Finance - Chapter 6A
ELEMENTS OF ARM LOANS
-Index -Margin -Rate adjustment period -Interest rate cap (if any) -Negative amortization (if any) -Conversion option (if any)
2-1 BUYDOWN
A graduated payment buydown where the payments are lower for only two years. Need to get a quote from the lender. Rough estimate costs about 2.5 points.
MARGIN AKA Spread
A lender adds a margin to the index to ensure sufficient income for administrative expenses and profit. Generally remains fixed for the duration of the loan. Interest rates or other factors in the financial markets do not affect it. It benefits customers to shop around for a loan because margins can vary greatly from lender/lender.
ARM LOAN-TO-VALUE RATIOS (LTVs)
ARM loans with loans-to-value ratios (LTVs) of 80%, 90%, and 95% are available. Loans with higher LTVs are often subject to restrictions. Fannie May and Freddie Mac LTV ratios may not exceed 95%.
BUYDOWNS
Additional funds in the form of points paid to a lender at the beginning of a loan term to lower the interest rate and monthly payments.
INTEREST RATE CAP
Caps are limits. They protect a borrower from large interest rate increases. Both Fannie/Freddie and FHA/VA loans use guidelines to determine ARM interest rate caps
LIMITS ON SELLER-PAID POINTS: FHA
FHA guidelines also impose limits on discounts, buydowns, and other forms of seller contributions. Effective 2010 FHA allows maximum seller contribution of 6%
LIMITS ON SELLER-PAID POINTS: Fannie and Freddie
Fannie Mae and Freddie Mace guidelines limit discounts, buydowns, and other forms of seller contributions including finance costs such as prepaid interest, escrows for property taxes, hazard insurance, and mortgage insurance. Limits are placed to prevent buyers from acquiring property they can't afford. Contributions by sellers or other interested parties are limited to a percentage of the property's sale price or appraised value, whichever is less.
CONVERSION OPTION
In an ARM means the borrower has the right to convert from adjustable rate to a fixed rate mortgage. They typically include: -Higher interest rate -Limited time to convert -Conversion cost fee
TEASER RATES
Initial interest rates that are much lower than typical adjustable interest rates. Designed to entice borrowers to accept ARMs. What led the government to impose regulations
HOW ARMs WORK
Interest rate is determined initially by the cost of money. Three main elements of an ARM are: -Rate -Index -Margin Once the initial rate is set, it is tied to an index (a statistical report that is generally a reliable indicator of the approximate cost of money. (Prime rate) Margin is the difference between the index value and the interest rate charges on an ARM. Index + Margin = Adjustable Interest Rate Borrower Pays on the loan
ARM DISCLOSURES
Lenders must comply with federal guidelines under Regulation Z and the Truth in Lending Act. Disclosures must be provided to the borrower when the loan application is made or before payment of any non-refundable fees, whichever occurs first. Disclosures must be given at least 25 days in advance, but not more than 120, before a new payment level takes effect.
INDEX
Most lenders try to use an index that is responsive to economic fluctuations. The index should be one that is determined and affected by market conditions, and is regularly listed in a major publication.
DISCOUNT POINTS AKA Discounts or Points
Paid to a lender to make up the difference between the current market interest rate and the rate given to a borrower on a note. In other Words: By paying a one-time fee to a lender, a borrower gets a discount on the interest rate of the loan. -Points are computed only on the loan amount, not the sale price -Points can be combined with closing costs as fees charged to the buyer. A point is equal to 1% of the loan amount
ADJUSTABLE RATE MORTGAGES (ARMs)
Permit the lender to periodically adjust the interest rate so it reflects fluctuations in the cost of money. Why consider ARM? - When interest rates are high and they plan on not staying in home long (starter home)
PURPOSE OF NONTRADITIONAL FINANCING TOOLS
The HOUSING AND ECONOMIC RECOVERY ACT OF 2008 (HERA) was passed for several reasons, including the modernization of the Federal Housing Administration, foreclosure prevention, and the enhancement of consumer protection. When interest rates are too high or buyer's can't qualify for traditional financing, nontraditional financing tools are often used to lower a buyer's monthly payment and/or down payment or help them qualify in some other way.
RATE ADJUSTMENT PERIOD
The interval at which a borrower's interest rate changes with ARMs. Can range from monthly to ten years. Most common is every year.
ANNUAL PERCENTAGE RATE (APR)
The relationship between the cost of borrowing money and the total amount financed, represented as a percentage.
NEGATIVE AMORTIZATION
When a loan balance increases, rather than decreases, because payments don't cover interest on a loan. Most likely to occur when there are frequent rate changes and infrequent payment adjustments
TEMPORARY BYDOWN
When money is paid to a lender to reduce the interest rate and payments early in a loan, with both rising later.
