Financing Residential Real Estate
Lesson 6:
Basic Features of a
Residential Loan
Introduction
In this lesson we will cover:
amortization
repayment periods
loan-to-value ratios
mortgage insurance and loan guaranties
secondary financing
fixed and adjustable interest rates
Amortization
Loan amortization refers to how principal and
interest are paid to lender during loan term.
Amortization
Loan amortization refers to how principal and
interest are paid to lender during loan term.
Amortized loan
Borrower required to make regular
installment payments that include
principal as well as interest.
Amortization
Fully amortized loan
Payments for a fully amortized loan are enough to
pay off all principal and interest by end of loan term.
Payment amount is same throughout term.
Amortization
Fully amortized loan
Payments for a fully amortized loan are enough to
pay off all principal and interest by end of loan term.
Payment amount is same throughout term.
Every month, interest portion of payment is
smaller, and principal portion is larger.
Amortization
Fully amortized loan
Payments for a fully amortized loan are enough to
pay off all principal and interest by end of loan term.
Payment amount is same throughout term.
Every month, interest portion of payment is
smaller, and principal portion is larger.
Interest portion gets smaller because it’s
based on remaining principal balance.
Balance is steadily reduced by
principal portion of payments.
Amortization
Partially amortized loan
Partially amortized loan also requires regular
payments that include principal as well as interest.
But payments aren’t enough to pay off debt by
end of loan term.
Balloon payment is required to pay remainder
of principal.
Amortization
Interest-only loan
Interest-only loan calls for regular payments that
cover only the interest accruing, without paying any
of the principal, either:
during entire loan term, or
during specified interest-only period at
beginning of term.
Amortization
Interest-only loan
If payments are interest-only during entire term,
whole amount originally borrowed is due at end.
Amortization
Interest-only loan
If payments are interest-only during limited period:
At end of that period, borrower must start
making amortized payments that will pay off
all principal and interest by end of term.
Payment may increase sharply at end of
interest-only period.
Repayment Period
Repayment period: number of years borrower has
to repay loan.
Also called the loan term.
Repayment Period
Until 1930s, typical repayment period for
mortgage loan was 5 years.
If lender didn’t renew loan, balloon
payment required.
Repayment Period
Until 1930s, typical repayment period for
mortgage loan was 5 years.
If lender didn’t renew loan, balloon
payment required.
Now 30 years is standard repayment period.
Repayment Period
Until 1930s, typical repayment period for
mortgage loan was 5 years.
If lender didn’t renew loan, balloon
payment required.
Now 30 years is standard repayment period.
15-year, 20-year, and 40-year loans also
available.
Repayment Period
Length of repayment period affects:
1. amount of monthly payment, and
2. total amount of interest paid over life of loan.
May also affect interest rate charged.
Repayment Period
Monthly payment amount
Longer repayment period reduces amount of
monthly payment.
Makes 30-year loan more affordable
than 15-year loan.
Repayment Period
Monthly payment amount
Shorter repayment period:
higher payment amount
equity builds faster
more difficult to qualify for
Repayment Period
Total interest
Shorter repayment period substantially decreases
total amount of interest paid on loan.
Total interest for a 15-year loan is less than
half the total interest for a 30-year loan.
Repayment Period
Interest rate
Lenders generally charge lower interest rates for
shorter-term loans.
Repayment Period
15-year loan compared to 30-year loan
Advantages of 15-year loan:
 lower interest rate
 total interest much less
 clear ownership in half the time
Disadvantages of 15-year loan:
 higher monthly payments
 tax deduction lost sooner
Repayment Period
20-year loans
20-year loan is compromise between 15-year loan
and 30-year loan.
Monthly payments higher than payments
for 30-year loan.
But not as high as payments for 15-year
loan.
Repayment Period
40-year loans
Some lenders offer 40-year loans, but they aren’t
common.
Monthly payments even more affordable
than payments for 30-year loan.
But equity builds even more slowly and
borrower pays even more total interest.
Most likely to be used in areas with very
high housing costs.
Summary
Amortization and Repayment Period
Amortization
