rate and payments. If the Index moves too far, the maximum that the borrower’s rate can move is determined by the cap.

22. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company22 Types of Caps Periodic cap Lifetime Cap Payment cap Principal cap Note that the payment cap can induce negative amortization. The principal cap limits the amount that the principal of the loan can increase by negative amortization.

23. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company23 Negative Amortization Negative amortization occurs when the payment cap on a loan keeps the payment from covering the interest for that month. The deficit can be added to the loan’s principal. A principal cap can keep negative amortization from raising the principal due beyond a certain level. Loans on which negative amortization is possible are usually offered at very low introductory rates.

24. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company24 Conversion option Allows the borrower to convert from an ARM to a fixed rate mortgage without refinancing, a new title search, etc. Usually must be exercised in the 2 nd -5 th year. Lender will charge a small administrative fee. Fixed rate will depend upon the market at the time of conversion. It is not a refinance, as it is still the original mortgage.

25. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company25 Adjustment Process Amortization is refigured each time the interest rate is adjusted. The amortization usually is until the original maturity date. Amount of payment can rise or fall. Negative amortization may be converted into a balloon payment at end of loan.

26. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company26 Disadvantages of ARMs Payment may increase because of adjustment. Low teaser introductory rates almost assure that the payment will increase. Mortgage insurance on an ARM is slightly more costly than on a fixed rate loan.

27. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company27 Home Equity Line of Credit (HELOC) Financial Planning Tool: –Excellent safety net for the homeowner. –Funds available immediately in emergency situation. Investment Tool –Instant liquidity allows investors to seize an opportunity without a lengthy loan application process. –No interest is charged until the line of credit is used. This makes it a low cost option.

28. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company28 How the HELOC Works The borrower establishes a line of credit with a lender. The line of credit can be used like a checking account. It is a second mortgage, and the closing costs will be the same as any other mortgage. If the borrower does not use the credit, there will be no interest charged.

29. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company29 HELOC Features Cost –No interest cost unless credit line is used. –Initial fee, plus closing costs. –Account maintenance fee. Two phases: –Revolving. –Amortized. Most are ARMs.

30. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company30 Balloon Loans The balloon mortgage loan is an installment note whose amortization is longer than its term. The remaining principal is due in total at the maturity of the mortgage. Is used to keep initial payments low. ARMS that are 5/1 and 7/1 have largely replaced the Balloon Loan for residential loans. Most commercial loans are balloon loans.

31. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company31 Advantages and Disadvantages of Balloon Notes to the Borrower Shorter Term: –Shorter term Less risk to lender Lower interest rate. Longer amortization: –Lower payment required. –Fixed rate during the term. Main disadvantage is that the balloon note may require a larger down payment than a comparable 30 year fixed loan (At least 10%).

32. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company32 How a Balloon Loan Works Payments are computed on a 30 year fixed loan basis or even on interest only. After the term ends (typically 5 or 7 years), the homeowner still has a very large principal still due. At that point, the homeowner has to either come up with the cash to pay the loan or refinance, unless a conversion option is built into the loan.

33. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company33 Amortization of Balloon Loans Two-step balloons –Most typical are the 5/25 balloon and the 7/23 balloon. –At the end of the first time period, the balloon can be converted into a fixed rate 30 year loan. Balloon ARMs: –Start with a fixed rate. –Convert to an ARM. Interest-only balloons: –Principal due never goes down. –Low payment.

34. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company34 Buy-Down Programs – “Points” Buy-down programs reduce the interest rate through prepayment of the loan's interest. The prepayment is called “points,” with one point being equal to 1 per cent of the total loan. –Permanent Buy-Downs: Reduces the interest for the life of the loan. Generally takes 5 or more years to recoup the points, so should not be used by homeowners who intend to stay in their home for less than 5 years. –Temporary Buy-Downs: Only lower the interest rate for a few years. Buyer can qualify for a larger home, but must show that higher income is expected in the future. Generally the fixed rate is higher than it would be on a conventional mortgage.

35. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company35 Construction Loans Loans made to finance construction of a new property have different characteristics. Look at four main elements: –Loan commitment. –Rate lock. –Method of disbursement. –Lower LTV ratio limits.

36. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company36 Jumbo Loans A Jumbo loan is one that exceeds the conforming loan limits. Conforming loan limits are s et by Fannie Mae and Freddie Mac based on current market prices

37. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company37 Jumbo Loans without Jumbo Pricing Jumbo loans usually have a higher interest rate than conforming loans. To lower the interest rate, Make larger down payment to bring the mortgage balance down to conforming limit. Use two loans: a conforming first mortgage and a second mortgage.

38. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company38 No Income Verification (NIV) Loans Applicable Situations: –Self employment. –Recent job change. –Uneven income, such as commissioned employees. –Income claimed must be within reason. Cost of NIV Programs: –Higher rate: 1.50 to 4.00 percentage points higher than comparable full documentation loans. –Larger down payment: With A-credit, about 20 - 25%, with lower credit, 30-40%.

39. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company39 Other Mortgage Financing Alternatives Renegotiable rate mortgage Seller Take-back Growing equity mortgage Contract sale Rent with Option FHA loans VA loan USDA Rural Service Loan Community Reinvestment Loan Program Federal Home Loan Bank Board Fannie Mae

40. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company40 Refinance Loans Reasons for refinancing a mortgage: –Better interest rates. –Change of term. –Consolidation of debt. –Extra cash.

41. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company41 Cash-out Refinance Cash out refinances require higher LTV than conventional loans. A loan is a cash-out refinance if used for: –Cash back to the borrowers. –Debt consolidation. –Replace a first or second mortgage that is less than one year old.

42. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company42 Rate and Term (No Cash-Out) Refinance Refinance of a first mortgage that is at least one year old. Consolidation of multiple mortgages. Refinance that also pays closing costs and prepaid expenses. Limited cash back – less than 1% of the loan.

43. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company43 Considerations in Refinance Investment consideration: –May not be a good idea to refinance a loan that has been paid on for five or more years. –Difference in old interest rate and new rate needs to be large enough to justify closing costs. Appraisal value. Payoff statement.

44. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company44 Refinancing When There are Two or More Current Mortgages Complicates the refinance handling and paperwork. Refinance both or only one of the existing mortgages. LTV ratios change with whether it is considered a rate and term refinance or a cash out refinance just as when refinancing one loan. Refinancing only the first mortgage will require that lender on second mortgage subordinate his loan to the new first mortgage.

45. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company45 Mortgage Amortization Each payment consists of interest and principal. The interest portion is one month’s interest on the loan’s remaining balance. Thus, interest goes down over time. Since the payment is a fixed amount, whatever is left out of the fixed amount paid after paying the interest is credited to the loan balance (principal). Since interest goes down over time, the portion of the payment representing principal goes up.

46. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company46

47. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company47 Graphic Representation of Loan Amortization

48. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company48 Computing the Payment Amount If Pmt = the payment and Bal 0 = Starting Balance and r = interest rate per payment period and n = number of payments, Then, Pmt = Bal 0 x [r/(1 – (1+r) -n )].

49. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company49 Basics of Loan Rates The actual rate the borrower pays is usually higher than the stated rate: –Up-front costs are not computed in the stated rate. –Rate is computed as if loan is paid off over the stated term. Most mortgages are paid off early, so actual rate is higher. –Monthly rate is computed as 1/12 annual rate, which increases the effective annual rate.

50. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company50 Effect of Points and Closing Costs Closing costs and points can add up to 4% to the amount of money borrowed (They are typically added to the loan amount). These costs can be looked upon as affecting the rate on the net amount being borrowed. Therefore the rate of interest that the borrower is paying over the life of the loan is greatly increased.

51. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company51 Effect of Early Payoff on the APR It is rare for a homeowner to keep the same house for 30 years. Since an early payoff means that the points and closing costs must be amortized over a shorter period, the APR is increased by early payoff. For example, paying off a loan in five years rather than 30 could raise the APR by.7-.8%, a substantial increase.

52. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company52 Cost of Refinancing Refinancing adds a new set of points, closing costs, and fees to the cost of borrowing money. Thus, one rule of thumb is that it does not pay to refinance unless the interest rate is at least 2% lower than the old loan. An easy way to see the true cost of refinancing is to add up the payments over the term of the loan. The difference in the sums is how much one is actually saving (or losing) by refinancing. This method does not adjust for time value of money.

53. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company53 Effect of Biweekly Payments Making mortgage payments biweekly rather than monthly can significantly reduce the term of a mortgage. For most borrowers, splitting the monthly payment in half and paying it once every two weeks (rather than the full amount monthly) is not an undue hardship. –26 biweekly payments versus 12 monthly payments

54. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company54 Determining How Much House the Borrower Can Afford Front-end ratio - ratio of the monthly housing expense (PITI) to the borrower's gross (pre-tax) monthly income. The total amount the family can afford to pay for a home is equal to the amount they can afford to put down plus their maximum qualifying mortgage amount less mortgage closing costs and points on financing. Typical front-end ratio requirements are.25 -.35.

55. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company55 Back-End Ratio The ratio of the borrower's total debt (PITI plus other minimum monthly debt payments) to the gross monthly income. Most lenders use the front-end ratio to determine the maximum that they would lend, then use the back- end ratio to adjust the maximum downward to account for other obligations of the borrower.

56. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company56 Reasons for Leasing Reduce taxes. Reduce uncertainty. Reduce costs.

57. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company57 Types of Leases Operating Leases. Financial Leases: –Sale and Lease-back. –Leveraged Lease.

58. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company58 Lease Accounting In past, leases were not on the balance sheet. Now, certain leases are “capitalized” leases and show as both an asset and a liability. Example shows how various methods of acquisition of the asset can affect the company’s balance sheet.

59. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company59 One-Asset, Acquired Three ways

60. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company60 Capital Lease The lessee must capitalize a lease if any one of the following criteria is met: –Present value of the lease payments is at least 90% of the fair market value of the asset. –The lease transfers ownership of the property to the lessee by the end of the term of the lease. –The lease term is 75% or more of the estimated economic life of the asset. –Bargain price at the expiration of the term of the lease.

61. Financing Asset Acquisitions Chapter 18 Tools & Techniques of Financial Planning Copyright 2009, The National Underwriter Company61 Leasing and Taxes The lessee can deduct lease payments if the lease is qualified by the IRS. To be qualified: –Term less than 30 years. –No bargain purchase option. –No high then low payment schedule. –Lessor must receive a fair market rate of return. –No limit to lessee’s right to issue debt or pay dividends. –Renewal options must be reasonable and reflect fair market value of the asset.