I. Chapter 1 – The Mortgage Loan – Mortgagee = Lender; Mortgagor = borrower/buyer

a. Basics:

i. Determining Price Range – Obtaining Necessary Financing

1. banks will only lend 80% of the purchase price of the house without requiring the new owner to acquire private mortgage insurance (PMI)

2. buyers will have to cover a 20% down payment

3. (available cash x 4 + available cash = price)

4. from the lender’s perspective, this is called the loan to value ratio (if you put up 20%, lender loans 80%)

5. if you borrow more than 80%, you may have to pay a higher interest rate and must obtain mortgage insurance on a portion of the loan

a. note: even if you have 50% to put down, depending on what you could do with the money and how important it is for you to have a cash reserve, it may be more costly to borrow

i. if the interest rate of borrowing is higher than the interest rate of investing, then its most costly to borrow (but those numbers are usually reversed)

b. in commercial real estate transactions, people want to borrow as much as they can b/c the income from the property is higher than the cost of borrowing:

i. leveraged transaction: one in which a substantial portion of the investor’s fund is borrowed ( when cost of borrowing is less than investment deal, borrow )

1. more you borrow, higher rate of return

2. Leveraged principle doesn’t work in all circumstances. When the annual debt service (principal and interest payments) as a percentage of the amount borrowed exceeds rate of return, it is not more profitable to borrow

ii. How much can they borrow?

1. determining factors:

a. income (amount of mortgage your income qualified for)

b. the total amount needed monthly to pay the mortgage installment, taxes, and insurance may not exceed 33% of the borrower’s gross income (gross = before taxes)

i. housing: gross income needed = yearly payments/ .33 (% of income that they can’t exceed) (28% – 33%)

ii. all debt: mortgage principal and interest plus any other debt due monthly (33% – 38%)

c. if interest rate is lower, monthly payment is lower

2. Example: lower interest rate (6.5% à 6%)

a. The lower the monthly payment and, lower yearly income require

3. Length of mortgage

a. the longer the term, the lower the monthly payments, and lower yearly income required

b. the shorter the term, higher monthly payments, more income needed

4. Rate of Interest

a. Higher the rate, higher monthly payment

5. General Principles:

a. The more you borrow, the higher the payments

b. The longer the term, the lower the payments

c. The higher the rate, the higher the payments

i. From the perspective of the borrower, the cheapest loan is the loan of the smallest amount at the lowest interest rate for the shortest period

d. very few home mortgages are paid to term (usually the home is sold)

i. therefore, the total finance charge on the average loan is less than the amount that would be paid if the loan went to term

6. Affordability:

a. Affordability is a function of the monthly payment; people generally take longer terms b/c longest term has lowest monthly payment, but there has also been in an increase in 15 year mortgages (attractive lower rate)

b. Standard mortgage documents permit prepayment at any time (Fannie Mae/Freddie Mac – highly consumer oriented, secondary market for mortgages)

i. Prepayment allows you to pay more in the beginning and less at the end

1. prepaying after the 6th year, for example, and adding extra money to each payment allows homeowner to prepay by customizing the term of the loan to their improved financial situation

c. Fannie Mae and Freddie Mac

i. 1990 underwriting criteria:

1. mortgage debt test: basic home expense (total of monthly mortgage payment, plus 1/12 of the RE taxes, insurance cost) could not exceed 26% if 5% down, 28% if 10% down, 33% if 20% down)

2. debtor must add to the basic housing cost, the monthly payment in education, car and personal loans, 5% of credit card balances to arrive at the aggregate debt payment and that amount may not exceed 33% if 5% down, 36% if 10% down, 38% if 20% down…

ii. Since 1996, FM and FM have used underwriting systems that look at more variables and weigh those variables based on actual experience. For example, better credit histories may obtain a larger loan

d. Taxes:

i. The cost of taxes and insurance directly reduces the amount available for debt service and the amount that may be borrowed

1. you just want to know what the house costs/year in taxes (based on the assessed value)

2. note: high taxes erode bargaining power and, when you’re buying a new house, you could get a new assessed value that might raise the taxes

iii. Options if they don’t have enough to borrow: Alter

1. rate

a. ARM (brings rate down now, but exposes you to higher rates in the future)

2. amount

3. term

4. borrow less – come up with more for down payment

iv. Refinancing:

1. When interest rates drop, people with a higher rate can save money by refinancing

a. New mortgage costs money up front:

i. Cost of new title insurance

ii. Cost of new application/appraisal fees

2. Keys to Refinancing:

a. rate spread: higher the spread, more benefit in adjustable rate mortgage if your only goal is to have more purchasing power

b. total cost to refinance

c. length of time the homeowner expects to remain in the home

3. To entice folks to refinance, lenders often offer zero point mortgages

v. Deductibility of Interest

1. Section 163 of the IRC authorizes a deduction for interest paid by a taxpayer on a residential mortgage. This means that if (Bob and Alice) itemize their deductions, a portion of the annual cost of homeownership will be paid by the government through a lower tax bill.

