Financing Residential Real Estate Lesson 1: Finance and Investment

Introduction This lesson will cover: Mortgage financing and how it works Investments and returns Types of investments Investment risks Market interest rates and factors affecting them

Borrowing Money to Buy a Home Buying a home is the most expensive purchase most people ever make. Typically requires borrowing a large amount of money.

Borrowing Money to Buy a Home An individual or family’s ability to afford a home depends on: housing prices, income level, tax considerations, availability of mortgage financing, and many other factors.

Borrowing Money to Buy a Home In a typical loan transaction: 1.Lender loans buyers a portion of the purchase price.

Borrowing Money to Buy a Home In a typical loan transaction: 1.Lender loans buyers a portion of the purchase price. 2.Buyers provide the rest of the purchase price amount as a downpayment.

Borrowing Money to Buy a Home In a typical loan transaction: 1.Lender loans buyers a portion of the purchase price. 2.Buyers provide the rest of the purchase price amount as a downpayment. 3.Buyers execute mortgage or deed of trust, giving lender a security interest in purchased property.

Borrowing Money to Buy a Home In a typical loan transaction: 1.Lender loans buyers a portion of the purchase price. 2.Buyers provide the rest of the purchase price amount as a downpayment. 3.Buyers execute mortgage or deed of trust, giving lender a security interest in purchased property. 4.Once paid off, lien is released.

Borrowing Money to Buy a Home Buyers agree to pay back the loan with monthly payments over a specified period.

Borrowing Money to Buy a Home Buyers agree to pay back the loan with monthly payments over a specified period. Loan Term – period of loan repayment Principal – amount borrowed Interest – the cost of borrowing money

Borrowing Money to Buy a Home Remember that a lender sees a loan as an investment.

Borrowing Money to Buy a Home Remember that a lender sees a loan as an investment. Any interest paid by the buyer is the lender’s profit from the investment.

Investments and Returns The national economy is driven in part by investment capital: money used to fund business enterprises, ventures, and projects.

Investments and Returns An investor’s return may take various forms.

Investments and Returns An investor’s return may take various forms. Return on investment = a profit over and above the amount originally invested.

Investments and Returns An investor’s return may take various forms. Return on investment = a profit over and above the amount originally invested. Return of investment = receiving the full amount originally invested (also called recapture).

Summary Investments and Returns  Principal  Loan term  Interest  Investment capital  Return on investment  Return of investment

Types of Investments Two general categories of investments: 1) Ownership investments 2) Debt investments

Types of Investments An ownership investment is an asset or property interest in an asset purchased by an investor. Ownership investments

Types of Investments An ownership investment is an asset (or property interest in an asset) purchased by an investor. Ownership investments are:  income-producing, or Ownership investments

Types of Investments An ownership investment is an asset (or property interest in an asset) purchased by an investor. Ownership investments are:  income-producing, and/or  appreciate in value over time. Ownership investments

Ownership Investments Real estate is an example of an ownership investment. It:  produces income (rent), and  appreciates in value. Real estate

Ownership Investments Corporate stock is another example of an ownership investment. Shares = ownership interest in corporation Dividends = return on stockholder investment Corporate stock

Types of Investments In a debt investment, the investor provides money to an individual or company that will repay the money along with interest. Debt investments

Types of Investments Examples of debt investments include:  Loans  Bonds  Savings accounts Debt investments

Debt Investments Loans Any type of loan that earns interest for the lender is a debt investment. Includes residential mortgage loans. Loans

Debt Investments Loans Any type of loan that earns interest for the lender is a debt investment. Includes residential mortgage loans.  Bank makes debt investment by loaning money to home buyers. Loans

Debt Investments Loans Any type of loan that earns interest for the lender is a 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 an asset. Loans

Debt Investments Bonds A bond is a certificate of indebtedness issued by a governmental body or corporation. Bonds

Debt Investments Bonds A bond is a certificate of indebtedness issued by a governmental body or corporation.  Coupon rate = rate paid on a bond Bonds

Debt Investments Bonds A bond is a certificate of indebtedness issued by a governmental body or corporation.  Coupon rate = rate paid on a bond  Principal = face amount of a bond Bonds

Debt Investments Savings Accounts Funds deposited into savings accounts are used by the bank to make loans to other borrowers. Savings accounts

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

Debt Investments Certificates of deposit (CDs) are similar to savings accounts.  Depositor agrees to keep funds on deposit for certain time period in return for interest payments.  Bank can charge a penalty for early withdrawal of funds. CDs

Types of Investments Securities are investment instruments that grant the holder an interest or right to payment, but no managerial control. Securities

Types of Investments Securities are investment instruments that grant the holder an interest or right to payment, but no managerial control. May be ownership or debt investments Securities

Types of Investments Securities are investment instruments that grant the holder an interest or right to payment, but no managerial control. May be ownership or debt investments Liquid assets = quickly converted to cash Securities

Types of Investments Securities are investment instruments that grant the holder an 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 Securities

Types of Investments Securities are investment instruments that grant the holder an 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

Mutual Fund A company that buys and sells stocks and bonds on behalf of its investors. Investors purchase shares in company. Company uses capital to invest in securities. Fund managers choose which securities to buy and sell. Mutual funds

Securities Securities Regulation Issuance and trading of securities is regulated by the federal Securities and Exchange Commission (SEC). Regulation

