Real Estate Finance Unit 4

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Purchase, Refinance, or Cash out

Types of loans include conventional and government-backed (FHA and VA). Loans are further described by occupancy (residence or investment) and by priority (first or second loans)

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Real estate loans can be classified in several ways. One of the most obvious ways to classify loans is by their purpose—

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Fixed-rate, ARM, or GPM

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Lenders classify loans by the type of amortization—

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Nontraditional mortgage product

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Any mortgage product other than a 30-year, fixed-rate mortgage is called a:

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Purchase money loan

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A loan that is used to purchase property is called a ______. Any loan made at the time of a sale, as part of the sale, is a __________. Even a second loan that finances part of the purchase of a property is a _________. Most loans used to purchase property are closed-end loans

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Closed-end loan

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Is one in which the borrower receives all loan proceeds in one lump sum at the time of closing. The borrower may not draw additional funds against the loan at a later date

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Refinancing

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Replaces the old loan with a new one. The loan amount remains the same, but the terms change

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Cash-out refinancing

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Involves refinancing the loan for a larger amount than the current loan. If the borrower wants cash to make home repairs, pay for college tuition, pay off high-interest credit card debt, or take a vacation, he or she can get a ___________

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Hard money loan

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Any loan used to take cash out of a property is a _______. Draw on the equity in property. This type of loan includes home equity loans, home equity lines-of-credit, and swing loans

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Differences between cash-out refinancing and home equity loan.

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Cash-out refinancing is not the same as a home equity loan. Cash-out refinancing replaces an existing loan with a new one. A home equity loan is a second loan against the equity in your home.

Example: Homeowner Pat owes $90,000 on a house valued at $180,000 and wants $30,000 to add a family room. Pat can refinance the loan for $120,000, pay off the existing loan, and have $30,000 to add the family room

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Amortization

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The interest rate and length of the loan help determine the payment the borrower will make. The other determining factor is the ______________. is the liquidation of a financial obligation on an installment basis. An amortization schedule details each payment, displays the specific amount applied to interest and principal, and shows the remaining principal balance after each payment.

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Fully amortized loan

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Is fully repaid at maturity by periodic reduction of the principal. When a loan is fully amortized, the payments the borrower makes are equal over the duration of the loan. Any mortgage other than a 30-year, fully amortized, fixed-rate mortgage is a nontraditional mortgage

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Partially amortized loan

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Has a repayment schedule that is not sufficient to pay off the loan over its term. This type of loan calls for regular, periodic payments of principal and interest for a specified period of time. At maturity, the remaining unpaid principal balance is due as a balloon payment

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Balloon payment

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Is substantially larger than any other payment and repays the debt in full

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Straight loan

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Is not amortized. The borrower only makes periodic interest payments during the term of the loan. The entire principal balance is due in one lump sum upon maturity. These loans are also called interest-only loans. This type of loan is not commonly offered by institutional lenders but may be offered by a seller or a private lender to a buyer

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Amount borrowed, Interest rate, Length of the loan, and Amortization type

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Loan products differ based on the terms of the loan, which include the:

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Amortization type

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Is the basis for how a loan will be repaid

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Fixed-rate loans, Adjustable-rate mortgages (ARM), and Graduated payment mortgages (GPM)

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The most common amortization types include

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Fixed-Rate Loan

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Has two distinct features—fixed interest for the life of the loan and level payments. The level payments of principal and interest are structured to repay the debt completely by the end of the loan term

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Maturity date

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Is the date on which a debt becomes due for payment. The longer the loan term, the smaller the payment and the more interest is paid over the term of the loan. During the early amortization period, a large percentage of the monthly payment is used to pay interest. As the loan is paid down, more of the monthly payment is applied to principal

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30-year fixed-rate loan

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Offers low monthly payments while providing for a never-changing monthly payment schedule. A typical 30-year, fixed-rate loan takes 22.5 years of level payments to pay half of the original loan amount

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15-year fixed-rate loan

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Is repaid twice as fast because the monthly payment is higher. More money is applied to the principal in the early months of the loan, which cuts the time it takes to reach free and clear ownership. Additionally, the borrower pays less than half the total interest costs of the traditional 30-year loan