2. Since the tax structure is progressive in nature, under the recently amended IRC, the more money you make, the more your ownership is subsidized by the government

3. All you have to do is convert the interest rate to the actual interest rate after taxes to find the marginal rate of tax, then subtract the percentage from 100% to get the after tax effective interest factor. Next, multiply that factor by the interest rate on the loan. As an aside, the same analysis is used to determine whether tax free bonds area suitable investment for a particular individual)

4. now it is capped at 1M$ (price of house) so even if you buy a 5M house, its capped at 1M

vi. APR and Points

1. There have always been fees (s/a application fee, document preparation fee and appraisal fee) which must be paid to the lender; now, we have points

2. Points are, prepaid interest: 1% of the loan (the amount borrowed)

3. Paying the points to save money each month

4. However, in order for the consumer to decide which loan is cheaper (considering a lower rate with points and a higher rate with zero points), the consumer must estimate how long she will live in the house

a. If consumer thinks she’ll only live in the house for 10 years, the zero point loan will cost 32$ more/month than the 2 point loan. Consumer may avoid the extra interest by paying the 2 points (pay the points to save 32/month)

b. The idea is that money received in the future is worth less than money received today b/c money you receive today can be invested today.

vii. Variations in Mortgages

1. Fixed Rate Mortgage

a. Same rate for 30 years; least amount of risk for consumer

2. Adjustable Rate Mortgages (ARM)

a. New mortgage instruments that link the mortgagor’s interest rate to some index of interest rate

b. 1 year ARM: rate fixed year one then adjust every year

c. 3 year ARM: fixed rate 3 years, then adjust every 3 years

d. Deferred ARM: fixed rate 3, 5, 7, 10 years then a one year ARM for balance. These mortgages have fixed rates that are higher than the 1 year ARM rate and lower than the rate for 15-30 year fixed rate.

e. In order to make ARMs saleable, lenders ‘cap’ the maximum interest rate adjustment for each adjustment period

i. Cap: absolute limit on the interest rate

1. period cap: usually 2% per adjustment – can’t go up more than 2%, also can’t go down more than 2%,

2. lifetime cap 6%

ii. Rate is what the market bears (federal reserve)

iii. Index: indexed to securities by the United States (government – constant maturity index) (mortgage flows with what the government is paying on one year borrowing)

iv. Each lender specifies a margin which is added to the index (index + margin)

ortgage

a. “I will pay you back $600 week until I pay you off” – fixed constant) (self amortizing would have been $632)

b. If you pay less than the interest due, shortfall gets applied to principal (negative amortization) (will basically create a balloon, may need to refinance)

c. Options (Option Mortgage) Negative amortization

i. Borrower given option of determining the amount of payment, and if that doesn’t cover the interest charged then:

1. The amount that accrues is added to the principal

ii. Options:

1. more than interest, but less than self amortizing

2. could be less than interest (negative amortization)

3. more than self amortizing

4. if you’re willing to give the lender the right to chop you off in 5 years, shouldn’t he charge you less than someone with a fixed rate mortgage (agree to amortization on a 30 year basis, with a call balloon for the lender)

iii. Fannie Mae does not support Option Mortgages

viii. The Arithmetic of Interest Rates

1. Methods to Calculate Interest Rates: based on 1000 principal

a. Actuarial

i. Loan interest is calculated on the reduced balance of the loan after each monthly payment

b. Add On

i. 1000 principal at 6%; add the 6% onto the 1000 (60$) = $1060/12 = monthly payment of $88.34

c. Discount: discount method loans; borrow 1000, but 6%is deducted an you receive $940.

i. Discount rate is computed as if the whole 1,000 is available for the term, but you only receive the $940.

2. Under the Truth in Lending Act, all interest rates or finance charges must be converted to APRs and disclosed to borrower/buyer

ix. Theory of Interest

1. when a person borrowers he receives something more than money – he receives the present availability of the money

2. lender gives up the opportunity to invest the money and to earn dividends or interest

3. interest is the compensation to the lender for the lender’s giving up the present availability of the money

4. whenever an obligation, typically a government or corporate bond has an interest rate that is below the current market, the obligation is discounted (purchased for less than the face amount of the obligation) so that the borrower gets a competitive yield

5. cost to the lender is compensated for by an interest charge: interest charge must be in excess of costs.

a. Interest rates made up of 4 components:

i. X% to cover the intrinsic cost to the lender making the loan

ii. Y% to make a profit

iii. % to reflect inflation

iv. The risk that the loan will not be repaid

6. Comparison of investments with varying streams – find present value of income stream

a. Present value is determine by:

i. The length of time before $ is repaid

ii. Cost of making the loan measured by alternative investment opportunities