Chapter 11 Sources of Capital and Financing

An insured mortgage is defined as

"A mortgage in which a party other than the borrower assures payment on default by the mortgagor in return for the payment of a premium, e.g., FHA-insured mortgages, private mortgage insurance (PMI)." An example of an insured mortgage would be an FHA mortgage. FHA is the name of the mortgage insurance program that is operated by the U.S. Department of Housing and Urban Development (HUD). HUD/FHA does not lend money; instead they charge the borrower an up-front mortgage insurance premium (UFMIP) based on a percentage of the loan amount, plus a monthly mortgage insurance premium (MIP). The FHA mortgage insurance program is funded entirely by mortgage insurance premiums paid by borrowers; no taxpayer money is involved. In the event of a default on an FHA loan, HUD reimburses the originating lender for losses incurred.

A Contract for Deed is defined as:

A contract in which a purchaser of real estate agrees to pay a small portion of the purchase price when the contract is signed and additional sums, at intervals and in amounts specified in the contract, until the total purchase price is paid and the seller delivers the deed; used primarily to protect the seller's interest in the unpaid balance because foreclosure can be exercised more quickly than it could be under a mortgage. Also called land contract or installment (sale) contract."

Amortization

Most mortgages are fully amortized loans, in which part of the payment goes to interest, and the rest goes toward reducing the principal balance. However, for a brief period in the early- to mid-2000s, other types of mortgage loans became popular, in which the borrower paid interest only and never reduced the original amount of the loan. Amortization is defined as "The process of retiring a debt or recovering a capital investment, typically through scheduled, systematic repayment of the principal; a program of periodic contributions to a sinking fund or debt retirement fund." It comes from the Latin "amort", which means "to kill." So by making the scheduled payments, the borrower is literally "killing off" the loan.

The primary sources of mortgage capital were:

State or federally chartered savings banks Savings and loan institutions Commercial banks Credit unions Savings banks are either mutual or stockholder owned. Mutual savings banks are similar to savings and loans and invest large amounts of their depositor's money in residential mortgages. Around 1990, many mutual savings banks went public and converted into stockholder-owned institutions. Most savings and loan institutions were chartered primarily to provide residential mortgages for borrowers in their local areas. Their purpose was to receive savings, loan money at interest, and distribute dividends to depositors. Commercial banks are privately-owned institutions that were obviously oriented towards business loans but dabbled in residential loans. Their loans were usually short term, but they played an important role - they supplied loans to builders and developers for construction and development. During this period, credit unions primarily loaned to their members. In subsequent years, many opened their doors to all borrowers.

A graduated-payment mortgage (GPM) is defined as

"A debt secured by real property in which mortgage payments are usually projected to match increases in the borrower's income. The periodic payments start out low and gradually increase." These have a place with younger people or people with a new job. The presumption is that as time goes by and the mortgage payments go up, the mortgagor will be earning more and be in a better position to make the higher payments, They would be able to qualify for a higher loan amount if the initial payments are lower. In qualifying for a mortgage amount, most lenders will loan up a certain percent of a person's income - generally in the range of 25% to 35%, depending on other factors.

An adjustable-rate mortgages (ARM) is defined as:

"A debt secured by real property with an interest rate that may move up or down following a specified schedule or in accordance with the movements of a standard or index to which the interest rate is tied." Adjustable-rate mortgages started up in the 1980s as another reaction against high interest rates. ARMs start at a lower initial rate than fixed rate mortgages. However, they can go up if key indicators, such as the cost of living, rise. They may have overall caps that they cannot exceed. For example, a 6% loan may have a cap of 10% -- it can never exceed that over the life of the loan. Some also have a yearly cap. For example, they could never increase more than 1% in any given year.

A first mortgage is

"A mortgage that has priority over all other mortgage liens on a property."

Points

Basic Appraisal Principles Help Documents Email Instructor NOTESCONTACT CUSTOMER SERVICE Ch. 11 - Sources of Capital and Financing Pg. 20 - Points Hide Media AUTOPLAY ON 02:4104:03 spaceplay / pause qunload | stop ffullscreen shift + ←→slower / faster (latest Chrome and Safari) ↑↓volume mmute ←→seek . seek to previous 12...6 seek to 10%, 20%, ...60% PROBLEMS PLAYING THE MEDIA? Leave a comment Points A point is one percent of the amount of a mortgage loan. Discount points are defined as: "A percentage of the loan amount that a lender charges a borrower for making a loan; may represent a payment for services rendered in issuing a loan or additional interest to the lender payable in advance; also called points. Each discount point is 1% of the original loan amount." Points are another example of creative financing that originated in the 1980s. The first time I heard of points was in regard to an FHA loan. Lenders started charging points, claiming that FHA loans were much more difficult and time-consuming to process and therefore they needed to be compensated by an additional processing fee. When interest rates ballooned in the 1980s, in many states they exceeded the usury limits that were written into laws or regulations. For example, a state may have decreed that it was usurious to charge more than 10% interest. When lenders felt they needed to charge a higher rate than the law would allow, they figured a way to do it within the confines of the law. It works out mathematically that if you charge 10% interest for a mortgage loan and then charge four points up front, it averages out to give the lender a yield in the range of 10.5% over the life of loan. So charging points became an accepted way to bump up the yield on conventional loans, above the stated interest rate (i.e., the "face rate").

