Mortgage Markets

1
Mortgage Markets

• Real Estate 310
• Principles of Real Estate
• Dr. Longhofer

2
Why Mortgages?

• Real estate is a very capital intensive
  investment
• Most households want to purchase a home long
  before they are able to save enough to pay cash
• Most real estate investors desirethe benefits of
  financial leverage
• As a result, most real estate is purchased using
  at least some borrowed funds

3
Why Mortgages?

• A mortgage is the pledge of real estate to secure
  a debt
• The term comes from the Middle Ages in Great
  Britain (mort dead, gage pledge)

4
What is a Mortgage?

• Although we usually speak of the mortgage as if
  it were a loan, technically it is a security
  instrument putting up the property as collateral
  for the loan
• Two basic documents make up the mortgage
• The promissory note, or financing instrument,
  actually creates the debt and specifies the terms
  of the loan
• The mortgage, or security instrument, pledges the
  real estate as collateral for the loan
• The borrower is called the mortgagor because he
  has pledged his land to the lender (the mortgagee)

5
The Promissory Note

• The promissory note (or simply note) actually
  creates the debt and specifies the terms and
  conditions of the loan
• Amount of the debt and the rate of interest
• Time and method of payment
• The note also contains a number of other clauses
• Whether the loan is due on sale (alienation
  clause)
• Acceleration of the debt in the event of default
• Prepayment penalties for early repayment
• How the interest rate will be adjusted for
  variable rate loans

6
The Mortgage

• The mortgage (security instrument) gives the
  lender the right to sue for foreclosure in the
  event of default
• The mortgage contains certain uniform covenants
  (promises) that require the borrower to
• Pay the debt in accordance with the terms of the
  note
• Keep insurance on the property
• Pay real estate taxes on the property
• Maintain the property

7
The Mortgage

• Other clauses in the mortgage may
• Allow the lender to collect reserves for taxes,
  insurance, and flood insurance
• Provide that rents from the property be assigned
  to the lender in the event of default
• Require the lender to release the mortgage in a
  timely fashion when the loan is repaid
• Allow the lender to assign the mortgage to a new
  lender
• Mortgages must be recorded in the Register of
  Deeds office in order to be valid

8
Mortgage Loan Default

• Default occurs when the mortgagor fails to make
  timely payment of principal and interest or
  violates any of the terms of the note or mortgage
• Default and delinquency are not the same thing
• Foreclosure refers to the process of seizing the
  property and having it sold to repay the debt
• Judicial foreclosure
• Nonjudicial foreclosure
• Strict foreclosure

9
Mortgage Loan Default

• If the foreclosure fails to fully repay what is
  owed, the lender may seek a deficiency judgment

10
Mortgage Loan Default

• Lenders would typically like to avoid foreclosure
  if possible
• Recasting, extending, or forgiving part of the
  loan
• Sell the property with the buyer assuming the
  loan
• Deed in lieu of foreclosure
• Even after default, borrowers have a right to
  redeem their property
• The equitable right of redemption applies before
  foreclosure takes place
• The statutory right of redemption can be used
  after foreclosure

11
Other Mortgage Tidbits

• There are a few security instruments that serve
  as an alternative to a mortgage
• Deed of trust
• Land contract
• Although most mortgages are repaid when the
  property is sold, it is possible to transfer
  title while keeping a mortgage in place
• Assuming the mortgage
• Purchase subject to an existing mortgage

12
Mortgage Market Structure

• In the primary mortgage market, new mortgages are
  created and funds are disbursed to borrowers
• Existing mortgages are traded in the secondary
  mortgage market, but no new loans are created
• The secondary mortgage market increases the
  supply of funds available to the primary
  mortgage market by creating instruments that are
  attractive to a wider class of investors

13
Primary Mortgage Market

• Primary mortgage market participants
• Thrifts, savings associations, commercial banks,
  and credit unions
• Mortgage banks
• Mortgage brokers
• Insurance companies, pension funds, and other
  institutional investors

