Tools

1
Tools Techniques of Financial
PlanningLeimberg, Satinsky, Doyle Jackson

• Chapter 18 Financing Asset Acquisitions
• Slides designed by Rosilyn H. Overton, MS, CFP,
  CRPS, LTCP
• New Jersey City University

2
Why Do People Borrow Money?

• To enhance returns by using positive financial
  leverage.
• To increase the scale of their investments.
• To purchase assets such as real estate and
  business assets, for which they currently do not
  have enough money.

3
Topics Discussed in this Chapter

• Financial leverage
• Margin trading
• Mortgage loan programs
• Other mortgage financing alternatives
• Refinance loans
• Mortgage (loan) math

• Mortgage and loan financial planning applications
• Fixed-rate versus adjustable-rate loans
• Determining how much home one can afford
• Leasing

4
Financial Leverage

• Financial leverage is the use of borrowed funds
  to supplement the investors own dollar
  investment (equity) to increase the scale of
  investment.
• The keys to leverage are
• Lower interest rate on loan than return on the
  investment. (Difference is called the Spread.)
• The ratio of borrowed funds to ones own equity.

5
Leverage Multiplies Gains and Losses

• In a positive environment, leverage enhances
  return, BUT, leverage multiplies losses as well
  as gains.
• Consider the person who buys a piece of property
  for 500,000, borrowing 400,000 on a 6
  mortgage.
• One year later, if property is worth 600,000,
  the buyer made 76,000 (100,000 appreciation -
  24,000 interest expense), for a 76 return on
  the 100,000 invested.
• However, if the propertys value declined to
  450,000, the buyer lost 50,000 24,000
  interest, for a 74 loss on his or her 100,000
  investment, even though the value of the property
  declined only 10!

6
Margin Trading

• Margin is borrowing against the market value of
  securities such as stocks or bonds.
• The purpose is to enhance the return on
  investment by using financial leverage.
• Example If the margin interest rate is 7, and
  you have a security that pays 10, and you borrow
  50 of the value (100,000) so that you can
  purchase more shares,
• Then, next slide

7
Example of Margin Trade

• Buyer puts up 50,000 and borrows 50,000 on
  margin at 7 to buy 100,000 of stock. The
  investor holds the stock exactly one year, and
  the price does not change.
• 10 of 100,000 10,000 income.
• 7 on 50,000 borrowed 3500 expense.
• Net income to investor 6500.
• Return on investor 50,000 investment 13.
• Borrowing to invest gave the investor 30 greater
  return than if he or she had not used leverage.

8
Equity Requirements Vary

• Equity percentage requirements are set by the
  Federal Reserve
• Stocks listed on the NASDAQ or the NYSE generally
  require that the investor put up 50.
• U. S. Treasury bonds generally require an equity
  investment of 10.
• High-grade corporate bonds generally require 30
  equity.
• Note Investment firms often require more than
  the Federal Reserve minimums to protect their
  accounts.

9
Mortgage Loan Programs

• Based on how the rate is set there are two types
  of mortgage
• Fixed Rate Mortgages.
• Adjustable Rate Mortgages.
• Based on payment terms there are also two types
• Self-amortizing loans.
• Balloon or interest-only mortgages.

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Fixed Rate Mortgage

• The interest rate is set at the time of the
  signing of the loan, and does not vary over the
  life of the loan.
• For financial planning purposes, fixed rate loans
  are the best choice when current interest rates
  are low, and the buyer intends to hold the
  property for many years.

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Features of Fixed Rate Mortgages

• Very simple, but not very flexible.
• Available terms are 5, 10, 15, etc. with 15 and
  30 years the most popular.
• Shorter loans usually have lower interest rates.
• In times of falling interest rates, borrowers may
  need to refinance several times to take advantage
  of lower rates.

Note Most, but not all, states now have laws
that specify that the borrower may pre-pay the
mortgage without any penalty. Know the law for
your state.
12
Adjustable rate mortgages

• The interest rate varies with the market.
• Rate based on a formula.
• Typically, the rate will be tied to an index such
  as the Prime Rate or LIBOR.
• Possibly a cap on how high the rate can go.
• Possibly a floor on how low it can go.

13
ARM Advantages

• For short term purchases (3 years or less).
• Initial rate is usually lower than rates on fixed
  loans.
• May have a provision that allows conversion to a
  fixed rate loan.
• Attractive when interest rates are high.
• Lenders will sometimes give a free or low-cost
  refinance to a fixed loan when interest rates
  fall.