Mortgages

Most homes in the United States are financed by a long-term loan secured by a mortgage on the property. A mortgage is defined as: "A pledge of a described property interest as collateral or security for the repayment of a loan under certain terms and conditions." Lenders are eager to offer loans secured with a mortgage, because homes provide very good security - unlike boats or airplanes, because they stay in one location, typically appreciate in value, and have long lives compared with most other assets. Mortgages come in a seemingly infinite variety but most common are conventional mortgages. A conventional loan is defined as: "A mortgage that is neither insured nor guaranteed by an agency of the federal government, although it may be privately insured." Many high loan-to-value conventional loans do have private mortgage insurance (PMI) covering the part of the loan that exceeds 80% LTV.

The Secondary Mortgage Market

The secondary mortgage market is defined as: "A market created by government and private agencies for the purchase and sale of existing mortgages, which provides greater liquidity for mortgages. In the United States, Fannie Mae, Freddie Mac, and Ginnie Mae are the principal operators in the secondary mortgage market." The Federal National Mortgage Association (FNMA) was created in 1938 to purchase FHA insured loans. It was felt that lenders would be more willing to originate long-term loans if they didn't have to hold them in their portfolio. Once lenders sold mortgages to FNMA, they could reinvest the funds by writing new mortgages. In 1948, FNMA began purchasing VA loans, and in 1970, it started purchasing conventional mortgages. In 1968, FNMA was split into two organizations: Fannie Mae; a federally chartered corporation owned by private shareholders Government National Mortgage Association (Ginnie Mae), a government agency under the oversight of the Department of Housing and Urban Development (HUD) Fannie Mae purchases single family and multifamily FHA, VA and conventional mortgages. The mortgages purchased from originators may be held in portfolio or may be securitized and sold to investors as mortgage-backed securities (MBS). Ginnie Mae guarantees securities that are backed by government-guaranteed or government-insured loans (e.g, VA, USDA, and FHA). Ginnie Mae also services a portfolio of mortgages owned by the federal government. Ginnie Mae does not purchase mortgage loans, hold a portfolio of loans, or sell mortgage-backed securities. Nevertheless, Ginnie Mae plays an important role in the secondary mortgage market. They provide a guarantee on mortgage-backed securities that are issued by approved issuers. Ginnie Mae is backed by the full faith and credit of the federal government. If the borrowers fail to perform on a loan, and the issuer of the MBS cannot pay the returns promised to the investor, Ginnie Mae will make the investor whole. In 1970, Congress created the Federal Home Loan Mortgage Corporation (Freddie Mac) to provide a secondary market for conventional mortgages, primarily for thrifts. Their initial funding came from the Federal Home Loan Bank, the central bank for thrifts. Historically, they have held little in portfolio; most of the time they purchase mortgages, package them, and sell them to investors.

A junior lien is defined as

"A lien placed on property after a previous lien has been made and recorded; a lien made subordinate to another by agreement; e.g., second and third mortgages; also called second lien or third lien."

A guaranteed mortgage is defined as

"A mortgage in which a party other than the borrower assures payment in the event of default, e.g., a VA-guaranteed mortgage or a SBA-guaranteed mortgage." An example of this type of mortgage is a loan that is guaranteed by the Veterans Administration (VA). In the event of a default, the VA would reimburse the lender for any losses.

