Real Estate Finance: Chapter 8 Loan Terms and Note Payments

Adjustable-Rate Mortgage

(ARM) The interest rate is adjusted in accordance with a prearranged index. The ARM usually includes an annual interest rate cap to protect the borrower from volatile interest rate fluctuations. There usually is an overall interest rate cap over the entire term of the loan. Fannie Mae continually revises its ARM plans. These plans are designed to give the consumer the protective features they desire. Consider the following when selecting an adjustable-rate or variable-rate mortgage. -Adjustment Periods -Initial Rate -Note Rate -Qualifying Rate -Index -Margin -Interest Rate Caps -Payment Caps

Note Rate

(Calculated Rate) The adjusted rate, index plus margin, imposed from time to time at the adjustment period.

Graduated-Payment Mortgage

(GPM) A graduated-payment mortgage is designed with lower payments in the early year of a loan. These payments increase gradually until they are sufficient to amortize the loan fully. Buyers are able to obtain home loans with affordable payments while the lender earn the desired interest rate over the loan term. A GPM may specify less-than-interest-only early payments. This results in negative amortization or deferred interest, and the principal amount owed increases over time by the amount of the deficiency. As the monthly payments are increased each year the situation is reversed and the loan is amortized.

Construction Mortgage

(Interim Financing Agreement) A unique form of open-end mortgage. It's a loan to finance the costs of labor and materials as they are used during the course of constructing a new building. An interim mortgage usually covers the period from the commencement of a project until the loan is replaced by a more permanent form of financing at the completion of construction. This financial format is unique because the building pledged as part of the collateral for the loan is not in existence at that time that the mortgage is created. The value of the land is the only available collateral at the loan's inception, a condition that requires the lender to seek some form of extra protection. The procedure for protecting the lender is both logical and practical. Although the full amount to be loaned is committed at the start of construction, the funds are distributed in installments as the building progresses, not as a lump sum in advance. The outstanding loan balance is matched to the value of the collateral as it grows.

Open-End Mortgage

(Mortgage for Future Advances) Allows a borrower to secure additional funds from a lender under terms specified in the original mortgage. Thus, an open-end mortgage can advance funds to a mortgagor on an existing mortgage -- funds that, in many instances, represent the principal already paid by the borrower. This allows a mortgage to stay alive for a longer period of time and can in some cases save the borrower the time and of the expense of refinancing. The funds advanced by this process are repaid by either extending the term of the mortgage loan or increasing the monthly payments by the amount appropriate to maintain the original amortization schedule. The interest rate can also be adjusted accordingly, and appropriate fees can be charged. Open-end mortgages have become useful financial tools for single-family home loans. Mortgagors are allowed to borrow funds for personal property purchases made after the original loan is recorded. These amounts are added to the principal owed, and the payments are increased to accommodate the new balance. If the personal property becomes part of the loans' collateral, along with the real property, the open-end mortgage is converted into a package mortgage. Open-end mortgages are often used by farmers to raise funds to meet their seasonal operating expenses. Similarly, builders use the open-end mortgage for their construction loans in which advances are made periodically while the building is being completed. Many private loan companies are offering customers an opportunity to draw down on a line of credit backed by the collateral of their home equity. A basic legal problem associated with open-end financing is one of securing future advances under an already existing debt instrument and, at the same time, preserving its priority against any possible intervening liens. In most states an obligatory future advance under the terms of an existing mortgage is interpreted as having priority over intervening liens. For example, an advance made under a construction mortgage that sets forth a specific pattern of draws is interpreted to have priority over a construction (mechanic's) lien that may have been filed in the period prior to the last advance. Nonobligatory future advances don't have priority over intervening liens, according to most state laws. The legal security of the advances to be made in the future under an already existing mortgage may not be enforceable against debts incurred by a borrower in the intervening time period. If the terms of a mortgage don't obligate a mortgage to make specific future advances, the mortgages is well advised to protect the priority of the lien by searching the record for intervening liens prior to making any advances. Prevailing practice doesn't require a title search, but merely binds a mortgage to any liens of which there has been outside notice. A few states require a title search and actually reduce the mortgagee to a junior position against any recorded intervening liens. A search of the records can only be to the advantage of the original mortgagee. Under the laws of those states that have adopted the Uniform Commercial Code, any personal property security agreements for the purchase of goods that become fixtures on the collateral property have a priority lien over future advances made under an original mortgage. Suppose a homeowner signs a financing contract with the ABC Appliance Company to purchase and install central air-conditioning system in June, and the agreement is recorded. In December the owners secure an advance on their open-end mortgage to build an addition to their home. Because the central air-conditioning system is now a fixture, the appliance company's lien will take priority over any future advances made by the original mortgagee. Not all states allow open-end mortgages. Texas doesn't allow open-end mortgages or line of credit loans for residential properties under their Home Equity Loan Legislation.