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ARM Loan Details

• ARM periods
• Index and margin 
• Caps
• Negative amortization
• Conversion option
• Adjustment Process

15
ARM periods

• The period is the span of time that a lender must
  wait before it can readjust the interest rate of
  the ARM loan.
• Can range from one month to several years.
• One-year ARM periods are the most common.
• Shorter ARM periods usually imply a lower
  interest rate.

16
Standard ARM Periods
17
Balloon or Two-step ARM Programs
18
Index and Margin

• The ARM agreement specifies how interest rate is
  to be adjusted by a formula -- usually an index
  plus a margin.
• The Index is based on rates of securities,
  financial papers, or a basket of indicators that
  adequately reflect market conditions.
• The Margin is a constant amount that is added to
  the Index to determine the new interest rate.
• For conforming loans, the usual margin is 2.75
  to 3.25

19
Common Indexes

• U.S. Treasury Bills - usually the one year rate.
• Prime rate The prime rate is the rate that
  banks charge to their best customers, usually
  commercial.
• Cost-of-Funds index (COFI) The COFI index is
  calculated by each of the Federal Reserves'
  regional districts, the most popular of which is
  the 11th District. The Cost-of-Funds index is a
  monthly survey of the cost to the banks of the
  money they have at their disposal.
• London InterBank Offered Rate (LIBOR) The LIBOR
  index has become the index of choice for
  non-conforming lenders, especially with sub-prime
  (B/C/D/E) credit loans. The LIBOR rate tends to
  remain close to though slightly higher than
  the T-Bill rate.

20
Caps

• Caps restrict the amount that the lender can
  change the rate on the specified anniversary date
  and thus protect the borrower from unforeseen
  rises in rate and payments.
• If the Index moves too far, the maximum that the
  borrowers rate can move is determined by the cap.

21
Types of Caps

• Periodic cap
• Lifetime Cap
• Payment cap
• Principal cap
• Note that the payment cap can induce negative
  amortization. The principal cap limits the amount
  that the principal of the loan can increase by
  negative amortization.

22
Negative Amortization

• Negative amortization occurs when the payment cap
  on a loan keeps the payment from covering the
  interest for that month.
• The deficit can be added to the loans principal.
• A principal cap can keep negative amortization
  from raising the principal due beyond a certain
  level.
• Loans on which negative amortization is possible
  are usually offered at very low introductory
  rates.

23
Conversion option

• Allows the borrower to convert from an ARM to a
  fixed rate mortgage without refinancing, a new
  title search, etc.
• Usually must be exercised in the 2nd -5th year.
• Lender will charge a small administrative fee.
• Fixed rate will depend upon the market at the
  time of conversion.
• It is not a refinance, as it is still the
  original mortgage.

24
Adjustment Process

• Amortization is refigured each time the interest
  rate is adjusted.
• The amortization usually is until the original
  maturity date.
• Amount of payment can rise or fall.
• Negative amortization may be converted into a
  balloon payment at end of loan.

25
Disadvantages of ARMs

• Payment may increase because of adjustment.
• Low teaser introductory rates almost assure that
  the payment will increase.
• Mortgage insurance on an ARM is slightly more
  costly than on a fixed rate loan.

26
Home Equity Line of Credit (HELOC)

• Financial Planning Tool
• Excellent safety net for the homeowner.
• Funds available immediately in emergency
  situation.
• Investment Tool
• Instant liquidity allows investors to seize an
  opportunity without a lengthy loan application
  process.
• No interest is charged until the line of credit
  is used. This makes it a low cost option.

See http//www.reiclub.com/articles/heloc-purcha
se-properties
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How the HELOC Works

• The borrower establishes a line of credit with a
  lender.
• The line of credit can be used like a checking
  account.
• It is a second mortgage, and the closing costs
  will be the same as any other mortgage.
• If the borrower does not use the credit, there
  will be no interest charged.

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HELOC Features

• Cost
• No interest cost unless credit line is used.
• Initial fee, plus closing costs.
• Account maintenance fee.
• Two phases
• Revolving.
• Amortized.
• Most are ARMs.

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Balloon Loans

• The balloon mortgage loan is an installment note
  whose amortization is longer than its term. The
  remaining principal is due in total at the
  maturity of the mortgage.
• Is used to keep initial payments low.
• ARMS that are 5/1 and 7/1 have largely replaced
  the Balloon Loan for residential loans.
• Most commercial loans are balloon loans.

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Advantages and Disadvantages of Balloon Notes to
the Borrower

• Shorter Term
• Shorter term Less risk to lender
  Lower interest rate.
• Longer amortization
• Lower payment required.
• Fixed rate during the term.
• Main disadvantage is that the balloon note may
  require a larger down payment than a comparable
  30 year fixed loan (At least 10).

