Real Estate and Consumer Lending
• Outline
– Residential real estate lending
– Commercial real estate lending
– Consumer lending
– Real estate and consumer credit
regulation
Real estate lending
• Mortgage debt outstanding
– Mortgage is a written conveyance of title to
real property. Property is collateral for the
loan. Loans for 1-4 family residences,
commercial real estate, farm property, and
multifamily residences.
– Secondary mortgage market for securitizing
loans tends to improve liquidity of
residential mortgages and lessens cyclical
disruptions in the housing market.
Residential real estate lending
• Characteristics of residential mortgage
loans
– Down payment, or borrower’s equity, is a
portion of the purchase price of the
property a financial institution requires
the mortgage borrower to pay up front.
– A typical loan-to-price ratio is 80%
e.g.) a person puts a down payment of
$41,880 for a new home with a purchase
price of $209,400.
– While most home loans have maturities
of up to 30 years, their average life is
only 12 years due to prepayments due
to refinancing and moving.
– Some lenders require Private Mortgage
Insurance (PMI) when the down payment is
less than 20%. This insurance protects the
lender in the event of default.
– Default risk, declining values, and lack of
liquidity are the principal risks associated with
real estate lending.
– Residential real estate is good collateral
because it is durable, easy to identify, and
cannot be moved in most cases.
Residential real estate lending
• Types of residential mortgage loans
Federally insured mortgages are originated by
financial institutions, but repayment is guaranteed
by either the Federal Housing Administration (FHA)
or the Veterans Administration (VA). FHA or VA
mortgages require either a very low or zero down
payment.
Conventional mortgages are mortgages held by
financial institutions and are not federally insured.
Private insurance (PMI) on conventional mortgages
can be obtained.
– Fixed rate mortgages and adjustable rate mortgages
(ARMs) -- fixed cash payments per month versus
changes in payment terms that can fluctuate with
movements in interest rates.
– Rates for ARMs are commonly tied to the average TBill rate over the previous year. ARM payments
increase when the index rate increases.
• Find Monthly mortgage payment for a $1,000
mortgage loan at 6 percent interest for 10 years.
• Because we are solving for a monthly payment,
the number of payments over the 10 years is 120
(10 years x 12 months per year). Moreover, only
one twelfth of the 6 percent annual interest rate
(0.06/12 = 0.005) is charged each month.
The present value of the annuity is the $1,000
mortgage loan in this example. The monthly
payment is $11.10.
PV of annuity = PMT[1 - (1 + I)-n]/i
= PMT[1 - ( 1 + 0.005)-n]/0.005
1,000 = PMT[1 - ( 1 + 0.005)-120]/0.005
PMT = $11.10
where PV = present value of the annuity,
PMT = payment per period, i = interest rate per
period, and n = number of periods.
Residential real estate lending
• Types of residential mortgage loans
• Adjustable rate mortgages
Changes in monthly payments, term of the loan, and/or
principal amount.
Benchmark interest rate tied to an index (e.g., one-year
Treasury Bill yield).
Caps on how much the interest rate or monthly payment can
change annually or over the term of the loan.
Margin is the percentage points added to the index rate.
Initial interest rates on ARMs lower than fixed rate
mortgages.
ARMs shift some of the interest rate risk to borrowers from
lenders (banks). However, ARMs may have higher default
risk to the bank.
8.4What factors affect monthly payments on a
residential mortgage loan? Explain the effect of each
factor.
• ANSWER: The size of the loan, interest rate,
and maturity are the principal factors. The first
two factors are positively related to the size of
the payments, while maturity is negatively. That
is, large loans and high rates result in large
monthly payment for a given maturity, while
payments can be reduced by extending the
maturity.
8.2What are the two basic types of 1–4 family
residential mortgage loans. Which is the most
widely used? Why?
• ANSWER: Fixed-rate and adjustable rate. Fixed rate
mortgages were more widely used in 1990s, but not in
1988. When interest rates are relatively low, borrowers
then do favor locking-in fixed rates. ARMs have the
advantage of benefiting from lower interest rates if and
when they decline. Holders of fixed rate mortgages can
always refinance their loans if it is cost efficient to do
so. Conversely, ARMs have the disadvantage of
increasing payments when rates increase.
– What are the advantages and disadvantages of an
ARM from the lender’s point of view?
• ANSWER: An ARM allows lenders to maintain a
positive spread between their cost of funds and
returns on loans, if the repricing of the loans are
done in a timely fashion. For example, if the
repricing of loans is only done once a year, and
interest rates (and cost of funds) change dramatically
during the year, the lender’s may not be able too
maintain their positive spread. Rate caps are another
factor to consider. They to limit lenders ability to
maintain a positive spread.
– Discount points (or points): fees or payments
made when a mortgage loan is issued. One
discount point is one percent of the loan.
For example, if the borrower pays 2 points up
front on a $100,000 mortgage, he or she must
pay $2,000 at the closing of the mortgage.
While the mortgage principal is $100,000, the
borrower effectively has received $98,000.
In exchange for points paid up front, the
financial institution reduces the interest rate
used to determine the monthly payments on the
mortgage. Points increase the effective interest
rate.
8.5 Why do lenders charge points on mortgage
loans?
• ANSWER: A point is one percent of the principal
amount of the loan. Points are charged to increase
the lender’s yield on the mortgage loan.
Residential real estate lending
• Types of residential mortgage loans
– Balloon mortgages require a fixed monthly
interest payment for a three to five year
period. Full payment of the mortgage
principal (the balloon payment) is then
required at the end of the period.
– Graduated payment mortgages (GPMs) have
fixed rates but with lower payments in early
years and higher payments in later years. Good
for younger homeowners whose income should
rise over time.
– Growing equity mortgages (GEMs) have
increasing debt payments over time that
reduces the principal balance faster than
otherwise. In contrast to GPMs, which do not
affect the time until the mortgage is paid off,
the incremental increase in monthly payments
on GEMs reduces the principal on the
mortgage more quickly. This reduces the
actual life of the mortgage.
– Automatic rate-reduction mortgages:
Mortgages in which the lender automatically
lowers the rate on an existing mortgage
when prevailing rates fall as a way of
keeping their mortgage customers from
refinancing their mortgages with another
mortgage lender when mortgage rates fall.
– Shared appreciation mortgages (SAMs) allow
the lender to share in the growth of equity
value in the home with the borrower in return
for lower interest payments.
• Reverse annuity mortgages (RAMs)
A mortgage borrower receives regular payments
from a lender rather than making them. When the
RAM matures (or the borrower dies), the
borrower (or the borrower’s estate) sells the
property to retire the debt. Designed for retired
people.
• Second mortgages
Loans secured by a piece of real estate already used to
secure a first mortgage. Should a default occur, the
second mortgage holder is paid only after the first
mortgage is paid off. As a result, interest rates on second
mortgages are higher than on first mortgages.
• Home equity loans
Loans that customers borrow on a line of credit
secured with a second mortgage on their homes.
The line of credit has more a flexible repayment
schedule than the traditional second mortgage.
Interest on all mortgages (first, second, and home
equity) secured by residential real estate is tax
deductible. Interest on other types of individual
loans is not eligible for a tax reduction.