Reverse Annuity Mortgage

(RAM) This plan is based on a borrower's ability to capitalize on accumulated equity and is designed to enhance the income of the elderly. Many senior citizens own their homes free and clear but often face the problem that their incomes are fixed and relatively low. The reverse annuity mortgage (RAM) allows them to utilize their equities, with the lender paying the borrower a fixed annuity. The property is pledged as collateral to a lender, who may provide funds to the borrower in one of the following 3 ways: 1. Regular monthly checks to the borrower until a stipulated balance has been achieved with no cash payment of interest involved. The increase in the loan balance each month represents the cash advanced, plus interest on the outstanding balance. 2. An initial lump-sum payment. 3. A line of credit on which checks may be drawn. When the maximum loan amount is reached, the borrower is obligated to start repayment. In some cases this requires the sale of the property. Under the HUD reverse mortgage program, known as the Home Equity Conversion Mortgage (HECM), the monthly payments continue for as long as the borrowers live in the home with no repayment required until the property is sold. Any remaining value is distributed to the homeowners or their survivors. If there is any shortfall, HUD pays the lender. The size of the reverse mortgage loan is determined by several factors: 1. The age of the borrower (Must be at least 62) 2. The interest rate 3. The value of the property. There are no asset or income limitations on the HUD RAM. HUD will insure loans taken out by owners 62-years of age or older and offers 3-mortgage plans: 1. A tenure mortgage, under which the lender makes monthly payments as long as the owner occupies the residence. 2. A term mortgage, under which the payments are made for a specific number of years. 3. A line-of-credit mortgage, under which the owner can draw against the credit as long as the cumulative draws plus accrued interest are less than the principal loan limit. Ex. Consider Sam and Sarah Jones who are both in their late 70s. They have lived in their home for 35 years and paid off the original mortgage loan many years ago. Unfortunately, Sam's health has been deteriorating over the past 2-years and he is no longer able to tend his rather extensive garden. The garden not only provided Sam with a greater deal of pleasure but it provided an extra source of income during the spring and summer months. Sarah has been famous for years for her scrumptious baked goods. During the long winter months she filled the house with the smells of her breads and muffins, which she delivered to local restaurants in exchange for cash to supplement their Social Security checks. Although Sam's condition doesn't require him to be hospitalized, he can't work in the garden anymore, nor can he deliver Sarah's baked goods to the restaurants. In fact, Sarah finds that with the additional care Sam needs, she really doesn't have the time (or the energy) to spend long hours in the kitchen baking. The loss of this additional income has made it very difficult for the Joneses. They realize, sadly, they will probably have to sell their home of 35 years and move into a small apartment. Is there a better solution for Sam and Sarah? Fortunately, Sam noticed an article in the AARP Modern Maturity magazine about the benefits of a reverse annuity mortgage (RAM). He contacted a local lender and learned that under this plan, the Joneses will be able to secure a mortgage on the house where the bank sends them a check every month. The loan will be repaid when the property is eventually sold, the Joneses will have enough cash to meet their monthly expenses, and -- most important -- Sam and Sarah can stay in the home they love!

