1. Fundamentals of Real Estate Lecture 19 Spring, 2003 Copyright © Joseph A. Petry www.cba.uiuc.edu/jpetry/Fin_264_sp03

2. 2 Introduction Primary versus Secondary Mortgage Market – Primary market is the loan origination market; where lenders and borrowers negotiate terms – Secondary market is where existing loans are purchased from local originators. The largest purchasers of residential mortgages are government sponsored groups: Federal National Mortgage Association, “Fannie Mae” and Federal Home Loan Mortgage Corp, “Freddie Mac” Chapter 15: Residential Mortgages

3. 3 Conventional Fixed-Payment Mortgage Loan A. Fixed-Payment, Fully Amortizing Mortgages 1. Conventional Mortgages – Largest segment of residential mortgages – Are not backed by FHA insurance or VA guarantee – May or may not require PMI (private mortgage insurance) – Conforming Conventional – Loan meets underwriting standards of Fannie Mae, Freddie Mac. – This limits loans to $207,000 (as of 1996). – Non-conforming conventional – If 1 or more of the Fannie Mae/Freddie Mac standards doesn’t apply. – If loan amount exceeds 207,000, termed “jumbo” loans Chapter 15: Residential Mortgages

4. 4 Conventional Fixed-Payment Mortgage Loan A. Fixed-Payment, Fully Amortizing Mortgages 2. Fixed Payment Mortgages – Historically, fixed-rate, level payment, fully-amortizing mortgage has been the most common mortgage loan form – Fixed payment mortgages (FPMs) are fully amortizing loans calling for equal (level) payments. – Fully amortizing mortgages are completely paid off over the term of the loan by periodic (usually monthly) payments. – 30 years (360 months) is most common loan term (50-60% of loans) Chapter 15: Residential Mortgages

5. 5 Conventional Fixed-Payment Mortgage Loan A. Fixed-Payment, Fully Amortizing Mortgages 3. Fifteen-year mortgages – represents about 15-30% of residential loans – on 15-year loan, monthly payments are higher, interest paid over the life of the loan is lower – Principal criteria for choosing 30-year over 15-year are: If you can make more on your money than you are paying on the 30-year mortgage (all after-tax) If cash liquidity or payment affordability is an issue – In addition to 15-, 30-year loans, 10- and 40-year also exist Chapter 15: Residential Mortgages

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7. 7 Conventional Fixed-Payment Mortgage Loan B. Alternative Amortization Schedules 4. Biweekly mortgages – an example of an early payment mortgage – one half payments are made every two weeks instead of full payments every month – because a portion of the payment is made early each month, and because there are 26 two-week periods (13 months), the mortgage principal is reduced quicker than the monthly FPM – Pros/cons of choosing between a biweekly mortgage and a standard monthly mortgage is the same as choosing between a 15-year and 30-year amortization period Chapter 15: Residential Mortgages

8. 8 Adjustable Rate Mortgages – Interest rate on an ARM adjusts on a periodic basis according to some index, or a predetermined set of rates. – 10-25% of loan originations are ARMs A. ARM Mechanics – Index: – the market interest rate on another security that is used as the benchmark to make adjustments to the ARM – One-year US Treasury Bill is the most common; average cost of funds – Margin: – spread between the interest rate on the index and the market interest rate. Chapter 15: Residential Mortgages

9. 9 Adjustable Rate Mortgages A. ARM Mechanics – predetermined at time of origination and held constant for life of loan (e.g. 225 basis points) – Market Interest Rate = Index + Margin – Adjustment Interval – length of time between ARM contract interest rate changes – most common is 1 year – Adjustment rate caps – annual caps: maximum rates can go up each adjustment period – life-of-loan caps: max rates can go up over initial rate for entire contract period – most common type is ARM 2/6 (annual, life-of-loan respectively) Chapter 15: Residential Mortgages

10. 10 Adjustable Rate Mortgages A. ARM Mechanics – Initial contract rate – first period interest rate on the ARM – If contract rate is less than market rate, this is a “teaser” rate – Contract interest rate – periodic interest rate actually applied to balance of the loan – contract rate=MIN(Index+Margin; Previous contract rate+Ann cap) – Discount Points – similar to FPMs, interest may be paid up front to reduce initial contract interest rate – points may also be paid for loan origination Chapter 15: Residential Mortgages

11. 11 Chapter 15: Residential Mortgages

12. 12 Private Mortgage Insurance – private mortgage insurance (PMI) is generally required for conventional loans when LTV is > 80% – PMI covers lenders up to 20% of loan amount in event of default – PMI premiums can be paid at time of origination, as monthly installments or both – PMI can be cancelled when remaining mortgage balance is less than 80% of property’s current market value (get that into contract at signing!) Chapter 15: Residential Mortgages

13. 13 Other Mortgage Types and Uses A. Purchase Money Mortgages – whenever seller lends all or part of the purchase price to the purchaser, and loan is secured by a mortgage B. Package Mortgages – provide additional funds for home buyers to include home- related items of personal property such as appliances and furnishings C. Reverse Annuity Mortgages (RAMs) – provide monthly payments to the homeowner from the lender in exchange for the rights to the equity in the home when it is sold at the end of the mortgage term Chapter 15: Residential Mortgages

14. 14 Other Mortgage Types and Uses – provide monthly payments to the homeowner from the lender in exchange for the rights to the equity in the home when it is sold at the end of the mortgage term – Assume a 100,000 home is owned debt-free. A RAM lends 70,000 for 10 years at 9% interest, paid annually. What is the annual payment to the homeowner? N=10, I=9%, PV=0, FV=70,000, PMT=?; PMT = $4607.41 – Assume a household owns a 200,000 home debt-free. A RAM lender agrees to a 130,000 10-year RAM at 8% interest, paid monthly. What would the monthly payments be to the homeowner? – Proceeds are paid from sale of house. Chapter 15: Residential Mortgages

15. 15 Other Mortgage Types and Uses D. Home Equity Loans 1. Types of loans – closed-end loans: a fixed amount is borrowed all at once and paid in monthly installments over a set period. – Open-end lines of credit: money is borrowed as needed, drawn against a maximum amount. Checks are often provided for this purpose. 2. How much can one borrow? – Determined by amount of equity in home – generally not more than 80% – some advertise for 125% LTV, only up to 100% is tax ded Chapter 15: Residential Mortgages

16. 16 Other Mortgage Types and Uses D. Home Equity Loans 3. Tax advantages – Interest paid on home equity loans to 100 percent of value of the home is tax deductible – Closing costs, with the exception of discount points, are not tax deductible. Chapter 15: Residential Mortgages

17. 17 Borrower’s Mortgage Loan Decisions A. Mortgage Choice 1. Up-front financing costs Lenders charge points to: – Generate income – Increase the yield on the loan – Reduce the incentive for borrowers to refinance Lenders usually charge loan origination fees of 1 – 2% of loan Other fees include: – Loan application fees and document preparation fees ($200-700) – Appraisal fees ($150-300) – Credit check fees ($35-75) – Mortgage insurance (.5-1.0 percent of loan amount) Chapter 15: Residential Mortgages

18. 18 Borrower’s Mortgage Loan Decisions – charges to transfer the deed and record the mortgage ($40-200) – Survey costs ($200-300) – Pest inspection ($25-75) – Attorney’s fees 2. The effective cost of borrowing—your actual interest rate – What is the effective cost of borrowing on a $100,000 FPM, amortized monthly over 30 years, at 8.5%. Assume all up-front financing costs are $2000 and that the borrower repays the mortgage after two years. – First find your payments = – Then find RMB = – (N=24, I=?, PV=98,000, PMT=-PMT, FV=-RMB); I = – Now assume, the borrower also paid 1 point to close the loan. I = ?? Chapter 15: Residential Mortgages

19. 19 Borrower’s Mortgage Loan Decisions 3.Estimating Closing Costs – The Real Estate Settlement and Procedures Act requires lenders to provide a “good faith” estimate on all costs associated with closing a residential loan within three days of loan application – The Truth in Lending Act requires lenders to provide borrowers with estimates of total finance charges and the annual percentage rate (APR) 4. Comparing Mortgage Options – Compare effective borrowing costs – For very short holding periods, effective cost on ARMs < FPMs – Consider affordability/liquidity needs and opportunity cost of funds Chapter 15: Residential Mortgages

20. 20 Borrower’s Mortgage Loan Decisions B. Loan Size – Relative costs of debt and equity financing – Household’s current and expected future income constraints – Household’s wealth constraints C. Refinancing Decision – “Rule of thumb” refinance when rates are 150-200bps below current mortgage rate – Compare present value of the payment reductions to present value of the cost of obtaining a new loan. The one thing that this can miss is postponing refinancing until even lower rate can be achieved. D.Default Decision – Usually arises from change in borrower’s ability to pay or low equity in the home. Default is usually not immediate even if home value is greater than the loan amount. Chapter 15: Residential Mortgages