Understanding Mortgage Loans and Repayment: Default, Redemption, and Underwriting - Prof. , Study notes of Real Estate Management

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Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 1 Mortgage Markets Real Estate 310 Principles of Real Estate Dr. Longhofer Dr. Longhofer Principles of Real Estate 2 Why Mortgages? • Real estate is a very capital intensive investment – Most households want to purchase a home long before they are able to save enough to pay cash – Most real estate investors desire the benefits of financial leverage • As a result, most real estate is purchased using at least some borrowed funds Dr. Longhofer Principles of Real Estate 3 Why Mortgages? • A mortgage is the pledge of real estate to secure a debt – The term comes from the Middle Ages in Great Britain (mort – dead, gage – pledge) Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 4 What is a “Mortgage”? • Although we usually speak of the “mortgage” as if it were a loan, technically it is a security instrument putting up the property as collateral for the loan • Two basic documents make up the mortgage – The promissory note, or financing instrument , actually creates the debt and specifies the terms of the loan – The mortgage, or security instrument , pledges the real estate as collateral for the loan • The borrower is called the mortgagor because he has pledged his land to the lender (the mortgagee) Dr. Longhofer Principles of Real Estate 5 The Promissory Note • The promissory note (or simply “note”) actually creates the debt and specifies the terms and conditions of the loan – Amount of the debt and the rate of interest – Time and method of payment • The note also contains a number of other clauses: – Whether the loan is due on sale (alienation clause) – Acceleration of the debt in the event of default – Prepayment penalties for early repayment – How the interest rate will be adjusted for variable rate loans Dr. Longhofer Principles of Real Estate 6 The Mortgage • The mortgage (security instrument) gives the lender the right to sue for foreclosure in the event of default • The mortgage contains certain uniform covenants (promises) that require the borrower to – Pay the debt in accordance with the terms of the note – Keep insurance on the property – Pay real estate taxes on the property – Maintain the property Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 13 Primary Mortgage Market • Primary mortgage market participants – Thrifts, savings associations, commercial banks, and credit unions – Mortgage banks – Mortgage brokers – Insurance companies, pension funds, and other institutional investors Dr. Longhofer Principles of Real Estate 15 Secondary Mortgage Market • Government sponsored enterprises (GSEs) are private companies that are chartered by the Federal government – Fannie Mae (Federal National Mortgage Association) – Freddie Mac (Home Loan Mortgage Corporation) • Ginnie Mae (Government National Mortgage Association) is an agency of the Federal government • Commercial banks, insurance companies, mutual funds, REITs, and other private investors are also active in the secondary market Dr. Longhofer Principles of Real Estate 17 Residential Mortgage Holdings GSEs $225.3 ABS Issuers $591.2 Other $211.8 Depository Institutions $1,787.8 Institutional Investors $22.8 Mortgage & Finance Companies $146.8 Federally-related Mortgage Pools $2,748.5 Billions of U.S. Dollars Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 18 Commercial Mortgage Holdings Other $84.6 Depository Institutions $718.1 Institutional Investors $202.2 Mortgage & Finance Companies $43.6 ABS Issuers $237.4 Billions of U.S. Dollars Dr. Longhofer Principles of Real Estate 19 Residential Loan Programs • Conventional loans are mortgages that have no direct government backing – Conventional loans must either have a loan-to-value (LTV) ratio no bigger than 80% or have private mortgage insurance (PMI) • FHA Loans – The Federal Housing Administration provides insurance on loans with high LTV ratios – The borrower pays an up-front fee and a monthly premium for this insurance • VA Loans – The Veterans Administration guarantees loans made to qualified veterans against default – The borrower pays a guarantee fee at the time the loan is originated, but no monthly premiums Dr. Longhofer Principles of Real Estate 20 Residential Loan Classifications • Conforming loans are loans that meet (or conform to) Fannie/Freddie underwriting and size guidelines • Nonconforming loans include – Jumbo loans that exceed the maximum loan size limits for Fannie Mae and Freddie Mac – B and C loans that have too many credit blemishes or other problems to be approved under Fannie/Freddie underwriting