14
Primary Mortgage Market
Mortgage Origination
Mortgage Satisfaction
15
Secondary Mortgage Market

• Government sponsored enterprises (GSEs) are
  private companies that are chartered by the
  Federal government
• Fannie Mae (Federal National Mortgage
  Association)
• Freddie Mac (Home Loan Mortgage Corporation)
• Ginnie Mae (Government National Mortgage
  Association) is an agency of the Federal
  government
• Commercial banks, insurance companies, mutual
  funds, REITs, and other private investors are
  also active in the secondary market

16
Secondary Mortgage Market
17
Residential Mortgage Holdings
Billions of U.S. Dollars
18
Commercial Mortgage Holdings
Billions of U.S. Dollars
19
Residential Loan Programs

• Conventional loans are mortgages that have no
  direct government backing
• Conventional loans must either have a
  loan-to-value (LTV) ratio no bigger than 80 or
  have private mortgage insurance (PMI)
• FHA Loans The Federal Housing Administration
  provides insurance on loans with high LTV ratios
• The borrower pays an up-front fee and a monthly
  premium for this insurance
• VA Loans The Veterans Administration guarantees
  loans made to qualified veterans against default
• The borrower pays a guarantee fee at the time the
  loan is originated, but no monthly premiums

20
Residential Loan Classifications

• Conforming loans are loans that meet (or conform
  to) Fannie/Freddie underwriting and size
  guidelines
• Nonconforming loans include
• Jumbo loans that exceed the maximum loan size
  limits for Fannie Mae and Freddie Mac
• B and C loans that have too many credit blemishes
  or other problems to be approved under
  Fannie/Freddie underwriting guidelines

21
Residential Mortgage Underwriting

• The first step in underwriting the loan is to
  verify the applicants creditworthiness by
  examining his or her credit report
• Installment loan and revolving credit
  delinquencies
• Mortgage loan delinquencies
• Bankruptcies, judgments, and foreclosures
• Recent blemishes are typically weighed more
  heavily
• Lenders often use credit scores (FICO scores) to
  summarize the applicants credit history
• A score above 700 is viewed as good, while a
  score below 600 is considered bad

22
Residential Mortgage Underwriting

• Next the lender verifies that the applicant is
  capable of making the required monthly payment on
  the loan
• The lender will verify the income reported by the
  applicant by inspecting past tax returns and
  calling employers
• The front-end (housing expense) ratio is the
  percentage of the applicants monthly income
  needed to meet required monthly housing expenses
• FER (Mortgage Payment Taxes Insurance)
  Monthly Income

23
Residential Mortgage Underwriting

• Conforming lenders typically require that the
  applicants FER be no greater than 28
• FHA guidelines allow a slightly higher FER of
  29, but calculate some items slightly
  differently
• Example Suppose a borrower has monthly income
  of 3,000. The proposed mortgage payment is 550
  per month, while taxes and insurance are expected
  to be 250 per month.
• FER (550 250) / 3,000 27
• This applicants income appears to meet this
  guideline

24
Residential Mortgage Underwriting

• The back-end (total debt) ratio is the percentage
  of the applicants monthly income needed to meet
  all of his or her debt payment obligations
• BER (Housing Expenses Other Debt
  Payments) Monthly Income
• Other debt payments include almost all other
  monthly obligations the applicant may have
• Auto loans, credit card payments, student loans,
  other installment loans, alimony and child
  support are all included

25
Residential Mortgage Underwriting

• Conforming lenders typically require that an
  applicants BER be no greater than 36
• FHA loans require BER be no greater than 41
• Example Suppose the applicant above has a car
  loan requiring a monthly payment of 350 and a
  student loan with a monthly payment of 200
• BER (550 250 350 200) / 3,000 45
• This applicants other debt obligations cause his
  debt ratio to exceed conforming loan underwriting
  guidelines

26
Residential Mortgage Underwriting

• Finally, lenders want to make sure that the
  property provides adequate collateral for the
  loan
• Does the applicant have clear title to the
  property?
• Does the property meet the lenders criteria?
• Is the value of the property high enough?
• The loan-to-value (LTV) ratio is used to evaluate
  the amount of the collateral
• LTV Loan Amount / Value
• Value is defined as the smaller of the sale price
  and the appraised value of the property