Wrap-around Contracts

A "wrap-around contract" is a variation of seller financing, and offers buyers an alternative to a new mortgage from a financial institution. The seller keeps the existing mortgage on behalf of the buyer, plus lends additional money to cover the price paid above the balance of the underlying loan. As an example, let's say you are buying a home for $220,000, with a $20,000 down payment. The property has an existing mortgage with a balance of $120,000 at 5%. The best rate you can find is 8% for a new first mortgage. So it might make sense for you to convince the seller to loan you $200,000 at 7%, and have him continue to make the monthly payments on his current mortgage. It's essentially a win-win. The seller wins because he receives a 7% return on $80,000, plus he will make 2% on the $120,000 current mortgage balance. You win because you get a loan at a below-market rate, which means you would have a lower monthly payment. The difference between a wrap-around contract and a first mortgage scenario is that with a first mortgage, the original mortgage is paid off. With a wrap, it is not. Interest in wrapping assumable loans increases when market interest rates begin to rise. Sellers feel a powerful incentive. Not only do they acquire a high-yielding investment, but they can often get a higher price for their house. Buyers, in turn, are drawn to lower-than-market interest rates. But the attractive return also comes at a significant risk - for both parties. If the buyer is late making payments (or stops paying entirely), the seller still has to make his or her payments. And if market values drop, the buyer has little incentive in maintaining the property, since he has so little equity at stake. If a comparable property is sold with this type of financing, the appraiser must evaluate the actual terms of the financing to determine if an adjustment for financing terms needs to be made.

Balloon Mortgage

A balloon mortgage is defined as "A mortgage that is not fully amortized at maturity, and thus requires a lump sum, or balloon, payment of the outstanding balance." This is another example of the "creative financing" that grew up in the 1970s and 1980s. In periods of rising interest rates, lenders were reluctant to lock themselves in for long periods of 10 or 30 years with fixed rate mortgages. They were more amenable with shorter term loans. However, to keep the payments affordable, they might write a loan based on a 30-year payout schedule but require that the loan be called at the end of five years with the remaining balance due in a lump sum or "balloon." I remember having to take out a loan in the early 1980s to buy a house. The best rate I could find was a 15% loan with a five-year balloon. Fortunately, I was able to refinance the loan four years later and cut my interest rate to "only" 12%.

Amortization - ARMs

Adjustable-rate mortgages were popular in the early 1980s, and became less popular in the late 1990s as interest rates fell. Interestingly enough, ARMs made a comeback in the mid-2000s, particularly in the subprime mortgage market. Take a look at the chart below. In every year, the average rate for ARMs is less than for the fixed rate loans. In some years, such as in 1985, there was a wide spread between the rates. In other years, such as 2000, the spread was only about one point. Back in 1984, ARMs captured 61% of the market, whereas in 2001 they only accounted for 12% of the market. The market share from year to year depends on factors such as current interest rates, supply and demand, and forecasts of future interest rates and actions of the Federal Reserve Board. The use of ARMs in the subprime market in the mid 2000s led to a significant increase in foreclosures when the rates reset. Exotic products like "2/28" ARMs were common, in which the interest rate was low for the first two years and then the rate would be adjusted periodically thereafter, based on an index. When these interest rates began to reset higher in the late 2000s, the increased payment amounts, coupled with the effects of an economic recession and diminishing equity for most owners, resulted in record numbers of defaults and foreclosures. These types of ARMs became known as "exploding ARMs" because the payments could increase 10%, 20%, or more at a time, leading to financial catastrophe for the borrower. The ARM share of the market settled to a low of 3% in 2009, and has remained stable at approximately 5% in 2011 and 2012 according to the Mortgage Bankers' Association (MBA). According to Black Knight Financial Services (BKFS), the percentage of new loans that were ARMs increased to approximately 10% in 2014, then decreased to 8% in 2015, and continued to decline to approximately 4% at the beginning of 2017. BKFS opines that as interest rates increase, the percentage of new ARM loans will also increase.

Seller-Financed Contract for Deed Sales and Deeds of Trust

Another way that buyers and sellers get creative is to write a contract where the seller receives regular payments from the buyer. In essence, the seller is acting as a bank for the buyer, i.e., the seller is providing the financing. The title to the property is only transferred when the contract price has been paid in full. Often a seller will offer this type of financing when mortgage rates are high, or if the property being sold is unique and difficult to finance, or when the seller is not in immediate need of money. The seller can often receive a higher interest rate than available elsewhere and in some cases part of capital gains taxes can be deferred and be paid as the payments are received over time instead of paying all capital gains taxes the year of the sale. If the buyer defaults on the payments and the seller needs to take back the property, this type of sale generally requires court action for a foreclosure. In some states, the seller in an installment sale can actually sign a warranty deed, and the buyer can sign a quitclaim deed, as part of the installment sale contract and have the deeds held in an escrow account. The contract for deed would contain the stipulation that the executed warranty deed be delivered to the buyer when the installment contract is paid in full but the quitclaim deed be recorded if there is a default in the installment loan payments, making the need for foreclosure court action unnecessary.