guidelines Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 21 Residential Mortgage Underwriting • The first step in underwriting the loan is to verify the applicant’s creditworthiness by examining his or her credit report: – Installment loan and revolving credit delinquencies – Mortgage loan delinquencies – Bankruptcies, judgments, and foreclosures – Recent blemishes are typically weighed more heavily • Lenders often use credit scores (FICO scores) to summarize the applicant’s credit history – A score above 700 is viewed as good, while a score below 600 is considered bad Dr. Longhofer Principles of Real Estate 22 Residential Mortgage Underwriting • Next the lender verifies that the applicant is capable of making the required monthly payment on the loan – The lender will verify the income reported by the applicant by inspecting past tax returns and calling employers • The front-end (housing expense) ratio is the percentage of the applicant’s monthly income needed to meet required monthly housing expenses – FER = (Mortgage Payment + Taxes + Insurance) Monthly Income Dr. Longhofer Principles of Real Estate 23 Residential Mortgage Underwriting • Conforming lenders typically require that the applicant’s FER be no greater than 28% – FHA guidelines allow a slightly higher FER of 29%, but calculate some items slightly differently • Example: Suppose a borrower has monthly income of $3,000. The proposed mortgage payment is $550 per month, while taxes and insurance are expected to be $250 per month. – FER = (550 + 250) / 3,000 = 27% – This applicant’s income appears to meet this guideline Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 30 Traditional Mortgage Structure • The traditional residential mortgage loan is a long- term , fully-amortizing , fixed-rate loan with constant monthly payments – Terms of 15 and 30 years are the most common – Fully-amortizing means that the regular monthly payments will fully repay the loan by the end of the term – The interest rate charged on the loan remains constant for the entire loan term, and the monthly payment never changes Dr. Longhofer Principles of Real Estate 31 Residential Mortgage Rates 0% 2% 4% 6% 8% 10% 12% 14% 16% 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 30-Year Fixed 15-Year Fixed Dr. Longhofer Principles of Real Estate 32 Mortgage Payment Mechanics • You can use the time value of money keys on your financial calculator to solve mortgage problems – P/Y = Number of payments to be made per year – N = Number of periods the payments will be made – I/Y = Annual nominal interest rate – PV = Present value, or the initial loan amount – PMT = Periodic payment on the loan – FV = Future value, or the balance due after all payments are made Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 33 Mortgage Payment Mechanics • What is the monthly payment required to purchase property worth $225,000 under the following terms? – 30-year, fixed-rate mortgage with monthly payments – 80% LTV ratio – 8.5% nominal interest rate • The first step in any problem is to clear your financial calculator of old information that may be entered in the registers – Press [2nd], [Clr TVM] Dr. Longhofer Principles of Real Estate 34 Mortgage Payment Mechanics • Next note that the loan amount is 80% of the property’s value, based on the lender’s required LTV ratio – Solve for the loan amount 225,000 × 0.80 = 180,000 – Enter this into your calculator by pressing [PV] • This loan has monthly payments, so the number of payments per year is 12 – Set this by entering [2nd], [P/Y], 12, [Enter] – Exit this feature by pressing [2nd], [Quit] Dr. Longhofer Principles of Real Estate 35 Mortgage Payment Mechanics • The total number of payments will be 30 × 12 = 360 – Enter this by pressing 360, [N] – Note that you can calculate the total number of payments by pressing 30, [2nd], [xP/Y]; make sure you then press [N] to enter this value • Next enter the annual interest rate on the loan – Press 8.5 , [I/Y] Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 36 Mortgage Payment Mechanics • Finally, note that because the loan is fully- amortizing, the loan balance will be 0 at the end of the term – Because we cleared the calculator at the beginning, the future value is preset to 0; check this by pressing [RCL], [FV] – To be safe, get in the habit of entering your future value again: 0, [FV] • Now you can solve for the monthly payment – Press [CPT], [PMT] to get −1,384.04 – This is negative because payments are cash outflows Dr. Longhofer Principles of Real Estate 37 Mortgage Payment Example • What is the required monthly payment on a 15-year, $75,000 fixed-rate mortgage with monthly payments and 5.50% interest rate? – P/Y = 12 – N = 15 × 12 = 180 – I/Y = 5.50% – PV = 75,000 – FV = 0 • Solve for PMT = −$612,81 Dr. Longhofer Principles of Real Estate 38 How Do Mortgages Work? • Traditional mortgages are structured so that each month a portion of the loan is repaid, with the last payment fully paying off the loan • Consider our $180,000 mortgage from earlier: – The monthly payment on the mortgage was $1,384.04 – In the first month, $1,275 of interest will accrue INT = $180,000 × (0.085 ÷ 12) = $1,275 – The balance of the payment is credited toward principal: PRN = $1,384.04 − $1,275.00 = $109.04 Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 45 Choosing Among Loans • The variety of different pricing options can making choosing a mortgage confusing – How do I decide which lender’s offer to take? – Should I choose a loan with fewer points or one with a lower interest rate? – When should I refinance my mortgage? • Usually, these questions come down to choosing the loan with the lowest total borrowing cost – The fact that loans are priced across two different dimensions (up-front fees and interest rate) can make figuring out the total borrowing cost tricky Dr. Longhofer Principles of Real Estate 46 Annual Percentage Rate • One tool for comparing loans is the Annual Percentage Rate (APR) – The APR is the effective interest rate you will pay over the entire term of the loan taking into account the up- front fees that reduce the net funds you receive from the lender • To calculate the APR, simply determine the net funds you will receive from the loan after paying any points or fees and then use your financial calculator to resolve for the (implicit) interest rate Dr. Longhofer Principles of Real Estate 47 APR Example • On the rate sheet from before, what is the APR of a 30-year $100,000 mortgage at 6.00% interest with 1 point? – Begin by calculating the monthly payment on the loan: P/Y = 12, N = 360, I = 6, PV = 100,000, FV = 0 ⇒ PMT = −$599.55 – Next calculate the net funds that will be received by the borrower and enter this as the new PV: PV = 100,000 × (1 − 0.01) = $99,000 – Finally, solve for the interest rate implied by this lower net amount financed: APR = 6.09% Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 48 Using the APR • What is the APR of the 6.375% loan with zero points? – If there are no up-front fees, the APR is simply the nominal interest rate • Choosing the loan with the lowest APR ensures that you are getting the best alternative, assuming you hold the loan until maturity – If you do not hold the loan for the entire term, then the loan with the lowest APR may not be the best choice Dr. Longhofer Principles of Real Estate 49 Effective Borrowing Cost • The effective borrowing cost (EBC) measures the true cost of the mortgage taking into account both the up-front fees and the anticipated holding period for the loan – If you hold the loan until maturity, EBC = APR – If there are no up-front fees on the loan, EBC = APR = nominal interest rate – If the loan has up-front fees and you don’t hold it until maturity EBC > APR • Calculating the EBC or the APR is relatively simple with a financial calculator Dr. Longhofer Principles of Real Estate 50 EBC Example • What is the EBC of the 6% loan if you only anticipate holding the mortgage for 5 years? – Begin by calculating the monthly payment as before: P/Y = 12, N = 360, I = 6, PV = 100,000, FV = 0 ⇒ PMT = −$599.55 – Next calculate the balance that will be due at the end of 5 years: N = 60 ⇒ FV = −$93,054.36 – Finally, calculate the implicit interest rate based on the net funds provided to the borrower: PV = 99,000 ⇒ EBC = 6.24% • Notice that the EBC is higher because there is less time to benefit from the lower interest rate Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 51 Rules of Thumb for Choosing Among Loans • If you anticipate holding the loan for the entire term, choose the option with the lowest APR – Also important is whether you can afford the monthly payment or have cash available to pay the closing costs • Example: Consider the rate point tradeoff with the $100,000 30-year, fixed-rate mortgage above – Zero points and 6.375% interest: APR = 6.375% – One point and 6.000% interest: APR = 6.09% – The monthly payment is also lower under the second alternative, so the only question is whether you can afford the additional $1,000 in closing costs Dr. Longhofer Principles of Real Estate 52 Rules of Thumb for Choosing Among Loans • Generally speaking, if your expected holding period is more than 3 or 4 years, you are better off paying points and getting a lower interest rate – If you plan on holding the loan for only 2 years, the EBC of the second alternative is 6.54% – The EBC of the first alternative is still 6.375%; because there are no up-front fees (EBC = APR) – Thus with a short