Fully amortized
Partially amortized
Balloon payment
Interest-only loan
Loan term
30-year loan
15-year loan
20-year loan
40-year loan
Loan-to-Value Ratio
Loan-to-value ratio (LTV) expresses relationship
between loan amount and value of home being
purchased.
Loan-to-Value Ratio
Loan-to-value ratio (LTV) expresses relationship
between loan amount and value of home being
purchased.
For example, if LTV is 80%, loan amount is
80% of sales price or appraised value,
whichever is less.
Loan-to-Value Ratio
Loan-to-value ratio (LTV) expresses relationship
between loan amount and value of home being
purchased.
For example, if LTV is 80%, loan amount is
80% of sales price or appraised value,
whichever is less.
The higher the LTV, the smaller the downpayment.
Loan-to-Value Ratio
Higher LTV = higher risk
Because downpayment is smaller, loan with higher
LTV is generally riskier than loan with lower LTV.
Loan-to-Value Ratio
Higher LTV = higher risk
Because downpayment is smaller, loan with higher
LTV is generally riskier than loan with lower LTV.
Borrower has less money invested in home,
won’t try as hard to avoid default.
Loan-to-Value Ratio
Higher LTV = higher risk
Because downpayment is smaller, loan with higher
LTV is generally riskier than loan with lower LTV.
Borrower has less money invested in home,
won’t try as hard to avoid default.
If foreclosure necessary, greater chance that
property won’t sell for enough to fully pay off
debt and costs.
Loan-to-Value Ratio
Maximum LTV
Lenders set maximum LTV limit for particular loan
program or type of loan.
Loan-to-Value Ratio
Maximum LTV
Lenders set maximum LTV limit for particular loan
program or type of loan.
In a transaction, maximum LTV determines:
maximum loan amount
minimum downpayment
Loan-to-Value Ratio
Maximum LTV
For example, if maximum LTV for loan program
is 95% and sales price is $200,000:
Maximum loan amount = $190,000
Minimum downpayment (5%) = $10,000
Loan-to-Value Ratio
Maximum LTV
For example, if maximum LTV for loan program
is 95% and sales price is $200,000:
Maximum loan amount = $190,000
Minimum downpayment (5%) = $10,000
Maximum LTV is key factor in determining
“how much house” borrower can buy.
Loan-to-Value Ratio
Maximum LTV
Lenders traditionally protected themselves by
setting low LTV limits.
Traditional maximum: 80%
Higher LTVs allowed only in special
programs like FHA and VA loan programs.
Loan-to-Value Ratio
Maximum LTV
In recent years, loans with higher LTVs widely
available.
With higher maximum LTVs, people who don’t
have much cash can buy homes.
Mortgage Insurance/Loan Guaranty
Purpose of mortgage insurance or guaranty:
to protect lender from foreclosure loss.
Mortgage Insurance/Loan Guaranty
Purpose of mortgage insurance or guaranty:
to protect lender from foreclosure loss.
Also encourages lenders to make loans that would
otherwise be too risky.
Mortgage Insurance/Loan Guaranty
Purpose of mortgage insurance or guaranty:
to protect lender from foreclosure loss.
Also encourages lenders to make loans that would
otherwise be too risky.
Insurance or guaranty may be:
required by lender, or
feature of loan program
(e.g., VA guaranty).
Mortgage Insurance/Loan Guaranty
Mortgage insurance
Mortgage insurance works like other types of
insurance:
policyholder pays premiums, and
insurer provides coverage for certain
types of losses, up to policy limit.
Mortgage Insurance/Loan Guaranty
Mortgage insurance
Policy protects lender against losses from borrower
default and foreclosure.
Mortgage Insurance/Loan Guaranty
Mortgage insurance
Policy protects lender against losses from borrower
default and foreclosure.
Mortgage insurance company agrees to
indemnify lender.
If foreclosure sale proceeds fall short,
insurer will make up the difference.
Mortgage Insurance/Loan Guaranty
Mortgage insurance
Policy protects lender against losses from borrower
default and foreclosure.
Mortgage insurance company agrees to
indemnify lender.
If foreclosure sale proceeds fall short,
insurer will make up the difference.
Borrower must meet underwriting standards of
insurer as well as lender’s standards.
Mortgage Insurance/Loan Guaranty
Loan guaranty
With loan guaranty, third party (the guarantor)
agrees to take on secondary legal responsibility for
borrower’s obligation to lender.
Mortgage Insurance/Loan Guaranty
Loan guaranty
With loan guaranty, third party (the guarantor)
agrees to take on secondary legal responsibility for
borrower’s obligation to lender.
If borrower defaults, guarantor must
reimburse lender for resulting losses.
Mortgage Insurance/Loan Guaranty
Loan guaranty
Guarantor might be:

