Chapter 4 History of Real Estate Finance and the Fixed-Rate Mortgage

Chapter 4 Learning Objectives Understand how residential lending evolved from the earliest of times through World War II Understand how residential lending evolved from the earliest of times through World War II Understand the mechanics of the standard fixed-rate mortgage Understand the mechanics of the standard fixed-rate mortgage 4-1

History Of Real Estate Finance ROMAN LAW ROMAN LAW Transfer Of Title And Possession Until Repayment Transfer Of Title And Possession Until Repayment No Transfer Of Title Or Possession. Lender Could Take Title And Possession Under Suspicion Of Default No Transfer Of Title Or Possession. Lender Could Take Title And Possession Under Suspicion Of Default No Transfer Of Title Or Possession. Lender Could Take Title Under Actual Default No Transfer Of Title Or Possession. Lender Could Take Title Under Actual Default 4-2

History Of Real Estate Finance Con’t GERMAN LAW GERMAN LAW Gage Is A Deposit Made To Fulfill An Agreement Gage Is A Deposit Made To Fulfill An Agreement Mort Is French For Dead. Real Property (Not Transportable) Was A Dead Gage Mort Is French For Dead. Real Property (Not Transportable) Was A Dead Gage In Default The Lender Could Take Title But Could Not Look Further For Relief In Default The Lender Could Take Title But Could Not Look Further For Relief 4-3

History Of Real Estate Finance Con't ENGLISH LAW ENGLISH LAW Concept Of Usury In That Charging Interest Was Sinful Concept Of Usury In That Charging Interest Was Sinful Equitable Right Of Redemption Allowing Borrower To Redeem The Property After Default Equitable Right Of Redemption Allowing Borrower To Redeem The Property After Default 4-4

History Of Real Estate Finance Con’t U.S. Law Is A Mix Of Roman, German, And English Law U.S. Law Is A Mix Of Roman, German, And English Law EARLY EXPANSION EARLY EXPANSION Little Need For Lending Little Need For Lending Some Building Societies Formed To Consolidate Funds For Home Buying Some Building Societies Formed To Consolidate Funds For Home Buying POST-CIVIL WAR POST-CIVIL WAR Increased Mortgage Lending To Finance Westward Expansion Increased Mortgage Lending To Finance Westward Expansion Typical Loan Was Short-term, Interest Only Typical Loan Was Short-term, Interest Only 4-5

History Of Real Estate Finance Con’t 1920s BOOM 1920s BOOM S&Ls Expanded Rapidly S&Ls Expanded Rapidly Real Estate Prices Rose Rapidly Real Estate Prices Rose Rapidly 1930s DEPRESSION 1930s DEPRESSION Banking System Collapsed, Money Supply Plummeted Banking System Collapsed, Money Supply Plummeted Short-term, Non-Amortizing Loans Became A Problem Short-term, Non-Amortizing Loans Became A Problem A Number Of Federal Agencies Created Including FSLIC, FHA, And Fannie Mae A Number Of Federal Agencies Created Including FSLIC, FHA, And Fannie Mae 4-6

Fixed-rate Mortgages PRESENT VALUE OF AN ANNUITY PRESENT VALUE OF AN ANNUITY PV ANN = (1+i) n – 1 PV ANN = (1+i) n – 1 (i) (1+i) n (i) (1+i) n MORTGAGE CONSTANT MORTGAGE CONSTANT MC i = (i) (1+i) n MC i = (i) (1+i) n (1+i) n - 1 (1+i) n

Fixed-rate Mortgages IMPORTANT VARIABLES IMPORTANT VARIABLES Amount Borrowed Amount Borrowed Contract Interest Rate Contract Interest Rate Maturity (Term) Maturity (Term) Outstanding Balance Outstanding Balance Amortization Amortization Payment Payment Financing Costs Including Discount Points Financing Costs Including Discount Points Annual Percentage Rate (APR) Annual Percentage Rate (APR) 4-8

Fixed-rate Mortgages Suppose You Borrow 7.50% For 30 Years, Monthly Payments Suppose You Borrow 7.50% For 30 Years, Monthly Payments What Is Your Monthly Payment To Fully Amortize The Loan Over Its Term? What Is Your Monthly Payment To Fully Amortize The Loan Over Its Term? 4-8

Fixed-rate Mortgages PMT = AMT. BORROWED (MC i,n ) PMT = AMT. BORROWED (MC i,n ) PMT = $100,000 (MC 7.5,30 ) PMT = $100,000 (MC 7.5,30 ) PMT = $100,000 x PMT = $100,000 x (.075/12) (1+.075/12) 360 (1+.075/12) 360 – 1 (.075/12) (1+.075/12) 360 (1+.075/12) 360 – 1 = $100,000 ( ) = $

Fixed-rate Mortgages LOAN AMORTIZATION LOAN AMORTIZATION Payment Consists Of Interest And Repayment Of Principal Payment Consists Of Interest And Repayment Of Principal AMORTIZATION FOR MONTH ONE AMORTIZATION FOR MONTH ONE Payment Is $ Payment Is $ Interest Portion Is $100,000 (.075/12) = $625 Interest Portion Is $100,000 (.075/12) = $625 Repayment Of Principal Portion Is Remainder, $ = $74.21 Repayment Of Principal Portion Is Remainder, $ = $74.21 Each Month’s Interest Is Calculated As The Loan Balance At The Beginning Of The Month Times The Monthly Interest Rate Each Month’s Interest Is Calculated As The Loan Balance At The Beginning Of The Month Times The Monthly Interest Rate 4-10

Fixed-rate Mortgages OUTSTANDING BALANCE OUTSTANDING BALANCE Present Value Of The Remaining Stream Of Payments Discounted At The Contract Rate Present Value Of The Remaining Stream Of Payments Discounted At The Contract Rate FOR OUR EXAMPLE AT THE EOY 5: FOR OUR EXAMPLE AT THE EOY 5: Enter The Payment (699.21) Enter The Payment (699.21) Enter The Contract Rate (.075/12) Enter The Contract Rate (.075/12) Enter The Number Of Remaining Payments (300) Enter The Number Of Remaining Payments (300) Solve For Present Value (PV) ($94,617) Solve For Present Value (PV) ($94,617) 4-11

Fixed-rate Mortgages KEYSTROKES FOR PAYMENT CALCULATION KEYSTROKES FOR PAYMENT CALCULATION Enter Amount Borrowed As Negative PV Enter Amount Borrowed As Negative PV Enter The Contract Rate (Adjusted Monthly) Enter The Contract Rate (Adjusted Monthly) Enter The Number Of Payments Enter The Number Of Payments Solve For Payment (PMT) Solve For Payment (PMT) Caution: If Your Calculator Is Set On One Payment Per Year, You Must Divide The Interest Rate By 12 And Multiply The Years By 12. Caution: If Your Calculator Is Set On One Payment Per Year, You Must Divide The Interest Rate By 12 And Multiply The Years By

Fixed-rate Mortgages APR APR The Effective Cost Of The Loan Assuming It Is Held For Its Full Term The Effective Cost Of The Loan Assuming It Is Held For Its Full Term Some Items Included In APR Calculation: Some Items Included In APR Calculation: Origination Fee, Lender Inspection Fee, Assumption Fee, Underwriting Fee, Tax Service Fee, Document Prep Fee, Prepaid Interest, Mortgage Insurance Premium, Discount Points Origination Fee, Lender Inspection Fee, Assumption Fee, Underwriting Fee, Tax Service Fee, Document Prep Fee, Prepaid Interest, Mortgage Insurance Premium, Discount Points 4-13

Fixed-rate Mortgages 4-14

Fixed-rate Mortgages 4-15

Trade Off Between Contract Rate and Discount Points Contract Rate Contract Rate 7% 7% 6.75% 6.75% 6.50% 6.50% 6.25% 6.25% Discount Points

Calculating The APR Assumption: Borrow $100,000 for 30 years, monthly payments Assumption: Borrow $100,000 for 30 years, monthly payments 7% & O pts: 7% & O pts: 100, = $ (PVAF i/12,360 ) i =7% 100, = $ (PVAF i/12,360 ) i =7% 6.75% & 1 pt: 6.75% & 1 pt: 100, ,000 = $ (PVAF i/12,360 ) 100, ,000 = $ (PVAF i/12,360 ) i = 6.85% i = 6.85% 4-17

Calculating The APR Cont. 6.50% & pts: 6.50% & pts: 100,000-2,875= $ (PVAF i/12,360 ) i = 6.78% 100,000-2,875= $ (PVAF i/12,360 ) i = 6.78% 6.25% & 3 pts: 6.25% & 3 pts: 100,000-3,000= $615.72(PVAF i/12,360 ) i = 6.54% 100,000-3,000= $615.72(PVAF i/12,360 ) i = 6.54% 4-18

Calculating the Effective Cost Under Shortened Holding Period Assumption: Borrow $100,000 for 30 years, monthly payments, hold for five years Assumption: Borrow $100,000 for 30 years, monthly payments, hold for five years 7% & 0 pts: $100, = 7% & 0 pts: $100, = $ (PVAF i/12,60 ) + $94,132 (PVF i/12,60 ) $ (PVAF i/12,60 ) + $94,132 (PVF i/12,60 ) i = 7% i = 7% 6.75% & 1 pt: $100,000 - $1,000 = 6.75% & 1 pt: $100,000 - $1,000 = $ (PVAF i/12,60 ) + $93,876 (PVF i/12,60 ) $ (PVAF i/12,60 ) + $93,876 (PVF i/12,60 ) i = 6.99% i = 6.99% 4-19

