Fundamentals of Real Estate
Lecture 19
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
Chapter 15: Residential Mortgages
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:
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Federal National Mortgage Association, “Fannie Mae” and
Federal Home Loan Mortgage Corp, “Freddie Mac”
Chapter 15: Residential Mortgages
Conventional Fixed-Payment Mortgage Loan
A. Fixed-Payment, Fully Amortizing Mortgages
1. Conventional Mortgages
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Conforming Conventional
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Loan meets underwriting standards of Fannie Mae, Freddie
Mac.
This limits loans to $207,000 (as of 1996).
Non-conforming conventional
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Largest segment of residential mortgages
Are not backed by FHA insurance or VA guarantee
May or may not require PMI (private mortgage insurance)
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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
Conventional Fixed-Payment Mortgage Loan
A. Fixed-Payment, Fully Amortizing Mortgages
2. Fixed Payment Mortgages
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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
Conventional Fixed-Payment Mortgage Loan
A. Fixed-Payment, Fully Amortizing Mortgages
3. Fifteen-year mortgages
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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
Interest Payments on 15 vs. 30 Year Fixed Rate Mortgages
Assume 9% on 90,000
30-Year
15-Year
Monthly Payment
Total Payment
Less: Principal Paid
Total Interest Paid
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Chapter 15: Residential Mortgages
Conventional Fixed-Payment Mortgage Loan
B. Alternative Amortization Schedules
4. Biweekly mortgages
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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
Adjustable Rate Mortgages
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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
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Index:
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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:
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spread between the interest rate on the index and the market
interest rate.
Chapter 15: Residential Mortgages
Adjustable Rate Mortgages
A. ARM Mechanics
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Market Interest Rate = Index + Margin
Adjustment Interval
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length of time between ARM contract interest rate changes
most common is 1 year
Adjustment rate caps
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predetermined at time of origination and held constant for life of
loan (e.g. 225 basis points)
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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
Adjustable Rate Mortgages
A. ARM Mechanics
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Initial contract rate
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Contract interest rate
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periodic interest rate actually applied to balance of the loan
contract rate=MIN(Index+Margin; Previous contract rate+Ann cap)
Discount Points
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first period interest rate on the ARM
If contract rate is less than market rate, this is a “teaser” rate
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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
Annual Contract Interest Rate Adjustments on an ARM (2/6)
Year
Index Rate
Margin
Market Rate Contract Rate
1
4.5
+
2.25
=
6.75
2
5.5
+
2.25
=
7.75
3
6
+
2.25
=
8.25
Assume an initial teaser rate of 150bps below the market rate
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Chapter 15: Residential Mortgages
Private Mortgage Insurance
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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
Other Mortgage Types and Uses
A. Purchase Money Mortgages
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whenever seller lends all or part of the purchase price to the
purchaser, and loan is secured by a mortgage
B. Package Mortgages
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provide additional funds for home buyers to include homerelated items of personal property such as appliances and
furnishings
C. Reverse Annuity Mortgages (RAMs)
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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
Other Mortgage Types and Uses
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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
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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
Other Mortgage Types and Uses
D. Home Equity Loans
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1. Types of loans
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closed-end loans: a fixed amount is borrowed all at once and
paid in monthly installments over a set period.
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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?
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Determined by amount of equity in home
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generally not more than 80%
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some advertise for 125% LTV, only up to 100% is tax ded
Chapter 15: Residential Mortgages
Other Mortgage Types and Uses
D. Home Equity Loans
3. Tax advantages
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Interest paid on home equity loans to 100 percent of value of
the home is tax deductible
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Closing costs, with the exception of discount points, are not tax
deductible.
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Chapter 15: Residential Mortgages
Borrower’s Mortgage Loan Decisions
A. Mortgage Choice
1.
Up-front financing costs
Lenders charge points to:
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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:
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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
Borrower’s Mortgage Loan Decisions
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2.
The effective cost of borrowing—your actual interest rate
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charges to transfer the deed and record the mortgage ($40-200)
Survey costs ($200-300)
Pest inspection ($25-75)
Attorney’s fees
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
Borrower’s Mortgage Loan Decisions
3. Estimating Closing Costs
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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
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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
Borrower’s Mortgage Loan Decisions
B. Loan Size
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Relative costs of debt and equity financing
Household’s current and expected future income constraints
Household’s wealth constraints
C. Refinancing Decision
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“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
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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.