holding period you should not pay the point to lower your interest rate • The breakeven point between the two alternatives in this example is 3 years Dr. Longhofer Principles of Real Estate 53 When Should You Refinance? • As a general rule, you should refinance if the EBC of the new loan is lower than the nominal interest rate of your existing loan – Note that the EBC of your existing loan is irrelevant for this decision because the up-front fees have already been paid (they are sunk costs) • If your new loan term is the same, then refinance if you can lower your monthly payment – Be careful about extending the loan term, however, because you can get a lower payment will increasing your total borrowing cost Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 60 ARM Adjustment Mechanics • How do you figure out your new monthly payment on an ARM? – Although it can seem complicated, it is fairly simply to calculate the new monthly payment on an ARM • The initial payment on the ARM is calculated exactly as it would be with a fixed-rate mortgage • At each adjustment date you simply recalculate the new payment based on the new interest rate and the balance outstanding at that time Dr. Longhofer Principles of Real Estate 61 ARM Adjustment Mechanics • Step 1: Determine the principal balance still outstanding – You can use the FV key or the amortization worksheet in your financial calculator • Step 2: Calculate the fully-indexed rate based on the current value of the index and the margin • Step 3: Determine whether any rate caps apply and determine the new contract rate – If no cap or floor is binding, the new contract rate is simply the fully-indexed rate – If a cap is binding, the cap determines the new rate Dr. Longhofer Principles of Real Estate 62 ARM Adjustment Mechanics • Step 4: Determine how many payments are left on the loan – For a 1 -year ARM, this is simply 12 fewer than the last time the rate was adjusted • Step 5: Calculate the new payment, based on the new contract interest rate, the outstanding principal balance, and the remaining term of the loan – This is a straightforward calculation on your financial calculator Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 63 ARM Adjustment Example • Consider a $75,000, 1-year ARM, 30-year amortization, indexed to the 1-year treasury, with a 3% spread, 2-6 caps (2% in the first year and 6% over the life of the loan), and an initial interest rate of 5.75% – The initial payment on this loan is $437.68 • Suppose that at the end of the first year, the T-Bill rate is 5.875%. What is the new monthly payment on this loan? Dr. Longhofer Principles of Real Estate 64 ARM Adjustment Example • Step 1: Determine the principal balance outstanding – Remember that all of the information for the original loan payment is still in your calculator – Press 12, [N], [CPT], [FV] to get $74,035.18 • Step 2: Calculate the fully-indexed rate by adding the margin to the new value of the index – The fully-indexed rate is 5.875% + 3% = 8.875% Dr. Longhofer Principles of Real Estate 65 ARM Adjustment Example • Step 3: Determine if any caps apply and then calculate the new contract rate – The highest rate this loan can ever have is 5.75% + 6% = 11.75% • Since 8.875% < 11.75%, this cap is not binding – The highest rate this loan can have this year is last year’s rate plus the annual cap, or 5.75% + 2% = 7.75% • Since 8.875% > 7.75%, this cap is binding – The new contract rate is therefore 7.75% Real Estate 310 Mortgage Markets Dr. Longhofer Principles of Real Estate 66 ARM Adjustment Example • Step 4: Determine how many payments are remaining on the loan – We started with 360 payments and have made 12 payments over the last year, so there are 348 payments left • Step 5: Calculate the new payment on the loan – Enter N = 348, I = 7.75, PV = 74,035.18, FV = 0 and solve for PMT = $535.09 • That’s all there is to it! Dr. Longhofer Principles of Real Estate 67 Commercial Property Mortgages • Although most of the calculations are the same for both commercial and residential mortgages, there are a number of important differences: – These loans are often structured as balloon loans, in which the entire balance is due before the monthly payments have fully repaid the principal balance – Prepayment penalties (yield maintenance provisions) are common with fixed-rate commercial mortgages – Long-term commercial mortgages are often non- recourse – Depository institutions and institutional investors are much more important in commercial mortgage markets Dr. Longhofer Principles of Real Estate 68 Commercial Mortgage Holdings Other $84.6 Depository Institutions $718.1 Institutional Investors $202.2 Mortgage & Finance Companies $43.6 ABS Issuers $237.4 Billions of U.S. Dollars