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40-year fixed-rate loan

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Has the lowest monthly payments of fixed-rate loans but has a dramatically higher amount of interest costs

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Interest-only fixed-rate loans

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Are short-term fixed-rate loans that have fixed monthly payments usually based on a 30-year fully amortizing schedule and a lump sum payment at the end of its term. They typically have terms of 3, 5, and 7 years

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Biweekly payment

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Call for half the monthly payment every 2 weeks. Since there are 52 weeks in a year, the borrower makes 26 payments, which is equivalent to 13 months of payments, every year. The shortened loan term decreases the total interest costs. The interest costs for the _______ are decreased even farther because a payment is applied to the principal (upon which the interest is calculated) every 14 days

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Adjustable-rate mortgage (ARM

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Is a loan with an interest rate that adjusts in accordance with a movable economic index. The interest rate on the loan varies upward or downward over the term of the loan depending on money market conditions and the agreed upon index. The interest rate on the ARM only changes if the chosen index changes. The borrower’s payment stays the same for a specified time (for example, one year or two years) depending on the borrower’s agreement with the lender. At the agreed upon time, the rate adjusts according to the current index rate

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Initial interest rate and payment, Adjustment period, Index, Margin, and Caps

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These basic features are incorporated into every ARM loan:

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Initial Interest Rate and Payment

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For a limited period of time, every ARM has an initial interest rate and payment. These payments are usually lower than if the loan were a fixed-rate loan. In some ARMs, the initial rate and payment adjust after the first month. Other ARMs keep the initial rate and payment for several years before an adjustment is made

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Adjustment period

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For most ARMs, the interest rate and monthly payment change every month, quarter, year, 3 years, or 5 years. The period between rate changes is the _______

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The index and The margin

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The interest rate on an ARM changes periodically, usually in relation to an index, and payments may go up or down accordingly. The interest rate is made up of two parts:

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Index

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Is a measure of interest rates

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Margin

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Is an extra amount that the lender adds

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Beginning rate/start rate

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The initial interest rate is determined by the current rate of the chosen index. Then, a margin, which might be anywhere from 1 to 3 percentage points, is added to the initial interest rate to determine the actual beginning rate (start rate) the borrower will pay

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Cap

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There is usually a limit to how much the interest rate can change on an annual basis, as well as a lifetime cap, or limit, on changes to the interest rate. The annual maximum increase (cap) is usually 1.0% to 2.0% while the lifetime cap cannot exceed 5 or 6 points above the start rate on the loan

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Index

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Is a publicly published number that is used as the basis for adjusting the interest rates of adjustable-rate mortgages

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Constant Maturity Treasury (CMT), the 11th District Cost of Funds Index (COFI), the London Inter Bank Offering Rates (LIBOR), Certificate of Deposit Index (CODI), and the Bank Prime Loan (Prime Rate)

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The most common indices, or indexes, are the

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So does the interest rate

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If the index rate moves up

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Constant Maturity Treasury Index (CMT)

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Is the most widely used index. Nearly half of all ARMs are based on this index. It is used on ARMs with annual rate adjustments

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11th District Cost of Funds Index (COFI)

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Is more prevalent in the West. The COFI reflects the weighted-average interest rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts and other sources of funds. Unlike the CMT and the LIBOR, this index tends to lag behind market interest rate adjustments. In fact, the COFI is the slowest moving and most stable of all ARM indexes. It smoothes out a lot of the volatility of the market. The COFI is one of the most widely used indexes for option ARMs

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London Interbank Offering Rate (LIBOR)

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Is the interest rate charged on Eurodollars traded between banks in London. market has been around for over 40 years and is a major component of the international financial market. The LIBOR rate quoted in the Wall Street Journal is an average of rate quotes from five major banks: Bank of America, Barclays, Bank of Tokyo, Deutsche Bank, and Swiss Bank. The LIBOR is an international index that tracks world market conditions. The LIBOR is similar to the CMT and less stable than the COFI. The LIBOR index is quoted for 1, 3, and 6 months, and 1 year. The 6-month LIBOR is the most common