Term Loan

(Straight Loan) (Bullet Loan) Requires payments of interest only with the entire principal being repaid at a specified time, called stop date. The loan is then paid in full with a balloon payment of the principal plus any interest still owed. Ex. Consider a term loan of $10,000 at 8% per annum, payable interest only monthly, to be paid in full in 3-years. $10,000 Loan Amount x 0.08 Interest Rate = 800 Annual Interest ÷ 12 Pro Rata Months = 66.66 Monthly Interest Payment 10,000 Final Principal Payment $10,066.66 Balloon Payment

Initial Rate

(Teaser Rate) It will always be below the market rate in order to attract borrowers to this type of loan.

Qualifying Rate

Because ARM interest rates fluctuate from time to time, the rate at which to qualify a borrower often creates problems. If the initial loan rate is low but is expected to increase in the near future, the borrower may not be able to make the higher payments. Freddie Mac has an underwriting rule concerning the method by which borrowers can qualify for an ARM. Those with less than 20% down payment must qualify at the maximum second-year rate. All interest rate adjustments on the loan will be made from the initial loan rate. Borrowers should be cautious about incentives offered by some lenders. Lenders sometimes advertise below-market rates for a limited time period. At the end of the initial period, the interest rate is automatically increased. Ex. An initial rate of 5% results in monthly payments of $429.46 on an $80,000, 3-year loan, but payments will increase to $702.06 at 10%.

Margin

Each lender adds a certain margin percentage amount to the index at every adjustment period to derive the new rate. Individual lenders set different margins based on their estimated expenses and profit goals. Fannie Mae's interest rate adjustment for its ARMs fall between 1.5 and 3%, depending on the market. An initial rate of 6% will increase to 9% with an index adjustment of 1% and a margin of 2%.

Fannie Mae Senior Housing Opportunities Program

Fannie Mae has a special program available to Americans 62-years old or older that offers four financing options: 1. An accessory apartment, which is a private living unit in a single-family home, allowing independence and privacy with an assurance of help nearby. 2. A cottage housing opportunity, which is a separate, self-contained unit built on the lot of an existing home, generally the home of a relative, offering privacy and proximity. 3. Home sharing within a single-family home converted into up to four living units according to Fannie Mae standards. 4. A sale-leaseback arrangement allowing a senior the opportunity to sell the home to an investor, perhaps a member of the family and then lease it back. To qualify, a regular salary is not essential, but income from part-time work, pensions, Social Security, interest, dividends, and other sources must be sufficient to meet Fannie Mae's usual requirements. The monthly mortgage payments must not exceed 28% of the borrower's monthly gross income and the borrower's total debt, including monthly payments, may not exceed 36% of the gross income.

Fannie Mae's Two-Step Mortgage Plan

Fannie Mae, in its continual efforts to introduce new products to enhance its activities, has available a 2-step mortgage, a hybrid between a fixed-rate and an adjustable-rate loan. The 2-step requires a 10% down payment and offers interest rates at least 3/8 of 1% lower than the market rates for a 30-year fixed-rate loan. The lower rate remains in effect for seven years and is then adjusted automatically once for the balance of the loan period. The new rate is based on the 10-year Treasury bond rate but has a maximum 6% cap. No additional fees are charged when the 2-step is converted.

*Interest

From a borrower's point of view, interest can be described as rent paid for the use of money. A lender views interest as money received or earned from a loan investment. Just as rent is paid and received for the use of an apartment, house, office, or store under the process by which interest and principal are paid and received under the terms and conditions of a loan agreement. Money is borrowed (leased) at a certain interest rate (rent) for a specific time period during which the amount borrowed is repaid. The amount of rent that a landlord can charge for the use of property depends on the rental market for that particular type of real estate. Similarly, the rate of interest that a lender can charge depends on the money market as it affects that particular type of loan. A rational borrower will not pay a lender more interest than the lowest interest rate available on a specific loan at a particular time.