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How a Balloon Loan Works

• Payments are computed on a 30 year fixed loan
  basis or even on interest only.
• After the term ends (typically 5 or 7 years) the
  homeowner still has a very large principal still
  due.
• At that point, the homeowner has to either come
  up with the cash to pay the loan or refinance,
  unless a conversion option is built into the loan.

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Amortization of Balloon Loans

• Two-step balloons
• Most typical are the 5/25 balloon and the 7/23
  balloon.
• At the end of the first time period, the balloon
  can be converted into a fixed rate 30 year loan.
• Balloon ARMs
• Start with a fixed rate.
• Convert to an ARM.
• Interest-only balloons
• Principal due never goes down.
• Low payment.

33
Buy-Down Programs Points

• Buy-down programs reduce the interest rate
  through prepayment of the loan's interest. The
  prepayment is called points, with one point
  being equal to 1 per cent of the total loan.
• Permanent Buy-Downs
• Reduces the interest for the life of the loan.
• Generally takes 5 or more years to recoup the
  points, so should not be used by homeowners who
  intend to stay in their home for less than 5-7
  years.
• Temporary Buy-Downs
• Only lower the interest rate for a few years.
• Buyer can qualify for a larger home, but must
  show that higher income is expected in the
  future.
• Generally the fixed rate is higher than it would
  be on a conventional mortgage.

34
Construction Loans

• Loans made to finance construction of a new
  property have different characteristics. Look at
  four main elements
• Loan commitment.
• Rate lock.
• Method of disbursement.
• Lower LTV ratio limits.

35
Jumbo Loans

• A Jumbo loan is one that exceeds the conforming
  loan limits.
• Conforming Loan Limits
• Set by Fannie Mae and Freddie Mac based on
  current market prices
• For 2005, for conventional mortgages (those which
  may be purchased from local lenders by national
  organizations such as Fannie Mae and Freddie Mac,
  the loan limits for owner-occupied properties
  are
• One-unit properties 359,650.
• Two-unit properties 460,400.
• Three-unit properties 556,500.
• Four-unit properties 691,600.
• For properties in Alaska, Hawaii, Guam, and the
  U.S. Virgin Islands, the loan limits are 50
  percent higher.

36
Jumbo Loans without Jumbo Pricing

• Jumbo loans usually have a higher interest rate
  than conforming loans. To lower the interest
  rate,
• Make larger down payment to bring the mortgage
  balance down to conforming limit.
• Use two loans a conforming first mortgage and a
  second mortgage.

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No Income Verification (NIV) Loans

• Applicable Situations
• Self employment.
• Recent job change.
• Uneven income such as commissioned employees.
• Income claimed must be within reason.
• Cost of NIV Programs
• Higher rate -- 1.50 to 4.00 percentage points
  higher than comparable full documentation loans.
• Larger down payment With A-credit, about 20 -
  25, with lower credit, 30-40.

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Other Mortgage Financing Alternatives

• Renegotiable rate mortgage
• Seller Take-back
• Growing equity mortgage
• Contract sale
• Rent with Option
• FHA loans

• VA loan
• USDA Rural Service Loan
• Community Reinvestment Loan Program
• Federal Home Loan Bank Board
• Fannie Mae

39
Refinance Loans

• Reasons for refinancing a mortgage
• Better interest rates.
• Change of term.
• Consolidation of debt.
• Extra cash.

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Cash-out Refinance

• Cash out refinances require higher LTV than
  conventional loans. A loan is a cash-out
  refinance if used for
• Cash back to the borrowers.
• Debt consolidation.
• Replace a first or second mortgage that is less
  than one year old.

41
Rate and Term (No Cash-Out) Refinance

• Refinance of a first mortgage that is at least
  one year old.
• Consolidation of multiple mortgages.
• Refinance that also pays closing costs and
  prepaid expenses.
• Limited cash back less than 1 of the loan.

42
Considerations in Refinance

• Investment consideration
• May not be a good idea to refinance a loan that
  has been paid on for five or more years.
• Difference in old interest rate and new rate
  needs to be large enough to justify closing
  costs.
• Appraisal value.
• Payoff statement.

43
Refinancing When There are Two or More Current
Mortgages

• Complicates the refinance handling and paperwork.
• Refinance both or only one of the existing
  mortgages.
• LTV ratios change with whether it is considered a
  rate and term refinance or a cash out refinance
  just as when refinancing one loan.
• Refinancing only the first mortgage will require
  that lender on second mortgage subordinate his
  loan to the new first mortgage.