Where did the money come from? If banks wanted to loan out funds for mortgages, the sources were limited to:

Depositors Sale of stock or shares of ownership in the bank or thrift Repayment of existing mortgages Borrowing of funds from the Federal Reserve Lenders were regulated, had limits on the number of branches, and had reserve requirements. If they had a deposit reserve requirement of 10% and they were a $10 million bank; once they lent out $9 million, they were out of the lending business. They had to wait to replenish the money supply as money slowly trickled in from deposits and from repayment of existing loans. Money could be borrowed from the Federal Reserve Bank, if the rates were favorable.

mortgage (capital ) source history

From the 1930s through the 1960s, mortgage lending was done primarily at the local level. If you wanted a mortgage, you went to the local bank or thrift and filed an application. A bank officer might drive by your house, and they would check your employment record. Decisions on lending were usually made by the board of directors or loan committee of the lending institution at their weekly meeting. Formal appraising and underwriting, as we know it today, was not part of the process. After the closing, they would put the papers in a drawer and hold the mortgage "in house."

Reverse Annuity Mortgages

Help Documents Email Instructor NOTESCONTACT CUSTOMER SERVICE Ch. 11 - Sources of Capital and Financing Pg. 19 - Reverse Annuity Mortgages Hide Media AUTOPLAY ON 00:3704:03 spaceplay / pause qunload | stop ffullscreen shift + ←→slower / faster (latest Chrome and Safari) ↑↓volume mmute ←→seek . seek to previous 12...6 seek to 10%, 20%, ...60% PROBLEMS PLAYING THE MEDIA? Leave a comment Reverse Annuity Mortgages Let's say your elderly Aunt Agnes has a large amount of equity in her home, which she paid off decades ago. But she has little or nothing to live on besides Social Security. She also does not want to sell her home to access the equity in it. She might want to take out what is called a reverse mortgage. They are defined as: "A type of mortgage whereby age-qualified homeowners systematically borrow against the equity in their homes, receiving regular (usually monthly) payments from the lender. Borrowed funds and accrued interest come due when the last surviving borrower dies or permanently vacates the premises. Under current HUD guidelines, all of the mortgagors must be at least 62 years of age. When the loan is due, the estate usually has approximately twelve months to repay the balance of the reverse mortgage or sell the home to pay off the loan amount. All remaining equity is paid to the vacating homeowner or the estate. An FHA insurance program ensures that the vacating homeowner or estate is not liable if the loan balance exceeds the value of the home at the time the loan is due. Also called a reverse-annuity mortgage or home equity conversion mortgage." FHA-insured reverse mortgages have become popular throughout the United States. They can give older Americans greater financial security to supplement a fixed income, meet unexpected medical expenses, make home improvements, and more. FHA calls these Home Equity Conversion Mortgage, or HECMs. Aunt Agnes might decide to borrow $100,000 for 20 years on her home, which is currently worth $200,000. Instead of getting the money all at once, she would receive it in monthly installments. When she dies, her house is sold and the remaining mortgage (plus any accrued interest) is paid off. Her estate receives the balance. Hopefully, her house will have appreciated since she took out the mortgage, possibly even at the same rate as her interest or even higher, basically allowing her to live off the appreciation while she is still alive.

Importance and growth of secondary mortgage market

Over the last 30 years or so, the secondary market has grown tremendously in importance and has revolutionized the mortgage lending process. Annual sales of mortgages to Fannie Mae and Freddie Mac rose from $69 billion in 1980 to over $700 billion by 2000. Fannie Mae and Freddie Mac were private shareholder-owned corporations, but were known as "government-sponsored enterprises", or GSEs. Of course, it hasn't always been smooth sailing. In the early 2000s, Fannie and Freddie became embroiled in controversies regarding their accounting practices, and there were unsuccessful attempts to reform them. Then, the economic recession and the subprime mortgage meltdown of the late 2000s hit, and Fannie and Freddie teetered on the brink of collapse. Considered by many as "too big to fail", the twin mortgage giants were taken into government conservatorship in 2008, where they remain today. Their stock became virtually worthless overnight, and they were de-listed from the New York Stock Exchange as a result. Their stock can still be purchased over-the-counter (OTC), which simply means the purchase is made on a dealer network and not on a centralized exchange. Today, Fannie and Freddie continue to operate under the watchful eye of their government overseer, the Federal Housing Finance Agency (FHFA). They still purchase a majority of the mortgage loans originated in the U.S. Nevertheless, their future is uncertain; there are some within the federal government who want them to continue to operate, while others believe they should be wound down and closed.