*Variations in Payments and Interest Rates

In a fixed-rate mortgage instrument two basic characteristics don't change throughout the life of the loan: the interest rate and the repayment term. In addition to the principal and interest, the lender often collects monthly amounts needed to pay annual taxes and insurance. These amount, referred to as impound funds or escrow funds, are determined by dividing the total amounts due each year by 12. Although the principal plus interest payment remains constant over the life of the loan, the amount needed to pay the taxes and insurance may vary, resulting in a change in the total monthly payment. The accrued interest due on the loan is always paid first, with the balance of the payment allocated to principal, taxes, and insurance accordingly. The result of this payment format is that the borrower begins to build equity with the first monthly payment. Traditionally most loans are fairly standard in the payment schedules, requiring a certain sum to be paid at regular intervals over a prescribed time period. Some real estate loans are designed to vary the required payments and interest to reflect more accurately the financial capabilities of a borrower, as well as the current state of the economy. These alternative mortgage instruments allow a lender's return to keep pace with prevailing interest rates while simultaneously providing a borrower the opportunity to qualify for larger mortgage amounts.

*Innovative Payment Plans

In addition to varying the payments and interest in a real estate loan, alternative types of loans can be arranged to satisfy the borrower's specific needs. The following are a few popular alternative loan plans: 1. The 15-Year Mortgage 2. Reverse Annuity Mortgage (RAM) 3. Fannie Mae Senior Housing Opportunities Program 4. Fannie Mae's Two-Step Mortgage Plan

Distribution of Principal and Interest

Intrinsic in the amortization design is the distribution of the level payments into proportionate amounts of principal and interest. Ex. Consider the $90,000 loan at 7% interest for 30-years with a monthly principal and interest payment of $599.40. Payment # - Balance - Interest - Principal 1 - $90,000 - $525.00 - $74.40 2 - 89,925.60 - 524.57 - 74.83 3 - 89,850.77 - 524.13 - 75.27 4 - 89,775.50 - 523.69 - 75.71 5 - 89,699.79 - 523.25 - 76.15 etc. to 360 The schedule in the example can be extended for the full period of 360 months to show the complete distribution of principal and interest and the remaining balance of the loan at any time. These amortization schedules can be prepared on computer printouts and are often presented by lenders to borrowers so they can follow the progress of their payments.

Simple Interest

Most real estate loans are established at a simple rate of interest. Simple interest is rent that is paid only for the amount of principal still owed. When money is repaid to the lender, rent for that money stops. The formula for computing simple interest is: I = PRT Where: I = Interest P = Principal R = Rate T = Time Ex. Using this formula, the interest rate on a $1,000 loan to be repaid in one year 8% is $80. I = PRT I = $1,000 x 0.08 x 1 I = $80 This simple interest formula is incorporated into the following: -Term loan -Amortization

Interest Rate Caps

Most variable rate loans include an annual cap applied to the adjusted interest rate. This cap limits interest rate increases or decreases over a stated period of time and varies from lender to lender and ranges from 1 to 2 percentage points per year. Some lenders also include a life-of-the-loan interest cap ranging up to 6%. This combination of caps provides the borrower protection against debilitating payment increases.

Intro

Real estate loans can be as flexible and adaptable as needed to satisfy market demands. Contemporary financing techniques offer an opportunity to provide for most contingencies by varying one or more of the 3-basic characteristics of a real estate loan -- the principal amount, the interest rate, and the payment schedule. Each loan lends itself to a number of variations, limited only by the imaginations of those involved.