Securities Securities Regulation Issuance and trading of securities regulated by the federal Securities and Exchange Commission (SEC). Requires companies to disclose financial information to the public. Regulation

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

Securities Securities trading affects mortgage lending in two ways: Securities and mortgage industry

Securities Securities trading affects mortgage lending in two ways: 1.Mortgage lending competes with other investments for funds. Securities and mortgage industry

Securities Securities trading affects mortgage lending in two ways: 1.Mortgage lending competes with other investments for funds. 2.Mortgages can be pooled together and “securitized” for sale to investors (mortgage- backed securities). Securities and mortgage industry

Summary Types of Investments  Ownership investments  Debt investments  Corporate stock  Savings accounts  Securities  Liquid assets  Mortgage-backed securities

Key Investment Characteristics Investors look at three potential investment advantages:  Safety  Liquidity  Yield

Key Investment Characteristics Safety An investment is safe if there’s little risk that the investor will actually lose money. Safety

Key Investment Characteristics Safety An investment is safe if there’s little risk that the investor will actually lose money. Investor can count on return of investment, if not a return on investment. Safety

Key Investment Characteristics Liquidity A liquid investment can be converted into cash (liquidated) quickly. Liquidity

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

Key Investment Characteristics Yield An investment’s yield is its rate of return. Yield

Key Investment Characteristics Yield An investment’s yield is its rate of return.  Low yield = safe and liquid investments  High yield = high risk/illiquid investments Yield

Key Investment Characteristics Yield An 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 an investment is made. Yield

Key Investment Characteristics Diversification An investor diversifies by putting her money into a variety of different investments. Portfolio = a mix of investments and cash reserves Diversification

Investment Risk From the lender’s point of view, risks involved in mortgage lending include:  Risk of default  Risk of loss  Interest rate risk  Prepayment risk Lending risks

Lending Risks Risk of default Degree of risk with a loan depends on likelihood the borrower will default. Default

Lending Risks Risk of default Degree of risk with a loan depends on likelihood the borrower will default.  Underwriting process screens loan applicants for risk. Default

Lending Risks Risk of default Degree of risk with a loan depends on likelihood the borrower will default.  Underwriting process screens loan applicants for risk. Lender may charge higher interest rate to compensate for extra risk. Default

Lending Risks Risk of Loss Lenders take steps to limit risk of loss if a borrower does default. Loss

Lending Risks Risk of Loss Lenders take steps to limit risk of loss if a borrower does default. Includes:  appraising the property Loss

Lending Risks Risk of Loss Lenders take steps to limit risk of loss if a borrower does default. Includes:  appraising the property  requiring borrower to maintain fire and hazard insurance Loss

Lending Risks Interest Rate Risk After lender has loaned money at a certain interest rate, market interest rates may rise. Interest rate

Lending Risks Interest Rate Risk After lender has loaned money at a certain interest rate, market interest rates may rise. Risk increases with length of loan term. Interest rate

Lending Risks Interest Rate Risk After lender has loaned money at a certain interest rate, market interest rates may rise. Risk increases with length of loan term. Lenders deal with this risk by:  using adjustable-rate mortgages, and  selling loans on secondary market. Interest rate

Lending Risks Prepayment Risk Borrowers sometimes pay back all or part of the principal before it’s due. Homeowners often refinance when interest rates decrease. Prepayment

Lending Risks Prepayment Risk Borrowers sometimes pay back all or part of the principal before it’s due. Decline in interest rates usually leads to increase in refinancing and loan prepayment. Prepayment

Refinancing does several things: Gives home owners a new mortgage at lower interest rate. New mortgage proceeds pay off old mortgage.

Refinancing: Gives homeowners a new mortgage at lower interest rate. New mortgage proceeds pay off old mortgage. Lenders protect themselves from prepayment by charging borrowers a penalty for prepayment.

Market Interest Rates Market interest rates are the typical rates lenders are currently charging borrowers for certain types of loans.

Market Interest Rates Market interest rates are the typical rates lenders are currently charging borrowers for certain types of loans. Can be influenced by factors such as:  size of the loan,

Market Interest Rates Market interest rates are the typical rates lenders are currently charging borrowers for certain types of loans. Can be influenced by factors such as:  size of the loan,  whether it has a fixed or adjustable rate,

Market Interest Rates Market interest rates are the typical rates lenders are currently charging borrowers for certain types of loans. Can be influenced by factors such as:  size of the loan,  whether it has a fixed or adjustable rate,  length of the loan term,

Market Interest Rates Market interest rates are the typical rates lenders are currently charging borrowers for certain types of loans. Can be influenced by factors such as:  size of the loan,  whether it has a fixed or adjustable rate,  length of the loan term, and  borrower’s credit score.

Market Interest Rates Mortgage interest rates have considerable impact on real estate activity.  High rates cause slowdowns in real estate activity.

Market Interest Rates Mortgage interest rates have considerable impact on real estate activity.  High rates cause slowdowns in real estate activity.  Low rates spur the market.

Market Interest Rates Mortgage interest rates have considerable impact on real estate activity.  High rates cause slowdowns in real estate activity.  Low rates spur the market. Mortgage rates also respond to changes in supply and demand.

Summary Investment Risk  Safety  Liquidity  Yield  Diversification  Risk of default  Risk of loss  Prepayment  Market interest rates