27
Residential Mortgage Underwriting

• Conventional lenders typically require the LTV
  ratio be no greater than 80
• With private mortgage insurance (PMI) the LTV
  ratio can be as high as 95
• FHA loans can have LTV ratios of up to 98.75
• Example A property is selling for 115,000 and
  has been appraised at 112,500. The loan amount
  is 90,000. What is the LTV Ratio?
• LTV 90,000 / 112,500 80
• Often the LTV ratio is used to determine how
  large of a loan the lender will provide

28
Housing Finance Regulations

• Equal Credit Opportunity Act (ECOA)
• Prohibits discrimination on the basis of race,
  color, religion, national origin, sex, marital
  status, age, or receipt of public assistance
• Applicants must be informed of the loans status
  within 30 days of the application, along with
  reasons for denial
• Truth in Lending Act (TILA)
• Lenders must disclose the costs of the loan
  within three business days of the application,
  including the total finance charges and the
  annual percentage rate (APR)
• Provides borrowers on refinance loans to rescind
  the loan within three business days of the
  application

29
Housing Finance Regulations

• Real Estate Settlement Procedures Act (RESPA)
• Requires lenders to provide applicants with a
  good faith estimate of settlement costs within
  three business days of the application
• Prohibits kickbacks and referral fees by the
  lender
• Allows the borrower to receive a copy of the
  appraisal
• Requires the HUD-1 settlement statement to be
  used at closing to show the costs of the
  transaction
• Community Reinvestment Act (CRA) and the Home
  Mortgage Disclosure Act (HMDA)
• Intended to prohibit redlining

30
Traditional Mortgage Structure

• The traditional residential mortgage loan is a
  long-term, fully-amortizing, fixed-rate loan with
  constant monthly payments
• Terms of 15 and 30 years are the most common
• Fully-amortizing means that the regular monthly
  payments will fully repay the loan by the end of
  the term
• The interest rate charged on the loan remains
  constant for the entire loan term, and the
  monthly payment never changes

31
Residential Mortgage Rates
32
Mortgage Payment Mechanics

• You can use the time value of money keys on your
  financial calculator to solve mortgage problems
• P/Y Number of payments to be made per year
• N Number of periods the payments will be made
• I/Y Annual nominal interest rate
• PV Present value, or the initial loan amount
• PMT Periodic payment on the loan
• FV Future value, or the balance due after
  all payments are made

33
Mortgage Payment Mechanics

• What is the monthly payment required to purchase
  property worth 225,000 under the following
  terms?
• 30-year, fixed-rate mortgage with monthly
  payments
• 80 LTV ratio
• 8.5 nominal interest rate
• The first step in any problem is to clear your
  financial calculator of old information that may
  be entered in the registers
• Press 2nd, Clr TVM

34
Mortgage Payment Mechanics

• Next note that the loan amount is 80 of the
  propertys value, based on the lenders required
  LTV ratio
• Solve for the loan amount 225,000 ? 0.80
  180,000
• Enter this into your calculator by pressing PV
• This loan has monthly payments, so the number of
  payments per year is 12
• Set this by entering 2nd, P/Y, 12, Enter
• Exit this feature by pressing 2nd, Quit

35
Mortgage Payment Mechanics

• The total number of payments will be 30 ? 12
  360
• Enter this by pressing 360, N
• Note that you can calculate the total number of
  payments by pressing 30, 2nd, xP/Y make sure
  you then press N to enter this value
• Next enter the annual interest rate on the loan
• Press 8.5, I/Y

36
Mortgage Payment Mechanics

• Finally, note that because the loan is
  fully-amortizing, the loan balance will be 0 at
  the end of the term
• Because we cleared the calculator at the
  beginning, the future value is preset to 0 check
  this by pressing RCL, FV
• To be safe, get in the habit of entering your
  future value again 0, FV
• Now you can solve for the monthly payment
• Press CPT, PMT to get ?1,384.04
• This is negative because payments are cash
  outflows

37
Mortgage Payment Example

• What is the required monthly payment on a
  15-year, 75,000 fixed-rate mortgage with
  monthly payments and 5.50 interest rate?
• P/Y 12
• N 15 ? 12 180
• I/Y 5.50
• PV 75,000
• FV 0
• Solve for PMT ?612,81

38
How Do Mortgages Work?

• Traditional mortgages are structured so that each
  month a portion of the loan is repaid, with the
  last payment fully paying off the loan
• Consider our 180,000 mortgage from earlier
• The monthly payment on the mortgage was 1,384.04
• In the first month, 1,275 of interest will
  accrue
• INT 180,000 ? (0.085 12) 1,275
• The balance of the payment is credited toward
  principal
• PRN 1,384.04 ? 1,275.00 109.04

39
How Do Mortgages Work?

• As a result, the borrowers loan balance is only
  179,890.96 after the first payment
• BAL 180,000.00 ? 109.04 179,890.96
• Because part of the loan has been repaid, less
  interest accrues during the second month
• INT 179,890.96 ? (0.085 12) 1,274.23
• Hence, even more of the payment is left over to
  pay down the principal of the loan
• PRN 1,384.04 ? 1,274.23 109.81
• BAL 179,890.96 ? 109.81 179,781.15

40
Amortization Table
41
Amortization Schedule
42
How Much Does My Mortgage Really Cost?

• The nominal interest rate determines how fast
  interest accrues on your outstanding loan
  balance, but it may not accurately measure the
  true cost of the loan
• Up-front fees charged by the lender reduce the
  net cash you receive from the loan, raising the
  effective cost of your mortgage
• Fees often come in the form of points, where
  one point is one percent of the loan amount
• Thus, if you must pay 2 points for a 180,000
  loan, the total fee you will pay is 180,000 ?
  0.02 3,600

43
Why Do I Pay Points?

• Origination points are used to compensate the
  lender for the costs of processing and
  originating the loan
• Many lenders charge a fixed number of origination
  points on all mortgages, and this charge is often
  fairly standard across lenders in the market
• Discount points are used to buy down the
  interest rate that will be paid by the borrower
• By paying discount points you can get a lower
  rate on your loan

44
Discount Points and Rate Sheets
45
Choosing Among Loans

• The variety of different pricing options can
  making choosing a mortgage confusing
• How do I decide which lenders offer to take?
• Should I choose a loan with fewer points or one
  with a lower interest rate?
• When should I refinance my mortgage?
• Usually, these questions come down to choosing
  the loan with the lowest total borrowing cost
• The fact that loans are priced across two
  different dimensions (up-front fees and interest
  rate) can make figuring out the total borrowing
  cost tricky

46
Annual Percentage Rate

• One tool for comparing loans is the Annual
  Percentage Rate (APR)
• The APR is the effective interest rate you will
  pay over the entire term of the loan taking into
  account the up-front fees that reduce the net
  funds you receive from the lender
• To calculate the APR, simply determine the net
  funds you will receive from the loan after paying
  any points or fees and then use your financial
  calculator to resolve for the (implicit) interest
  rate

47
APR Example

• On the rate sheet from before, what is the APR of
  a 30-year 100,000 mortgage at 6.00 interest
  with 1 point?
• Begin by calculating the monthly payment on the
  loan P/Y 12, N 360, I 6, PV 100,000, FV
  0 ? PMT ?599.55
• Next calculate the net funds that will be
  received by the borrower and enter this as the
  new PV PV 100,000 ? (1 ? 0.01) 99,000
• Finally, solve for the interest rate implied by
  this lower net amount financed APR 6.09

48
Using the APR

• What is the APR of the 6.375 loan with zero
  points?
• If there are no up-front fees, the APR is simply
  the nominal interest rate
• Choosing the loan with the lowest APR ensures
  that you are getting the best alternative,
  assuming you hold the loan until maturity
• If you do not hold the loan for the entire term,
  then the loan with the lowest APR may not be the
  best choice

49
Effective Borrowing Cost

• The effective borrowing cost (EBC) measures the
  true cost of the mortgage taking into account
  both the up-front fees and the anticipated
  holding period for the loan
• If you hold the loan until maturity, EBC APR
• If there are no up-front fees on the loan, EBC
  APR nominal interest rate
• If the loan has up-front fees and you dont hold
  it until maturity EBC gt APR
• Calculating the EBC or the APR is relatively
  simple with a financial calculator

