Real Estate and Consumer Lending

1. Real Estate and Consumer Lending • Outline • Residential real estate lending • Commercial real estate lending • Consumer lending • Real estate and consumer credit regulation

2. Real estate lending • Mortgage debt outstanding • Mortgage is a written conveyance of title to real property. Property is collateral for the loan. Loans for 1-4 family residences, commercial real estate, farm property, and multifamily residences. • Secondary mortgage market for securitizing loans tends to improve liquidity of residential mortgages and lessens cyclical disruptions in the housing market.

3. Residential real estate lending • Characteristics of residential mortgage loans • Down payment, or borrower’s equity, is a portion of the purchase price of the property a financial institution requires the mortgage borrower to pay up front. • A typical loan-to-price ratio is 80% e.g.) a person puts a down payment of $41,880 for a new home with a purchase price of $209,400.

4. While most home loans have maturities of up to 30 years, their average life is only 12 years due to prepayments due to refinancingand moving.

5. Some lenders require Private Mortgage Insurance (PMI) when the down payment is less than 20%. This insurance protects the lender in the event of default. • Default risk, declining values, and lack of liquidity are the principal risks associated with real estate lending. • Residential real estate is good collateral because it is durable, easy to identify, and cannot be moved in most cases.

6. Residential real estate lending • Types of residential mortgage loans Federally insured mortgages are originated by financial institutions, but repayment is guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA). FHA or VA mortgages require either a very low or zero down payment. Conventional mortgages are mortgages held by financial institutions and are not federally insured. Private insurance (PMI) on conventional mortgages can be obtained.

7. Fixed rate mortgages and adjustable rate mortgages (ARMs) -- fixed cash payments per month versus changes in payment terms that can fluctuate with movements in interest rates. • Rates for ARMs are commonly tied to the average T-Bill rate over the previous year. ARM payments increase when the index rate increases.

8. Find Monthly mortgage payment for a $1,000 mortgage loan at 6 percent interest for 10 years. • Because we are solving for a monthly payment, the number of payments over the 10 years is 120 (10 years x 12 months per year). Moreover, only one twelfth of the 6 percent annual interest rate (0.06/12 = 0.005) is charged each month.

9. The present value of the annuity is the $1,000 mortgage loan in this example. The monthly payment is $11.10. PV of annuity = PMT[1 - (1 + I)-n]/i = PMT[1 - ( 1 + 0.005)-n]/0.005 1,000 = PMT[1 - ( 1 + 0.005)-120]/0.005 PMT = $11.10 where PV = present value of the annuity, PMT = payment per period, i = interest rate per period, and n = number of periods.

10. Residential real estate lending • Types of residential mortgage loans • Adjustable rate mortgages Changes in monthly payments, term of the loan, and/or principal amount. Benchmark interest rate tied to an index (e.g., one-year Treasury Bill yield). Caps on how much the interest rate or monthly payment can change annually or over the term of the loan. Margin is the percentage points added to the index rate. Initial interest rates on ARMs lower than fixed rate mortgages. ARMs shift some of the interest rate risk to borrowers from lenders (banks). However, ARMs may have higher default risk to the bank.

11. 8.4 What factors affect monthly payments on a residential mortgage loan? Explain the effect of each factor. • ANSWER: The size of the loan, interest rate, and maturity are the principal factors. The first two factors are positively related to the size of the payments, while maturity is negatively. That is, large loans and high rates result in large monthly payment for a given maturity, while payments can be reduced by extending the maturity.

12. 8.2 What are the two basic types of 1–4 family residential mortgage loans. Which is the most widely used? Why? • ANSWER: Fixed-rate and adjustable rate. Fixed rate mortgages were more widely used in 1990s, but not in 1988. When interest rates are relatively low, borrowers then do favor locking-in fixed rates. ARMs have the advantage of benefiting from lower interest rates if and when they decline. Holders of fixed rate mortgages can always refinance their loans if it is cost efficient to do so. Conversely, ARMs have the disadvantage of increasing payments when rates increase.

13. What are the advantages and disadvantages of an ARM from the lender’s point of view? • ANSWER: An ARM allows lenders to maintain a positive spread between their cost of funds and returns on loans, if the repricing of the loans are done in a timely fashion. For example, if the repricing of loans is only done once a year, and interest rates (and cost of funds) change dramatically during the year, the lender’s may not be able too maintain their positive spread. Rate caps are another factor to consider. They to limit lenders ability to maintain a positive spread.

14. Discount points (or points): fees or payments made when a mortgage loan is issued. One discount point is one percent of the loan. For example, if the borrower pays 2 points up front on a $100,000 mortgage, he or she must pay $2,000 at the closing of the mortgage. While the mortgage principal is $100,000, the borrower effectively has received $98,000. In exchange for points paid up front, the financial institution reduces the interest rate used to determine the monthly payments on the mortgage. Points increase the effective interest rate.

15. 8.5 Why do lenders charge points on mortgage loans? • ANSWER: A point is one percent of the principal amount of the loan. Points are charged to increase the lender’s yield on the mortgage loan.

16. Residential real estate lending • Types of residential mortgage loans • Balloon mortgages require a fixed monthly interest payment for a three to five year period. Full payment of the mortgage principal (the balloon payment) is then required at the end of the period.

17. Graduated payment mortgages (GPMs) have fixed rates but with lower payments in early years and higher payments in later years. Good for younger homeowners whose income should rise over time. • Growing equity mortgages (GEMs) have increasing debt payments over time that reduces the principal balance faster than otherwise. In contrast to GPMs, which do not affect the time until the mortgage is paid off, the incremental increase in monthly payments on GEMs reduces the principal on the mortgage more quickly. This reduces the actual life of the mortgage.

18. Automatic rate-reduction mortgages: Mortgages in which the lender automatically lowers the rate on an existing mortgage when prevailing rates fall as a way of keeping their mortgage customers from refinancing their mortgages with another mortgage lender when mortgage rates fall. • Shared appreciation mortgages (SAMs) allow the lender to share in the growth of equity value in the home with the borrower in return for lower interest payments.

19. Reverse annuity mortgages (RAMs) A mortgage borrower receives regular payments from a lender rather than making them. When the RAM matures (or the borrower dies), the borrower (or the borrower’s estate) sells the property to retire the debt. Designed for retired people. • Second mortgages Loans secured by a piece of real estate already used to secure a first mortgage. Should a default occur, the second mortgage holder is paid only after the first mortgage is paid off. As a result, interest rates on second mortgages are higher than on first mortgages.

20. Home equity loans Loans that customers borrow on a line of credit secured with a second mortgage on their homes. The line of credit has more a flexible repayment schedule than the traditional second mortgage. Interest on all mortgages (first, second, and home equity) secured by residential real estate is tax deductible. Interest on other types of individual loans is not eligible for a tax reduction.