CHAPTER 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)

INTEREST RATES REAL RATE OF INTEREST - MINIMUM RATE REQUIRED TO DIVERT FUNDS FROM PRESENT CONSUMPTION TO FUTURE CONSUMPTION USUALLY MEASURED AS A SHORT-TERM INTEREST RATE A NOMINAL (CURRENT DOLLARS) RATE CORRECTED FOR ACTUAL (OR ANTICIPATED) CHANGES IN INFLATION Continued

INTEREST RATES USUALLY THOUGHT OF AS A “RISKLESS” RATE HISTORICALLY ABOUT 3 PERCENT NOMINAL RATE - INFLATION RATE = REAL RATE

NOMINAL INTEREST RATE (CONTRACT RATE) = REAL INTEREST RATE + ANTICIPATED INFLATION PREMIUM + DEFAULT RISK PREMIUM + PREPAYMENT RISK PREMIUM + LIQUIDITY RISK PREMIUM + LEGISLATIVE RISK PREMIUM

NOMINAL 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.

NOMINAL 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)

NOMINAL 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)

NOMINAL INTEREST RATE (CONTRACT RATE) AND, it = - 1 = - 1 = 1.087977 - 1 = .087977 = 8.7977% (HP10B) 1.5244, shift, yx, 1/5 = 0.2, = 1.0880 and 1.0880 - 1 = .088 = 8.8% Continued

NOMINAL 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 $1.5244 IN 5 YEARS

MORTGAGE PAYMENT PATTERNS PRIOR TO GREAT DEPRESSION: HIGH DOWN PAYMENTS (50%) SHORT MATURITY (5 YEARS) INTEREST ONLY LOANS BALLOON PAYMENTS

MORTGAGE PAYMENT PATTERNS THEREFORE, FEW COULD AFFORD HOME PURCHASE SHORT MATURITY/ BALLOON PAYMENT CREATED REPAYMENT DANGER R.E. AS COLLATERAL WAS NOT HIGHLY REGARDED

MORTGAGE PAYMENT PATTERNS MID 1930’s - 1970’s “NEW DEAL” PROGRAMS FHA/VA LOANS, LOW DOWN PAYMENTS SELF - AMORTIZING LOANS MONTHLY PAYMENTS

SELF - AMORTIZING LOANS AMORITIZATION - THE PROCESS OF LOAN REPAYMENT OVER TIME 1. CONSTANT AMORTIZATION MORTGAGE (CAM) MONTHLY PAYMENT = CONSTANT AMORTIZATION OF PRINCIPAL + INTEREST DUE ON OUTSTATNDING LOAN BALANCE (OLB)

SELF - AMORTIZING LOANS EXAMPLE: $100,000 LOAN, 10% INTEREST, 30YEARS (360 PAYMENTS) MONTH 1 PAYMENT = $100,000/360= 277.78 +100,000(.10/12)= 833.33 $1,111.11

SELF - AMORTIZING LOANS MONTH 2 PAYMENT = 277.78 + ((100,000-277.78)(.10/12) = 277.78 + 827.69 = $1,105.47 BORROWERS DIDN’T CARE FOR CHANGING MONTHLY PAYMENTS

SELF - AMORTIZING LOANS 2. CONSTANT PAYMENT MORTGAGE (CPM) MONTHLY PAYMENT IS CONSTANT OVER LIFE OF LOAN LOAN IS FULLY AMORTIZED AT MATURITY PORTION OF PAYMENT THAT IS PRINCIPAL VERSUS INTEREST CHANGES IN EVERY PAYMENT EASIER TO QUALIFY FOR THAN CAM BECAUSE INTIAL PAYMENT IS LOWER MORE INTEREST IS PAID OVER LIFE OF LOAN

SELF - AMORTIZING LOANS CONSTANT PAYMENT = ORIGINAL LOAN AMOUNT

SELF - AMORTIZING LOANS WHERE: i IS ANNUAL INTEREST RATE m IS NUMBER OF TIMES COMPOUNDING OCCURS PER YEAR n IS NUMBER OF YEARS FOR LOAN TO MATURE

Self-Amortizing Loans Example: $100,000 Loan, 10% Interest, 30 Years Payment = = $877.57

SELF - AMORTIZING LOANS INSERT CHARTS AND GRAPHS

CACULATING OUTSTANDING LOAN BALANCES (OLB) HP10B 1. CALCULATE MORTGAGE PAYMENT 2. RECORD PAYMENT IN QUESTION, IMPUT 3. SHIFT, AMORT = INTEREST EXPENSE = PRINCIPAL REDUCTION = OLB

CACULATING OUTSTANDING LOAN BALANCES (OLB) OLB = PV OF REMAINING PAYMENTS DISCOUNTED AT CONTRACT RATE EXAMPLE: $100,000 LOAN, 10% INTEREST, 30 YEARS PMT = $877.57 OLB357 = $2,589.37 HP10B = $2,589.43 PV OF PMTS METHOD

CLOSING COSTS EXPENSES 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.

CLOSING COSTS STATUTORY COSTS - LEGAL REQUIREMENTS PERTAINING TO TITLE TRANSFERS, RECORDING DEEDS, TAX STAMPS, ETC... THESE COSTS SHOULD NOT BE CONSIDERED PART OF FINANCING COSTS.

CLOSING COSTS THIRD-PARTY COSTS - ATTORNEY’S FEES, APPRAISALS, SURVEYS, BUILDING INSPECTION, TERMITE INSPECTION, TITLE INSURANCE, BROKER COMMISSIONS. NOT TO BE CONSIDERED PART OF FINANCING COSTS.

CLOSING COSTS FINANCE 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.

CLOSING COSTS 2. 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.

EFFECTIVE 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.

EFFECTIVE 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.

Calculating Effective Yield The basic idea: The present value of forecasted stream of income + PV of any reversion amount should be equal to the disbursement [orig. loan] when discounted at the appropriate rate [Effective Yield/Cost].

IRR (Internal Rate of Return] = the discount rate that caused the PV of CFs to equal the initial cost = The i that causes NPV = 0 Think of a loan disbursement as the lender’s investment. The CFs equal the loan payment.

Examples: Loan Amount $100,000 Interest Rate 8% Maturity Term 30 years- monthly payment Calculate monthly payment = $733.76 Calculate effective yield (YTM or IRR) = 7.99999 = 8%

What 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) $ 97,000 CFS = $733.76/mo. IRR = 8.3237%

What 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

CFs Time (100,000) 0 733.76 1 733.76 2 . . . . 733.76 + 76,781.55 180 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.

2. 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. $76,781.55 Calculate prepayment penalty = X.03 $ 2,303.45

CFs Time (100,000) 0 733.76 1 733.76 2 . . . . 733.76 + 76,781.55+2,303.45 180 IRR = 8.0853%

3. Assume 3 points, 3% prepayment penalty 3. Assume 3 points, 3% prepayment penalty. Loan prepaid at end of year 15. IRR = 8.4628% 4. Assume same as #3, but prepayment occurs at end of year 5. IRR = 9.2278% The earlier a loan is prepaid that has origination or discount points, or a prepayment penalty, the higher the effective yield.

Mortgage Tilt Tilting 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.

Mortgage Tilt Tilt 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).

Graduated 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 Effect Makes initial qualifying easier What about GPMs in non inflationary periods ? Yes for homebuyers who have careers that offer future (substantial) wage increases.

Because 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.

Higher 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.

What 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

Common 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

Common 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.

Common 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.