50
EBC Example

• What is the EBC of the 6 loan if you only
  anticipate holding the mortgage for 5 years?
• Begin by calculating the monthly payment as
  before P/Y 12, N 360, I 6, PV 100,000,
  FV 0 ? PMT ?599.55
• Next calculate the balance that will be due at
  the end of 5 years N 60 ? FV ?93,054.36
• Finally, calculate the implicit interest rate
  based on the net funds provided to the borrower
  PV 99,000 ? EBC 6.24
• Notice that the EBC is higher because there is
  less time to benefit from the lower interest rate

51
Rules of Thumb forChoosing Among Loans

• If you anticipate holding the loan for the entire
  term, choose the option with the lowest APR
• Also important is whether you can afford the
  monthly payment or have cash available to pay the
  closing costs
• Example Consider the rate point tradeoff with
  the 100,000 30-year, fixed-rate mortgage above
• Zero points and 6.375 interest APR 6.375
• One point and 6.000 interest APR 6.09
• The monthly payment is also lower under the
  second alternative, so the only question is
  whether you can afford the additional 1,000 in
  closing costs

52
Rules of Thumb forChoosing Among Loans

• Generally speaking, if your expected holding
  period is more than 3 or 4 years, you are better
  off paying points and getting a lower interest
  rate
• If you plan on holding the loan for only 2 years,
  the EBC of the second alternative is 6.54
• The EBC of the first alternative is still 6.375
  because there are no up-front fees (EBC APR)
• Thus with a short holding period you should not
  pay the point to lower your interest rate
• The breakeven point between the two alternatives
  in this example is 3 years

53
When Should You Refinance?

• As a general rule, you should refinance if the
  EBC of the new loan is lower than the nominal
  interest rate of your existing loan
• Note that the EBC of your existing loan is
  irrelevant for this decision because the up-front
  fees have already been paid (they are sunk costs)
• If your new loan term is the same, then refinance
  if you can lower your monthly payment
• Be careful about extending the loan term,
  however, because you can get a lower payment will
  increasing your total borrowing cost

54
Alternative Loan Structures

• Adjustable-rate mortgages (ARMs) do not have a
  fixed interest rate over the life of the loan
• 1-year ARMs allow the interest rate to adjust
  every year
• 6-month ARMs adjust every six months
• 3-1, 5-1, and 7-1 ARMs have a fixed interest rate
  for the first several years (3, 5, or 7,
  respectively) which then adjusts annually
  thereafter
• Many other mortgage products exist as well
• Graduated-payment mortgages (GPMs)
• Price level adjusted mortgages (PLAMs)
• Reverse-annuity mortgages (RAMs)

55
Residential Mortgage Rates
56
How Do ARMs Work?

• Because the interest rate on an ARM can change on
  a regular basis, there must be some benchmark to
  determine how the rate will change
• The index is the base rate on which adjustments
  are calculated
• 1-year constant maturity treasury security yield
• 11th District Cost of Funds Index (COFI)
• Freddie Mac 30-year national contract rate
• LIBOR
• Prime rate

57
ARM Index Histories
58
How Do ARMs Work?

• The fully-indexed rate is calculated by adding a
  margin to the index
• Typical margins for ARMs are 2-3
• It is common for ARMs to have a teaser rate in
  the first period that is below the current
  fully-indexed rate
• Caps are used to limit the amount that the
  interest rate or payment may change from one
  period to the next
• Rate caps are the most common, and can include a
  per-period cap and a lifetime cap (e.g., 2-6
  caps)
• Caps often also serve as floors for rate changes,
  limiting how much the rate may decline each period

59
How Do ARMs Work?

• An alternative cap mechanism is a payment cap,
  which limits how much the monthly payment can
  change each adjustment period
• Payment caps are less common because they can
  result in negative amortization, or a payment
  that is less than the accrued interest so that
  the loan balance increases over time
• The contract rate on an ARM can differ from the
  fully-indexed rate at any given time because of
  teaser rates and rate caps

60
ARM Adjustment Mechanics

• How do you figure out your new monthly payment on
  an ARM?
• Although it can seem complicated, it is fairly
  simply to calculate the new monthly payment on an
  ARM
• The initial payment on the ARM is calculated
  exactly as it would be with a fixed-rate mortgage
• At each adjustment date you simply recalculate
  the new payment based on the new interest rate
  and the balance outstanding at that time