private party,

nonprofit organization, or

governmental agency.
Mortgage Insurance/Loan Guaranty
Loan guaranty
Guarantor might be:

private party,

nonprofit organization, or

governmental agency.
Guarantor may have its own underwriting standards
that borrower must meet, in addition to meeting
lender’s standards.
Secondary Financing
Secondary financing: Second loan obtained to pay
part of downpayment or closing costs required for
main loan (primary loan).
Secondary Financing
Secondary financing: Second loan obtained to pay
part of downpayment or closing costs required for
main loan (primary loan).
May be provided by institutional lender, private third
party, or property seller.
Secondary Financing
Lender making primary loan usually places some
restrictions on type of secondary financing borrower
can use.
Restrictions intended to prevent secondary loan
from increasing risk of default on primary loan.
Secondary Financing
Lender making primary loan usually places some
restrictions on type of secondary financing borrower
can use.
Restrictions intended to prevent secondary loan
from increasing risk of default on primary loan.
Borrower must qualify for combined payment on
both loans.
Secondary Financing
Lender making primary loan usually places some
restrictions on type of secondary financing borrower
can use.
Restrictions intended to prevent secondary loan
from increasing risk of default on primary loan.
Borrower must qualify for combined payment on
both loans.
In many cases, primary lender still requires
borrower to make small downpayment from
own funds.
Summary
Loan-to-value Ratio and Other Features
Loan-to-value ratio
Maximum loan amount
Minimum downpayment
Mortgage insurance
Indemnify
Loan guaranty
Guarantor
Secondary financing
Fixed or Adjustable Interest Rate
Fixed-rate mortgages
With a fixed-rate mortgage, interest rate charged on
loan remains constant throughout loan term.
When market rates rise or fall, loan rate
stays the same.
Fixed or Adjustable Interest Rate
Fixed-rate mortgages
With a fixed-rate mortgage, interest rate charged on
loan remains constant throughout loan term.
When market rates rise or fall, loan rate
stays the same.
Considered standard.
Fixed or Adjustable Interest Rate
Adjustable-rate mortgages
An adjustable-rate mortgage (ARM) allows lender to
adjust loan’s interest rate to reflect changes in cost
of money.
Fixed or Adjustable Interest Rate
Adjustable-rate mortgages
An adjustable-rate mortgage (ARM) allows lender to
adjust loan’s interest rate to reflect changes in cost
of money.
Transfers risk of rate fluctuations to borrower.
Fixed or Adjustable Interest Rate
Adjustable-rate mortgages
An adjustable-rate mortgage (ARM) allows lender to
adjust loan’s interest rate to reflect changes in cost
of money.
Transfers risk of rate fluctuations to borrower.
ARM’s initial interest rate often lower than
market rate for a fixed-rate loan.
Not true under all market conditions,
however.
Adjustable-Rate Mortgages
How an ARM works
Borrower’s interest rate first determined by
market rates at time loan is made.
Adjustable-Rate Mortgages
How an ARM works
Borrower’s interest rate first determined by
market rates at time loan is made.
Interest rate on loan is tied to an index.
Index = Published statistical report used
as indicator of changes in cost of money.
Lender chooses index when loan is made.
Adjustable-Rate Mortgages
How an ARM works
Loan’s interest rate periodically adjusted to
reflect changes in index rate.
If index rate has increased, lender
raises interest rate charged on loan.
If index rate has decreased, lender lowers
interest rate charged on loan.
Adjustable-Rate Mortgages
ARM features
ARM may have all or only some of these features:
Note rate
Interest rate cap
Index
Payment cap
Margin
Negative amortization
cap
Rate adjustment period
Payment adjustment
period
Lookback period
Conversion option
ARM Features
Note rate
ARM’s note rate is its initial interest rate, as stated
in promissory note.
ARM Features
Note rate
ARM’s note rate is its initial interest rate, as stated
in promissory note.
Some ARMs have teaser rate: discounted initial rate
that is lower than initial rate indicated by index.
ARM Features
Index
ARM’s index is the statistical report indicating
changes in market interest rates that the loan’s
interest rate is tied to.
When loan is made, lender chooses one of several
published indexes, such as:
 Treasury securities indexes
 11th District cost of funds index
 LIBOR index
ARM Features
Margin
ARM’s margin is the difference between index rate
and interest rate lender charges borrower.
Lender adds margin to index to cover
administrative expenses and provide profit.
ARM Features
Margin
ARM’s margin is the difference between index rate
and interest rate lender charges borrower.
Lender adds margin to index to cover
administrative expenses and provide profit.
Example:
3.25% Current index rate
+ 2.00% Margin
5.25% Interest rate charged
ARM Features
Margin
ARM’s margin is the difference between index rate
and interest rate lender charges borrower.
Lender adds margin to index to cover
administrative expenses and provide profit.
Example:
3.25% Current index rate
+ 2.00% Margin
5.25% Interest rate charged
Margin stays same throughout loan term,
even when interest rate changes.
ARM Features
Conversion option
If ARM has conversion option, borrower allowed to
convert loan to fixed-rate mortgage.
Conversion typically can only take place:
on annual rate adjustment date;
during a limited period (for example, only
after first year and no later than fifth year).
Lender charges conversion fee.
Summary
Fixed or Adjustable Interest Rate
 Fixed-rate mortgage
 Adjustable-rate mortgage
 Index
 Note rate
 Margin
 Rate and payment adjustment periods
 Lookback period
 Interest rate and mortgage payment caps
 Negative amortization
 Option ARM
 Conversion option