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Eurodollar

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Is a dollar deposited in a bank in a country in which the currency is not the dollar

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Certificates of Deposit

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These indexes are averages of the secondary market interest rates on nationally traded Certificates of Deposit. The 6-month Certificate of Deposit Index (CODI) generally reacts quickly to changes in the market

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Monthly Treasury Average

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Which is also known as the 12-Month Moving Average Treasury index (MAT), is relatively new. This index is the 12-month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. It has a maximum interest rate adjustment of 2.0% every 12 months. The MAT index reacts more slowly in fluctuating markets, so adjustments in the ARM interest rate lag behind other market indicators

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Prime rate

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Refers to the interest rate lenders charge their most creditworthy customers for short-term loans. It is a short-term rate that is typically uniform across all banks in the U.S. and follows market interest rates very closely. Banks use this rate as a base rate when determining the interest rates they charge on commercial loans and on some consumer loan products

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Margin

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The lender adds a few percentage points, or ______, to the index to determine the interest rate that a borrower pays. The amount of the margin may differ from one lender to another, but it is constant over the life of the loan. Some lenders base the amount of the margin on the borrower’s credit record—the better the credit, the lower the margin the lender adds and the lower the interest on the loan

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Fully indexed rate

Example: The current index value is 5.5% and the loan has a margin of 2.5%. Therefore, the fully indexed rate is 8.0%

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Margins on loans range from 1.75% to 3.5%, depending on the index and the total amount financed in relation to the property value. When the margin is added to the index, the result is known as the

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Introductory rate or start rate

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Many adjustable-rate loans (ARMs) have a low introductory rate or start rate, sometimes as much as 5.0% below the current market rate of a fixed-rate loan. This start rate is usually good for 1 month to as long as 10 years. As a rule, the lower the start rate, the shorter the time before the lender makes the first adjustment to the loan

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Payment shock

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Is a significant increase in the monthly payment on an ARM that may surprise the borrower. Caps regulate how much the interest rate or payment can increase in a given period.

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Periodic adjustment caps and Lifetime caps

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The two interest rate caps are

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Periodic adjustment cap (interim cap)
The interim caps apply at the time the loan adjusts. For example, 1-year ARMs have annual caps, 3-year ARMs have 3-year caps, 5-year ARMs have 5-year caps, and so forth.

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Limits the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment

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Note rate

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Is the interest rate on the ARM loan at the time it is funded. It is important to know the note rate, in order to calculate future interest rate increases and future payments. The caps work in both directions. If the borrower has a 1-year ARM with 2.0% annual caps and a 6.0% lifetime cap, the interest rate cannot adjust more than 2.0% above or below the note rate at the annual adjustment period. In this example, the maximum interest rate (lifetime cap) is the note rate plus 6.0%

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Lifetime cap

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is the maximum interest rate that may be charged over the life of the loan. Loans with low lifetime caps usually have higher margins. Loans that carry low margins generally have higher lifetime caps.

Example: An ARM has an initial interest rate of 5.5% with a 6.0% lifetime cap. This means that the interest rate can never exceed 11.5%. If the index increases 1.0% for 10 years, the interest rate on the loan will be 15.5% without the lifetime cap. However, with the lifetime cap it will be 11.5%

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Payment cap

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Restricts a payment from increasing more than a specified percentage above the prior year’s payment amount. These loans reduce payment shock in a rising interest rate market, but can also lead to negative amortization

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Negative amortization

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Is an increase in the principal balance caused by low monthly payments that do not pay all the interest due on the loan. This deferred interest is added to the principal on the loan. Typically, the payment caps range between 5.0% and 8.0%. If a loan has a 6.0% payment cap and the borrower’s monthly payment is $1,000, the payment cannot increase more than $60 regardless of the actual interest rate increase

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Discount points

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Are a one-time charge paid by the borrower to lower the interest rate on the loan. A point is equal to one percent of the loan amount. If borrowers choose to pay these points or fees in return for a lower interest rate, they should keep in mind that the lower interest rate may only last until the first adjustment

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Prepayment penalty

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Is a fee charged when the loan is paid off early. Are commonly in effect for three years, although the time may be longer or shorter. The penalty is typically equal to six months’ interest on the loan

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Assumable feature

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Sometimes ARMs are assumable, which is important for borrowers who plan to resell the property within a short time. The_________ of a loan allows a borrower to transfer the loan to another borrower, usually with the same terms, if the new homebuyer qualifies for the loan

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Interest-only ARMs, Convertible ARMs, and Payment-option ARMs

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Lenders offer a variety of ARMs, including

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Interest-only ARM (IO)

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Loan that allows payment of interest only for a specified number of years (typically between 3 and 10 years). This allows the borrower to have smaller monthly payments for a period of time. After that, monthly payments increase even if interest rates stay the same, because the borrower must start repaying the principal and the interest each month. The longer the IO period, the higher the monthly payments are after the IO period ends

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Convertible ARM

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Is an ARM that can be converted to a fixed rate by the borrower at some point during the loan term. As an example, a lender may have a 1-year ARM with a feature that allows conversion from the ARM to a fixed–rate loan during the first 60 months of the loan. The lender may charge a one-time fee at the time the loan is converted to a fixed-rate. It is important for a borrower to know that the conversion fee may be large enough to take away all the benefits of the low interest rate charged at the beginning of the loan

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Option ARM

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Is a type of loan that allows the borrower to choose among several payment options each month. This provides flexibility for borrowers by allowing them to choose the payment that suits their current financial situation. Offer a variety of payment options, such as a minimum payment (which can lead to negative amortization), a 15-year or 30-year amortized payment, or an interest-only payment

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Option ARM- payment options

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Payment choices can be made on a monthly basis, thereby enabling borrowers to manage their monthly cash flow. For obvious reasons, many refer to these types of loans as pick-a-payment ARMs. World Savings (now part of Wachovia Bank) was one of the early pioneers of the pick-a-payment option. Managing the features of this type of loan requires expertise and vigilance on the part of the borrower because some payment choices may lead to negative amortization.

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Option ARM- Payment Cap

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With an option ARM, the minimum payment is usually capped so that it cannot be increased more than 7.5% above the prior year’s payment amount. Therefore, if the prior year payment was $1,000, the current year adjustment cannot increase the payment more than $75

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Teaser rate

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Is a low, short-term introductory interest rate designed to tempt a borrower to choose a loan. Option ARMs are often 1-month adjustable loans and typically have low initial _______ with low initial payments that enable a borrower to qualify for a larger loan amount

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Recasting

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Option ARM payments are typically adjusted every 5 years. Lenders do this by amortizing the higher principal balance created by the addition of interest (negative amortization). This automatic payment adjustment is called ______. It amortizes the loan so it can be paid in full by the end of the loan term

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Hybrid ARM

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Combines the features of a fixed-rate loan with those of an adjustable-rate loan. The fixed-rate feature gives the borrower some security with fixed payments in the initial term of the loan. The adjustable-rate feature is that the initial interest rates on these loans are typically lower than a fixed-rate loan. Initially, a fixed interest rate exists for a period of 3, 5, 7, or 10 years. At the end of the fixed-rate term of the loan, the interest rate adjusts periodically with an economic index. This adjustment period begins on what is called the reset date for the loan

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3/1, 5/1, 7/1, 10/1 ARMs
-The first number tells how long the fixed interest-rate period will be.
-The second number tells how often the rate will adjust after the initial period.

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Hybrid ARMs are often advertised as 3/1, 5/1, 7/1, or 10/1 ARMs. These loans are a mix (hybrid) of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans, for example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example) until the loan is paid of

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Graduated payment mortgage (GPM)

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Another alternative to an adjustable-rate mortgage. A fixed-rate loan with initial payments that are lower than the later payments. The difference between the lower initial payment and the required amortized payment is added to the unpaid principal balance. This loan is for the buyer who expects to be earning more after a few years and can make a higher payment at that time.
Unlike an ARM, GPMs are fixed-rate loans and have a fixed payment schedule. With a GPM, the payments are usually fixed for 1 year at a time. Each year for 5 years, the payments graduate from 7.5% to 12.5% of the previous year’s payment.
GPMs are available in 30-year and 15-year amortization and for both conforming and jumbo loans