44
Mortgage Amortization

• Each payment consists of interest and principal.
• The interest portion is one months interest on
  the loans remaining balance. Thus interest goes
  down over time.
• Since the payment is a fixed amount, whatever is
  left out of the fixed amount paid after paying
  the interest is credited to the loan balance
  (principal).
• Since interest goes down over time, the portion
  of the payment representing principal goes up.

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Example of AmortizationExcel Template from
http//office.microsoft.com/en-us/templates/TC0101
97771033.aspx?CategoryIDCT011377171033
46
Graphic Representation of Loan Amortization
47
Computing the Payment Amount

• If Pmt the payment and
• Bal0 Starting Balance and
• r interest rate per payment period and
• n number of payments,
• Then,
• Pmt Bal0 x r/(1 (1r)-n).

48
Basics of Loan Rates

• The actual rate the borrower pays is usually
  higher than the stated rate
• Up-front costs are not computed in the stated
  rate.
• Rate is computed as if loan is paid off over the
  stated term. Most mortgages are paid off early,
  so actual rate is higher.
• Monthly rate is computed as 1/12 annual rate,
  which increases the effective annual rate.

49
Effect of Points and Closing Costs

• Closing costs and points can add up to 4 to the
  amount of money borrowed (They are typically
  added to the loan amount).
• These costs can be looked upon as affecting the
  rate on the net amount being borrowed.
• Therefore the rate of interest that the borrower
  is paying over the life of the loan is greatly
  increased.

50
Effect of Early Payoff on the APR

• It is rare for a homeowner to keep the same house
  for 30 years.
• Since an early payoff means that the points and
  closing costs must be amortized over a shorter
  period, the APR is increased by early payoff.
• For example, paying off a loan in five years
  rather than 30 could raise the APR by .7-.8, a
  substantial increase.

51
Cost of Refinancing

• Refinancing adds a new set of points, closing
  costs and fees to the cost of borrowing money.
• Thus, the rule of thumb that it does not pay to
  refinance unless the interest rate is at least 2
  lower than the old loan.
• An easy way to see the true cost of refinancing
  is to add up the payments over the term of the
  loan. The difference in the sums is how much you
  are actually saving (or losing) by refinancing.
• This method does not adjust for time value of
  money.

52
Effect of Biweekly Payments

• Making mortgage payments biweekly rather than
  monthly can significantly reduce the term of a
  mortgage.
• The logistics of arranging this are non-trivial.
• There are companies that will do this for you,
  but make sure that their fees will not offset the
  savings.

53
Determining How Much House the Borrower Can Afford

• Front-end ratio - ratio of the monthly housing
  expense (PITI) to the borrower's gross (pre-tax)
  monthly income.
• The total amount the family can afford to pay for
  a home is equal to the amount they can afford to
  put down plus their maximum qualifying mortgage
  amount less mortgage closing costs and points on
  financing.
• Typical front-end ratio requirements are .25 -.35.

54
Back-End Ratio

• The ratio of the borrower's total debt (PITI plus
  other minimum monthly debt payments) to the gross
  monthly income.
• Most lenders use the front-end ratio to determine
  the maximum that they would lend, then use the
  back-end ratio to adjust the maximum downward to
  account for other obligations of the borrower.

55
Reasons for Leasing

• Reduce taxes.
• Reduce uncertainty.
• Reduce costs.

56
Types of Leases

• Operating Leases.
• Financial Leases
• Sale and Lease-back.
• Leveraged Lease.

57
Lease Accounting

• In past, leases were not on the balance sheet.
• Now, certain leases are capitalized leases and
  show as both an asset and a liability.
• Example shows how various methods of acquisition
  of the asset can affect the companys balance
  sheet.

58
One-Asset, Acquired Three ways
59
Capital Lease

• The lessee must capitalize a lease if any one of
  the following criteria is met
• Present value of the lease payments is at least
  90 of the fair market value of the asset.
• The lease transfers ownership of the property to
  the lessee by the end of the term of the lease.
• The lease term is 75 or more of the estimated
  economic life of the asset.
• Bargain price at the expiration of the term of
  the lease.

60
Leasing and Taxes

• The lessee can deduct lease payments if the lease
  is qualified by the IRS. To be qualified
• Term less than 30 years.
• No bargain purchase option.
• No high then low payment schedule.
• Lessor must receive a fair market rate of return.
• No limit to lessees right to issue debt or pay
  dividends.
• Renewal options must be reasonable and reflect
  fair market value of the asset.