Calculating the Effective Cost Under Shortened Holding Period 6.50% & pts: $100, ,875 = 6.50% & pts: $100, ,875 = $632.07(PVAF i/12,60 ) + $93,611(PVF i/12,60 ) $632.07(PVAF i/12,60 ) + $93,611(PVF i/12,60 ) i = 7.2% i = 7.2% 6.25% & 3 pts: $100,000 - $3,000 = $615.72(PVAF i/12,60 ) + $93,337(PVF i/12,60 ) 6.25% & 3 pts: $100,000 - $3,000 = $615.72(PVAF i/12,60 ) + $93,337(PVF i/12,60 ) i = 6.98% i = 6.98% 4-20

Summary of Effective Costs OptionAPR5 Years OptionAPR5 Years 7% & 0 pts7%7% 7% & 0 pts7%7% 6.75% & 1 pt6.85%6.99% 6.75% & 1 pt6.85%6.99% 6.50% &2.875 pts6.78%7.21% 6.50% &2.875 pts6.78%7.21% 6.25% & 3 pts6.54%6.98% 6.25% & 3 pts6.54%6.98% 4-21

Prepayment Penalty Assumptions: $100,000 at 7.5% for 30 years, monthly payments. Five percent prepayment penalty over entire term. Repay at the end of year 5 Assumptions: $100,000 at 7.5% for 30 years, monthly payments. Five percent prepayment penalty over entire term. Repay at the end of year 5 PMT = $ PMT = $ Balance EOY5 = 94,617 Balance EOY5 = 94,617 Effective cost with no points Effective cost with no points $100, = $699.21(PVAF i/12,60 )+$94,617(1.05)(PVF i/12,60 ) $100, = $699.21(PVAF i/12,60 )+$94,617(1.05)(PVF i/12,60 ) i = 8.28% i = 8.28% 4-22

Fifteen Year Mortgage Borrow $100,000 at 7.50% for 15 years, monthly payments Borrow $100,000 at 7.50% for 15 years, monthly payments PMT 15 = $100,000( MC 7.5,15 ) = $ PMT 15 = $100,000( MC 7.5,15 ) = $ PMT 30 = $100,000 (MC 7.5,30 ) = $ PMT 30 = $100,000 (MC 7.5,30 ) = $ Total interest over 15 year term Total interest over 15 year term $927.01(180) - $100,000 = $66,862 $927.01(180) - $100,000 = $66,862 Total interest over 30 year term Total interest over 30 year term $699.21(360) - $100,000=$151,716 $699.21(360) - $100,000=$151,716 Difference in Interest Paid Difference in Interest Paid $151,716 - $66,862 = $84,854 $151,716 - $66,862 = $84,

Extra Payment Monthly PMT= $100,000 (MC 7.5,30 ) = $ PMT= $100,000 (MC 7.5,30 ) = $ $699.21/12= $58.27 Extra Paid Monthly $699.21/12= $58.27 Extra Paid Monthly New PMT= $ $58.27 = $ New PMT= $ $58.27 = $ Number of Payments at New Payment Amount Number of Payments at New Payment Amount $100,000 = $ (PVAF 7.5/12, n ) $100,000 = $ (PVAF 7.5/12, n ) n= , approximately 23 years n= , approximately 23 years Amount Saved Amount Saved $ ( 80.16) - $58.27 (279.84) $ ( 80.16) - $58.27 (279.84) $56,049 - $16,306 = $39, 743 $56,049 - $16,306 = $39,

Extra Payment-Lump Sum PMT= $100,000 ( MC 7.5,30 ) = $ PMT= $100,000 ( MC 7.5,30 ) = $ $10,000 Extra Paid at the end of year 3 $10,000 Extra Paid at the end of year 3 BAL EOY3 : $97,014 BAL EOY3 : $97,014 Minus Extra Payment: $10,000 Minus Extra Payment: $10,000 New Balance EOY3 :$87,014 New Balance EOY3 :$87,014 Number of Payments Remaining After Extra Payment Number of Payments Remaining After Extra Payment $87,014= $ ( PVAF 7.5/12, n ) $87,014= $ ( PVAF 7.5/12, n ) n= n= Amount Saved: Amount Saved: $ (82.59) - $10,000= $47,748 $ (82.59) - $10,000= $47,