Transcript Chapter 19 Residential Real Estate Finance: Mortgage

Chapter 19
Residential Real Estate
Finance: Mortgage Choices,
Pricing and Risks
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Major Topics
 Primary and secondary mortgage markets
 FRMs and ARMs
 Conventional, FHA and VA mortgages
 The Effect of Points on Mortgage Choice
 Tax Effects of Mortgage Deductions
 Mortgage Underwriting Criteria
 Impact of the Internet on Residential
Finance
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction
 Home ownership is a national policy in the
United States
 Instruments such as the adjustable rate
mortgage which reduce interest rate risk for
lenders and increase this risk for borrowers
are a common alternative to fixed rate loans
 Another major development impacting the
way home purchases are financed today is
the emergence of a dominant secondary
market for home mortgage loans and the
securitization of these loans
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Residential Financing
 The fully amortizing fixed rate loan or FRM
is the most traditional loan format for
residential mortgages
 It is characterized by loan payments
(usually paid monthly) that are constant
throughout the term of the mortgage
 The typical loan classifications are
conventional loans, FHA loans, and VA
loans
 There are also “jumbo loans” that are
based on the mortgage limit for secondary
market sale to Freddie Mac
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Loan Fees and Costs
 In addition to the interest charged on the
money borrowed and any insurance
premiums for loan guarantees, the financial
institution typically charges the borrower
points, which are prepaid interest, and out
of pocket costs for administrative and third
party closing costs
 Out of pocket costs include the cost of the
appraisal, credit report, title insurance,
surveys if required, environmental phase
one reports if required, and other loan
processing fees
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
The True Cost of Borrowing
 The table below compares two loans of
$240,000 where the APR is not the best
indicator of the best consumer choice if the
loan is to be held 5 years or less
 The quicker the loan is to be repaid the
better choice A becomes even though the
initial contract rate is higher
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Tax Benefits of Mortgage Interest
Rate Deductions
 One of the key advantages of US home
ownership is that interest on the mortgage
loan is fully tax deductible
 This is one of the remaining few tax
shelters available to the typical consumer
 In addition, any points paid in connection
with the loan may also be tax deductible in
the year points are paid
 These tax deductions create a cash benefit
to the borrower which directly impacts the
effective borrowing cost
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Mortgage Buy Downs
 When mortgage lending environments are
competitive, lenders offer borrowers many
choices in terms of points and interest rate
combinations
 Often, the borrower may “buy down” the
interest rate by paying lender more points
 Example: What is the max points needed to
pay to buy down rate to 7.5% on a No points
loan @ 8.5%, 30 yr amortization. Assume
they plan to hold loan to maturity
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Mortgage Buy Down Example
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Residential Mortgage loan
Underwriting
 Borrower defaults on a loan can occur if the
borrower may lose the ability to make the
required loan payments or when a borrower
is in a negative equity situation
 Regardless, however, of who bears the risk
of default, the loan originator must adhere
to underwriting standards that seek to
minimize the likelihood of default
 Underwriting is the lender’s process of
evaluating the borrower and the property
offered as security for the mortgage to
determine the transaction’s level of default
and foreclosure loss risk
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Assessing the probability of
default
There are five major criteria to assess this:
1. Income:
2. Other Debt Obligations
3. Housing Expenses
4. Credit Evaluation
5. Net Worth
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Mortgage Buy Downs
 In evaluating the property, the lender wants
to determine that the property provides
adequate security for the debt
 The value of the security is established by
an appraisal on the property which includes
market data on comparable sales
 Acceptable loan to value ratios for
conventional loans are typically 75% or 80%
for non-insured mortgages and up to 95% for
private insured mortgages
 In the property evaluation process, the
practice of redlining is prohibited, i.e. the
lender is not permitted to make blanket
designations of geographic areas that are
considered to be unacceptable loan risks
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Future of Residential Finance
 Efficiency and speed of processing loans
will play a greater role in attracting
business in a market that is already very
thin on margins
 Loan applications can actually be taken
online using pre-formatted forms
 Credit checks can be ordered on line,
employment verified or financial reports
accessed
 An appraisal can be ordered on line and in
some cases performed without the need for
physical inspections using fully
computerized data bases, geographic
information systems or GIS and property
address electronic photo banks
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
END
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner