Why Do People Borrow Money?

1. Why Do People Borrow Money? • To enhance returns by using positive financial leverage. • To increase the scale of their investments. • To purchase assets such as real estate and business assets, for which they currently do not have enough money.

2. Financial leverage Margin trading Secured vs. unsecured debt Long-term vs. short-term debt Mortgage loan programs Other mortgage financing alternatives Refinance loans Mortgage (loan) math Mortgage and loan financial planning applications Fixed-rate versus adjustable-rate loans Determining how much home one can afford Leasing Topics Discussed in this Chapter

3. Financial Leverage • Financial leverage is the use of borrowed funds to supplement the investor’s own dollar investment (equity) to increase the scale of investment. • The keys to leverage are: • Lower interest rate on loan than return on the investment. (Difference is called the Spread.) • The ratio of borrowed funds to one’s own equity.

4. Leverage Multiplies Gains and Losses In a positive environment, leverage enhances return, BUT, leverage multiplies losses as well as gains. • Consider the person who buys a piece of property for $500,000, borrowing $400,000 on a 6% mortgage. • One year later, if property is worth $600,000, the buyer made $76,000 ($100,000 appreciation - $24,000 interest expense), for a 76% return on the $100,000 invested. • However, if the property’s value declined to $450,000, the buyer lost $50,000 +$24,000 interest, for a 74% loss on his or her $100,000 investment, even though the value of the property declined only 10%!

5. Margin Trading • Margin is borrowing against the market value of securities such as stocks or bonds. • The purpose is to enhance the return on investment by using financial leverage. • Example: If the margin interest rate is 7%, and you have a security that pays 10%, and you borrow 50% of the value (100,000) so that you can purchase more shares, • Then, next slide…

6. Example of Margin Trade • Buyer puts up $50,000 and borrows $50,000 on margin at 7% to buy $100,000 of stock. The investor holds the stock exactly one year, and the price does not change. • 10% of $100,000 = $10,000 income. • 7% on $50,000 borrowed = $3500 expense. • Net income to investor = $6500. • Return on investor $50,000 investment = 13%. Borrowing to invest gave the investor 30% greater return than if he or she had not used leverage.

7. Equity Requirements Vary Equity percentage requirements are set by the Federal Reserve: • Stocks listed on the NASDAQ or the NYSE generally require that the investor put up 50%. • U. S. Treasury bonds generally require an equity investment of 10%. • High-grade corporate bonds generally require 30% equity. Note: Investment firms often require more than the Federal Reserve minimums to protect their accounts.

8. Secured vs. Unsecured Debt • Unsecured debt does not have any collateral behind it; examples include credit cards, utility bills, and medical bills. • Secured debt is backed up by some form of collateral; examples include mortgage debt and most car loans. • A secured creditor is generally in a better position than an unsecured creditor because the secured creditor can take back the property.

9. Long-Term vs. Short-Term Debt • Short-term debt is generally any debt lasting from 90 days to up to 3 years; businesses may use short-term debt to cover accounts payable, pay salaries short-term, or provide for cash until receivables are paid. • Long-term debt is generally debt lasting longer than one to three years; generally used to purchase assets that are designed to be used for a longer period of time.

10. Mortgage Loan Programs Based on how the rate is set there are two types of mortgage : • Fixed Rate Mortgages. • Adjustable Rate Mortgages. Based on payment terms there are also two types: • Self-amortizing loans. • Balloon or interest-only mortgages.

11. Fixed Rate Mortgage • The interest rate is set at the time of the signing of the loan, and does not vary over the life of the loan. • For financial planning purposes, fixed rate loans are the best choice when current interest rates are low, and the buyer intends to hold the property for many years.

12. Features of Fixed Rate Mortgages • Very simple, but not very flexible. • Available terms are 5, 10, 15, etc. with 15 and 30 years the most popular. • Shorter loans usually have lower interest rates. • In times of falling interest rates, borrowers may need to refinance several times to take advantage of lower rates. Note: Most, but not all, states now have laws that specify that the borrower may pre-pay the mortgage without any penalty. Know the law for your state.

13. Adjustable rate mortgages • The interest rate varies with the market. • Rate based on a formula. • Typically, the rate will be tied to an index such as the Prime Rate or LIBOR. • Possibly a cap on how high the rate can go. • Possibly a floor on how low it can go.

14. ARM Advantages • For short term purchases (3 years or less). • Initial rate is usually lower than rates on fixed loans. • May have a provision that allows conversion to a fixed rate loan. • Attractive when interest rates are high. • Lenders will sometimes give a free or low-cost refinance to a fixed loan when interest rates fall.

15. ARM Loan Details • ARM periods • Index and margin • Caps • Negative amortization • Conversion option • Adjustment Process

16. ARM periods • The period is the span of time that a lender must wait before it can readjust the interest rate of the ARM loan. • Can range from one month to several years. • One-year ARM periods are the most common. • Shorter ARM periods usually imply a lower interest rate.

17. Standard ARM Periods

18. Balloon or Two-step ARM Programs

19. Index and Margin • The ARM agreement specifies how interest rate is to be adjusted by a formula -- usually an index plus a margin. • The Index is based on rates of securities, financial papers, or a basket of indicators that adequately reflect market conditions. • The Margin is a constant amount that is added to the Index to determine the new interest rate. • For conforming loans, the usual margin is 2.75% to 3.25%

20. Common Indexes • U.S. Treasury Bills - usually the one year rate. • Prime rate – The prime rate is the rate that banks charge to their best customers, usually commercial. • Cost-of-Funds index (COFI) – The COFI index is calculated by each of the Federal Reserves' regional districts, the most popular of which is the 11th District. The Cost-of-Funds index is a monthly survey of the cost to the banks of the money they have at their disposal. • London InterBank Offered Rate (LIBOR) – The LIBOR index has become the index of choice for non-conforming lenders, especially with sub-prime (B/C/D/E) credit loans. The LIBOR rate tends to remain close to – though slightly higher – than the T-Bill rate.

21. Caps • Caps restrict the amount that the lender can change the rate on the specified anniversary date and thus protect the borrower from unforeseen rises in rate and payments. • If the Index moves too far, the maximum that the borrower’s rate can move is determined by the cap.

22. Types of Caps • Periodic cap • Lifetime Cap • Payment cap • Principal cap Note that the payment cap can induce negative amortization. The principal cap limits the amount that the principal of the loan can increase by negative amortization.

23. Negative Amortization • Negative amortization occurs when the payment cap on a loan keeps the payment from covering the interest for that month. • The deficit can be added to the loan’s principal. • A principal cap can keep negative amortization from raising the principal due beyond a certain level. • Loans on which negative amortization is possible are usually offered at very low introductory rates.

24. Conversion option • Allows the borrower to convert from an ARM to a fixed rate mortgage without refinancing, a new title search, etc. • Usually must be exercised in the 2nd -5th year. • Lender will charge a small administrative fee. • Fixed rate will depend upon the market at the time of conversion. • It is not a refinance, as it is still the original mortgage.

25. Adjustment Process • Amortization is refigured each time the interest rate is adjusted. • The amortization usually is until the original maturity date. • Amount of payment can rise or fall. • Negative amortization may be converted into a balloon payment at end of loan.

26. Disadvantages of ARMs • Payment may increase because of adjustment. • Low teaser introductory rates almost assure that the payment will increase. • Mortgage insurance on an ARM is slightly more costly than on a fixed rate loan.

27. Home Equity Line of Credit (HELOC) • Financial Planning Tool: • Excellent safety net for the homeowner. • Funds available immediately in emergency situation. • Investment Tool • Instant liquidity allows investors to seize an opportunity without a lengthy loan application process.* • No interest is charged until the line of credit is used. This makes it a low cost option. * See http://www.reiclub.com/articles/heloc-purchase-properties

28. How the HELOC Works • The borrower establishes a line of credit with a lender. • The line of credit can be used like a checking account. • It is a second mortgage, and the closing costs will be the same as any other mortgage. • If the borrower does not use the credit, there will be no interest charged.

29. HELOC Features • Cost • No interest cost unless credit line is used. • Initial fee, plus closing costs. • Account maintenance fee. • Two phases: • Revolving. • Amortized. • Most are ARMs.

30. Balloon Loans • The balloon mortgage loan is an installment note whose amortization is longer than its term. The remaining principal is due in total at the maturity of the mortgage. • Is used to keep initial payments low. • ARMS that are 5/1 and 7/1 have largely replaced the Balloon Loan for residential loans. • Most commercial loans are balloon loans.

31. Advantages and Disadvantages of Balloon Notes to the Borrower • Shorter Term: • Shorter term Less risk to lender Lower interest rate. • Longer amortization: • Lower payment required. • Fixed rate during the term. • Main disadvantage is that the balloon note may require a larger down payment than a comparable 30 year fixed loan (At least 10%).

32. How a Balloon Loan Works • Payments are computed on a 30 year fixed loan basis or even on interest only. • After the term ends (typically 5 or 7 years) the homeowner still has a very large principal still due. • At that point, the homeowner has to either come up with the cash to pay the loan or refinance, unless a conversion option is built into the loan.

33. Amortization of Balloon Loans • Two-step balloons • Most typical are the 5/25 balloon and the 7/23 balloon. • At the end of the first time period, the balloon can be converted into a fixed rate 30 year loan. • Balloon ARMs: • Start with a fixed rate. • Convert to an ARM. • Interest-only balloons: • Principal due never goes down. • Low payment.