PERMANENT BUYDOWN
When points are paid to a lender to reduce the interest rate and loan payments for the entire life of the loan. Lender will write that interest rate into the promissory note. CASE STUDY PAGE 127
BUYDOWN
When points are paid to reduce the buyer's interest rate
GRADUATED PAYMENT BUYDOWN
Where payment subsidies in the early years keep payments low. Payments increase each year until they're high enough to fully amortize the loan.Usually structured so the subsidy lasts only 2-3 years. Most popular is referred to as a 2-1 buydown.
Referring to the scenario above, if the seller agrees to pay the discounts points, how much will the seller net from the transaction? (assume seller pays no other costs)
a. $130,950 b. $135,000 c. $145,950 d. $150,000 ANSWER: C 150,000 - 4050 = 145,950
Quiz A borrower wants to buy a $150,000 home, and plans to make a $15,000 down payment. The borrower is seeking a conventional loan but doesn't want to pay more than 6.5%. The lender agrees to make a 6.5% interest loan if it is discounted three points. How much will the lender receive in points for making this loan?
a. $3,000 b. $4,050 c. $4,500 d. $8,775 ANSWER: B 150,000-15,000 = 135,000 x 1% = 1,350 x 3 = 4050
Quiz The Jones family is buying a home for $105,000 and it appraised for $102,000. On an $80,000 loan, six points is equal to
a. $4,800 b. $4,896 c. $6,120 d. $6,300 ANSWER: C
If the sale price of a home is $120,000, it appraises for $122,000, and the buyer takes out a loans for $96,000, the discount points charged by the lender are computed on:
a. $96,000 b. $114,000 c. $120,000 d. $122,000 ANSWER: A
A borrower secures a 5/1 ARM for $152,000. The initial interest rate is 4.5%, but after five years, the rate will go to the LIBOR index (currently at <1% plus 3% margin). The interest rate will be adjusted annually. Rate caps are 2% per year and 5% over the life of the loan. For the loan described above, what is the lowest rate the borrower would ever have?
a. 2% b. 2.5% c. 3% d. 4.5% **ANSWER: C The lowest rate this borrower would ever have would be the lender's margin, which is 3%
Quiz A borrower secures a 5/1 ARM for $152,000. The initial interest rate is 4.5%, but after five years, the rate will go to the LIBOR index (currently at <1% plus 3% margin). The interest rate will be adjusted annually. Rate caps are 2% per year and 5% over the life of the loan. What's the highest the rate can be at the beginning of the sixth year?
a. 4.5% b. 6.5% c. 8.5% d. 9.5% ANSWER: B
A borrower secures a 5/1 ARM for $152,000. The initial interest rate is 4.5%, but after five years, the rate will go to the LIBOR index (currently at <1% plus 3% margin). The interest rate will be adjusted annually. Rate caps are 2% per year and 5% over the life of the loan. For the loan described above, what is the highest rate the borrower would ever have?
a. 6.5% b. 7.5% c. 8.5% d. 9.5% ANSWER: D
The margin is the difference between the
a. APR and the cost-of-funds index (COFI) b. index value and the interest rate charged to the borrower c. value of the home and the amount borrowed d. none of the above **ANSWER: B
Typical "nontraditional financing programs" include
a. adjustable rate mortgages b. permanent buydowns c. temporary buydowns d. all of the above ANSWER: D
Adjustable rate mortgages
a. allow the lender to adjust the interest rate in accordance with a chosen index at specified intervals b. may cause mortgage payments to increase or decrease over time c. pass part of the risk of interest rate fluctuations from the lender to the buyer d. all of the above ANSWER: D
Quiz There may be a difference in interest rates among lenders who use the same index primarily because of the
a. commissions paid to real estate agents b. lender's stock value c. loan balance d. profit and/or the administrative expenses of the lender ANSWER: D
A permanent buydown plan can reduce the borrower's payments
a. early in the loan only, but will require a balloon payment at the end of the term b. for the entire life of the loan c. for the entire life of the loan, but with an automatic prepayment penalty d. through gradual payment decreases throughout the life of the loan. ANSWER: B
The advantages of a permanent buydown for borrowers include
a. easier qualifying standards b. lower monthly payments c. the possibility of qualifying for a larger loan d. all of the above ANSWER: D
Which is NOT an element of an ARM?
a. index b. margin c. positive amortization cap d. rate ANSWER: C
Quiz Negative amortization occurs when
a. interest rate adjustments occur more frequently than mortgage payment adjustments b. the interest rate rises but payments are lock at a low amount due to payment caps c. the loan balance grows from deferred interest b. all of the above. ANSWER: D
A borrower secures a 5/1 ARM for $152,000. The initial interest rate is 4.5%, but after five years, the rate will go to the LIBOR index (currently at <1% plus 3% margin). The interest rate will be adjusted annually. Rate caps are 2% per year and 5% over the life of the loan. For the loan described above, do you think that negative amortization is likely to occur?
a. yes b. no ANSWER: B No, since its rate will reset on its anniversary, which is annually