Mortgage Priorities

Priorities are an important consideration. If there are second or third mortgages on a property, they carry a higher risk and therefore, typically a higher interest rate. In the event of a foreclosure because of default on the first mortgage, the junior liens don't get paid off unless and until the first mortgage gets paid. For example, let's assume there is a first mortgage of $100,000, a second mortgage of $20,000, and a third mortgage of $10,000. The borrower defaults and the property is foreclosed. Scenario 1: The property is sold at foreclosure for $130,000. Each mortgage gets paid in full. Scenario 2: The property is sold for $125,000. The first mortgagee gets paid in full - $100,000. The second mortgagee gets paid in full - $20,000. There is only $5,000 left and that would go to the next in line, the third mortgagee. Scenario 3: The property is sold for $110,000. The first mortgagee gets $100,000 and the remaining $10,000 goes to the second mortgagee. The third mortgagee is out of luck. Scenario 4: The property sells for $90,000. The entire $90,000 goes to the first mortgagee and the other two are left holding the bag. NOTE: Of course, if a property goes into foreclosure, the junior lien holder can cure the default on the first mortgage and begin foreclosure on the junior lien. That way they can protect their security interest but they are still at risk if the property does not sell later for an amount required to cover both the first mortgage and the junior lien balance.

The Contract for Deed sale is different than a seller-financed Note and Trust Deed transaction which is permitted in many states

The Contract for Deed sale is different than a seller-financed Note and Trust Deed transaction which is permitted in many states. In a seller-financed Note and Trust Deed transaction, a seller is financing the sale for the buyer, just as in the Contract for Deed sale, except that in this case, the seller delivers a warranty deed and legal title is passed right away to the buyer and the seller holds a Deed of Trust on the property in the same manner as a third-party institutional lender. Where a Contract for Deed is a two-party document (buyer and seller), a Deed of Trust is a three-party document: lender, borrower, and trustee. If the buyer (borrower) defaults on the payments, the trustee can take action and foreclose on the property with a trustee's auction without the need for action by a court. This makes the foreclosure process in the case of a default by the buyer much easier. Both a Contract for Deed and a seller-financed Note and Trust Deed transaction are considered "Installment Sales" because the seller receives payments over time rather than all cash at the original closing of the sale. In the seller-financed Note and Trust Deed sale, the buyer receives legal title at the original closing of the purchase transaction, then begins making the payments on the installment sale. In the Contract for Deed, the buyer receives legal title after the last payment is made on the installment sale.

Amortization - Fixed Rate

There are many patterns that can be followed when amortizing a loan. A fixed rate mortgage(FRM) is defined as "A mortgage with an interest rate that does not vary over the life of the loan." This was the first kind developed and is still the most common type of amortization schedule. The payment is determined through the use of financial tables or a financial calculator (more on this later). The amount paid each month or each period is fixed in amount. However, the interest is paid first on the remaining balance and then the balance of the payment is applied to reduce the principal. Because the principal is reduced after each payment, that means there is less interest due on the next payment, which means that more and more of the payment goes to principal as the loan ages. The illustration below is, for purposes of simplicity, the breakdown of the first three monthly payments of a $100,000 mortgage at 10% interest for a 30-year period (360 months). The equal monthly payments for this loan would be $877.57. The first month's interest is calculated by multiplying $100,000 times 10% then dividing by 12 months. Notice how the interest portion goes down and the principal portion goes up just a little each month.

Mortgage Assumption

When mortgage rates are going up or in a state of flux, it may be attractive for a buyer to purchase a house and take over its existing mortgage, rather than getting a new one at a higher or less stable rate. This is called a mortgage assumption. All the mortgage obligations are then transferred to the qualified buyer. Some lenders permit their mortgages to be assumed, but many do not. In the past, properties with FHA and VA loans could be purchased "subject to" those loans, meaning the buyer could assume the loan without the express permission of the lender. However, that has changed. Today, FHA and VA loans may not be assumed by a buyer in this manner, and most conventional loans also prohibit assumptions. In the current market, a buyer purchasing a property and assuming the seller's existing mortgage without the lender's approval is very rare. Most fixed-rate loans carry "due-on-sale" clauses requiring that a mortgage be repaid in full if the property is sold. Due-on-sale prohibits a home purchaser from assuming a seller's existing mortgage without the lender's permission, or buying the property "subject to" the existing financing. If permission for a mortgage assumption is given, it will usually be at the current market rate. Assumptions are not as common as they once were, due to historic low interest rates that have been available over the last several years. However, if mortgage rates were to increase substantially, mortgage assumptions could make a comeback. If an assumption is possible, it may make a big difference in the total cost to the buyer, and will likely affect the price paid for the property. If a property was purchased with a mortgage assumption, an appraiser will need to determine whether or not the sale should be used as a comparable or if an adjustment might be needed for favorable financing terms.