Payment Caps

Some lenders will use annual payment caps instead of interest rate caps. The most common payment cap is 7.5% of the initial payment. This is equivalent to 1% change in the interest rate. This means a payment of $750 per month, principal and interest, could not vary up or down more than $56.25 per month in one year's time. These payments caps are also combined with life-of-the-loan caps in some plans. Most variable-rate loans don't need to include a prepayment penalty. Without this penalty, a borrower can more easily refinance to a fixed rate mortgage. Some lenders also include a convertible loan feature that allows a variable-rate loan to be changed to a fixed-rate loan after the initial adjustment periods have been completed. All ARM originations from federally insured lending institutions must comply with disclosure regulations. Under an amendment to Regulation Z, the borrower must receive: 1. A descriptive ARM brochure 2. Details of the specific loan program 3. An illustrative example, based on a $10,000 loan, showing how the payments and loan balance have been affected by historical changes in the index.

The 15-Year Mortgage

The 15-year mortgage has become very popular. It constitutes about 33% of Freddie Mac's loan portfolio. The attraction of this relatively short-term real estate loan is the amount of interest that can be saved when compared with a 30-year loan. The major inhibiting quality of the 15-year loan is the higher amount required for monthly principal and interest.

*Variations in Formats

The deed of trust, note and mortgage, and contract for deed are flexible and therefore adaptable to many situations by using creative design. Almost every realty financing contingency can be solved to the satisfaction of all the participants. Not only can specific terms and conditions be designed to meet particular requirements, but special forms of these three lending instruments can also be developed to finance unique real estate situations.

Index

The index is the starting point to adjust a borrower's applicable interest rate. Lenders must use an index that is readily available to the borrower but beyond the control of the lender. Some indexes are more volatile than others. Those most frequently used are: 1. The 6-month, 3-year, and 5-year Treasury rates 2. The Eleventh District Federal Home Loan Bank cost of funds 3. The national average contract interest rate on conventional home loans 4. The national median cost of funds to federally insured savings institutions 5. The new CD-ARMs by Fannie Mae tied to the average certificate of deposit interest rate 6. The London Interbank (LIBOR) interest rates

Amortization

The most common payment format for a real estate loan is a system of regular payments made over a specified period. These payments include portions for both principal and interest, the process is called amortization. Amortization tables are available that have the level monthly payments precalculated when the loan is established under a fixed rate of interest. To compute the monthly principal and interest, multiply the number of thousands in the loan by the appropriate factor. Ex. Consider a loan of $90,000 at 7% for 30-days. The monthly payment of principal and interest is $599.40. 90 Number of Thousands x 6.66 Payment Factor (from given table) = $599.40 Monthly Payment P&I Note that there may be a few pennies difference in various amortization tables due to rounding.

Adjustment Periods

This indicates the frequency of interest rate adjustments with concomitant payments. Ex. The interest of a 1-year ARM will change every year, while the interest of a 3-year ARM will change every 3-years.

Application and Requirements

To obtain a construction loan, the borrower submits plans and specifications for a building to be constructed on a specific site to a loan officer for analysis. Based on the total value of the land and the building to be constructed thereon, a lender will make a commitment for a construction loan, usually at the rate of 75% of the property's total value. Hence a $250,000 project would be eligible for a $187,500 construction loan. This amount normally would be adequate to cover most, if not all, of the cost of construction, with the $62,500, or 25% equity, representing the value of the free and clear lot. Construction mortgages usually are secured from financial institutions that normally require that the lot be lien-free in order to preserve the first priority position of the construction loan. In a case where the lot is encumbered by an existing mortgage or lease, the mortgagee or the landlord must subordinate that interest to the lien of the construction mortgage before the loan can be granted. Construction loans are available for projects of all sizes, from the smallest home to the largest shopping center, and the basic loan format is similar in each case. The charges imposed for securing construction loan are usually based on a one-time 1% placement fee paid at the loan's inception, plus interest at about two points above the prime rate charged to AAA-rated borrowers. Based on a prime rate of 6% and a 2% overcharge, a $187,500 construction loan would be placed for a front-end fee of $1,875 plus 8% interest on the funds disbursed from time to time. Interest rates and placement fee fluctuate as a function of business cycle, borrowers' credit ratings, and individual situations.