34. Buy-Down Programs – “Points” Buy-down programs reduce the interest rate through prepayment of the loan's interest. The prepayment is called “points”, with one point being equal to 1 per cent of the total loan. • Permanent Buy-Downs: • Reduces the interest for the life of the loan. • Generally takes 5 or more years to recoup the points, so should not be used by homeowners who intend to stay in their home for less than 5-7 years. • Temporary Buy-Downs: • Only lower the interest rate for a few years. • Buyer can qualify for a larger home, but must show that higher income is expected in the future. • Generally the fixed rate is higher than it would be on a conventional mortgage.

35. Construction Loans Loans made to finance construction of a new property have different characteristics. Look at four main elements: • Loan commitment. • Rate lock. • Method of disbursement. • Lower LTV ratio limits.

36. Jumbo Loans • A Jumbo loan is one that exceeds the conforming loan limits. • Conforming Loan Limits: • Set by Fannie Mae and Freddie Mac based on current market prices • For 2007, for conventional mortgages (those which may be purchased from local lenders by national organizations such as Fannie Mae and Freddie Mac, the loan limits for owner-occupied properties are: • One-unit properties: $417,000. • Two-unit properties: $533,850. • Three-unit properties: $645,300. • Four-unit properties: $801,450. • For properties in Alaska, Hawaii, Guam, and the U.S. Virgin Islands, the loan limits are 50 percent higher.

37. Jumbo Loans without Jumbo Pricing • Jumbo loans usually have a higher interest rate than conforming loans. To lower the interest rate, • Make larger down payment to bring the mortgage balance down to conforming limit. • Use two loans: a conforming first mortgage and a second mortgage.

38. No Income Verification (NIV) Loans • Applicable Situations: • Self employment. • Recent job change. • Uneven income such as commissioned employees. • Income claimed must be within reason. • Cost of NIV Programs: • Higher rate -- 1.50 to 4.00 percentage points higher than comparable full documentation loans. • Larger down payment: With A-credit, about 20 - 25%, with lower credit, 30-40%.

39. Renegotiable rate mortgage Seller Take-back Growing equity mortgage Contract sale Rent with Option FHA loans VA loan USDA Rural Service Loan Community Reinvestment Loan Program Federal Home Loan Bank Board Fannie Mae Other Mortgage Financing Alternatives

40. Refinance Loans Reasons for refinancing a mortgage: • Better interest rates. • Change of term. • Consolidation of debt. • Extra cash.

41. Cash-out Refinance Cash out refinances require higher LTV than conventional loans. A loan is a cash-out refinance if used for: • Cash back to the borrowers. • Debt consolidation. • Replace a first or second mortgage that is less than one year old.

42. Rate and Term (No Cash-Out) Refinance • Refinance of a first mortgage that is at least one year old. • Consolidation of multiple mortgages. • Refinance that also pays closing costs and prepaid expenses. • Limited cash back – less than 1% of the loan.

43. Considerations in Refinance • Investment consideration: • May not be a good idea to refinance a loan that has been paid on for five or more years. • Difference in old interest rate and new rate needs to be large enough to justify closing costs. • Appraisal value. • Payoff statement.

44. Refinancing When There are Two or More Current Mortgages • Complicates the refinance handling and paperwork. • Refinance both or only one of the existing mortgages. • LTV ratios change with whether it is considered a rate and term refinance or a cash out refinance just as when refinancing one loan. • Refinancing only the first mortgage will require that lender on second mortgage subordinate his loan to the new first mortgage.

45. Mortgage Amortization • Each payment consists of interest and principal. • The interest portion is one month’s interest on the loan’s remaining balance. Thus interest goes down over time. • Since the payment is a fixed amount, whatever is left out of the fixed amount paid after paying the interest is credited to the loan balance (principal). • Since interest goes down over time, the portion of the payment representing principal goes up.

46. Example of AmortizationExcel Template from http://office.microsoft.com/en-us/templates/TC010197771033.aspx?CategoryID=CT011377171033

47. Graphic Representation of Loan Amortization

48. Computing the Payment Amount • If Pmt = the payment and • Bal0 = Starting Balance and • r = interest rate per payment period and • n = number of payments, Then, Pmt = Bal0 x [r/(1 – (1+r)-n)].

49. Basics of Loan Rates • The actual rate the borrower pays is usually higher than the stated rate: • Up-front costs are not computed in the stated rate. • Rate is computed as if loan is paid off over the stated term. Most mortgages are paid off early, so actual rate is higher. • Monthly rate is computed as 1/12 annual rate, which increases the effective annual rate.

50. Effect of Points and Closing Costs • Closing costs and points can add up to 4% to the amount of money borrowed (They are typically added to the loan amount). • These costs can be looked upon as affecting the rate on the net amount being borrowed. • Therefore the rate of interest that the borrower is paying over the life of the loan is greatly increased.