61
ARM Adjustment Mechanics

• Step 1 Determine the principal balance still
  outstanding
• You can use the FV key or the amortization
  worksheet in your financial calculator
• Step 2 Calculate the fully-indexed rate based on
  the current value of the index and the margin
• Step 3 Determine whether any rate caps apply and
  determine the new contract rate
• If no cap or floor is binding, the new contract
  rate is simply the fully-indexed rate
• If a cap is binding, the cap determines the new
  rate

62
ARM Adjustment Mechanics

• Step 4 Determine how many payments are left on
  the loan
• For a 1-year ARM, this is simply 12 fewer than
  the last time the rate was adjusted
• Step 5 Calculate the new payment, based on the
  new contract interest rate, the outstanding
  principal balance, and the remaining term of the
  loan
• This is a straightforward calculation on your
  financial calculator

63
ARM Adjustment Example

• Consider a 75,000, 1-year ARM, 30-year
  amortization, indexed to the 1-year treasury,
  with a 3 spread, 2-6 caps (2 in the first year
  and 6 over the life of the loan), and an initial
  interest rate of 5.75
• The initial payment on this loan is 437.68
• Suppose that at the end of the first year, the
  T-Bill rate is 5.875. What is the new monthly
  payment on this loan?

64
ARM Adjustment Example

• Step 1 Determine the principal balance
  outstanding
• Remember that all of the information for the
  original loan payment is still in your calculator
• Press 12, N, CPT, FV to get 74,035.18
• Step 2 Calculate the fully-indexed rate by
  adding the margin to the new value of the index
• The fully-indexed rate is 5.875 3 8.875

65
ARM Adjustment Example

• Step 3 Determine if any caps apply and then
  calculate the new contract rate
• The highest rate this loan can ever have is
  5.75 6 11.75
• Since 8.875 lt 11.75, this cap is not binding
• The highest rate this loan can have this year is
  last years rate plus the annual cap, or5.75
  2 7.75
• Since 8.875 gt 7.75, this cap is binding
• The new contract rate is therefore 7.75

66
ARM Adjustment Example

• Step 4 Determine how many payments are remaining
  on the loan
• We started with 360 payments and have made 12
  payments over the last year, so there are 348
  payments left
• Step 5 Calculate the new payment on the loan
• Enter N 348, I 7.75, PV 74,035.18, FV 0
  and solve for PMT 535.09
• Thats all there is to it!

67
Commercial Property Mortgages

• Although most of the calculations are the same
  for both commercial and residential mortgages,
  there are a number of important differences
• These loans are often structured as balloon
  loans, in which the entire balance is due before
  the monthly payments have fully repaid the
  principal balance
• Prepayment penalties (yield maintenance
  provisions) are common with fixed-rate commercial
  mortgages
• Long-term commercial mortgages are often
  non-recourse
• Depository institutions and institutional
  investors are much more important in commercial
  mortgage markets

68
Commercial Mortgage Holdings
Billions of U.S. Dollars
69
Commercial Mortgage Underwriting

• Commercial property lenders typically require
  lower LTV ratios (between 60 and 80 percent)
• The debt-coverage ratio (DCR) is used to evaluate
  whether the property has sufficient income to
  service the loan
• DCR Net Operating Income / Annual Debt Service
  (NOI / ADS)
• Lenders will establish a minimum DCR underwriting
  guideline (typically between 1.2 and 1.3)
• The DCR can be used to calculate the maximum loan
  amount a lender will provide

70
DCR Example

• Consider a 1.2 million shopping center with
  expected first-year NOI of 120,000
• Financing is available at 8.0 fixed interest
  over 20 years with a maximum LTV ratio of 75 and
  a minimum DCR of 1.30
• P/Y 12, N 20 ? 12 240, I 8, PV
  1,200,000 ? 0.75 900,000, FV 0 ? PMT
  7,528
• ADS 7,528 ? 12 90,336
• DCR 120,000 90,336 1.33 ?

71
Commercial Mortgage Underwriting

• Lenders evaluate a number of other factors in
  deciding whether to approve a commercial mortgage
  loan
• The type of property serving as collateral, as
  well as its size, age, quality, and geographic
  location
• How well the property fits into the lenders
  overall portfolio
• The creditworthiness of the tenants occupying
  the property
• The terms and conditions of the tenants current
  leases and the conditions of the overall market