Chapter 19 Residential Real Estate Finance: Mortgage Choices, Pricing and Risks

1. Chapter 19Residential Real Estate Finance: Mortgage Choices, Pricing and Risks “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

2. Major Topics • Primary and secondary mortgage markets • FRMs and ARMs • Conventional, FHA and VA mortgages • The Effect of Points on Mortgage Choice • Tax Effects of Mortgage Deductions • Mortgage Underwriting Criteria • Impact of the Internet on Residential Finance “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

3. Introduction • Home ownership is a national policy in the United States • Instruments such as the adjustable rate mortgage which reduce interest rate risk for lenders and increase this risk for borrowers are a common alternative to fixed rate loans • Another major development impacting the way home purchases are financed today is the emergence of a dominant secondary market for home mortgage loans and the securitizationof these loans “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

4. Residential Financing • The fully amortizing fixed rate loan or FRM is the most traditional loan format for residential mortgages • It is characterized by loan payments (usually paid monthly) that are constant throughout the term of the mortgage • The typical loan classifications are conventional loans, FHA loans, and VA loans • There are also “jumbo loans” that are based on the mortgage limit for secondary market sale to Freddie Mac “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

5. Loan Fees and Costs • In addition to the interest charged on the money borrowed and any insurance premiums for loan guarantees, the financial institution typically charges the borrower points, which are prepaid interest, and out of pocket costs for administrative and third party closing costs • Out of pocket costs include the cost of the appraisal, credit report, title insurance, surveys if required, environmental phase one reports if required, and other loan processing fees “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

6. The True Cost of Borrowing • The table below compares two loans of $240,000 where the APR is not the best indicator of the best consumer choice if the loan is to be held 5 years or less • The quicker the loan is to be repaid the better choice A becomes even though the initial contract rate is higher “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

7. Tax Benefits of Mortgage Interest Rate Deductions • One of the key advantages of US home ownership is that interest on the mortgage loan is fully tax deductible • This is one of the remaining few tax shelters available to the typical consumer • In addition, any points paid in connection with the loan may also be tax deductible in the year points are paid • These tax deductions create a cash benefit to the borrower which directly impacts the effective borrowing cost “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

8. Mortgage Buy Downs • When mortgage lending environments are competitive, lenders offer borrowers many choices in terms of points and interest rate combinations • Often, the borrower may “buy down” the interest rate by paying lender more points • Example: What is the max points needed to pay to buy down rate to 7.5% on a No points loan @ 8.5%, 30 yr amortization. Assume they plan to hold loan to maturity “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

9. Mortgage Buy Down Example “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

10. Residential Mortgage loan Underwriting • Borrower defaults on a loan can occur if the borrower may lose the ability to make the required loan payments or when a borrower is in a negative equity situation • Regardless, however, of who bears the risk of default, the loan originator must adhere to underwriting standards that seek to minimize the likelihood of default • Underwriting is the lender’s process of evaluating the borrower and the property offered as security for the mortgage to determine the transaction’s level of default and foreclosure loss risk “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

11. Assessing the probability of default There are five major criteria to assess this: Income: Other Debt Obligations Housing Expenses Credit Evaluation Net Worth “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

12. Mortgage Buy Downs • In evaluating the property, the lender wants to determine that the property provides adequate security for the debt • The value of the security is established by an appraisal on the property which includes market data on comparable sales • Acceptable loan to value ratios for conventional loans are typically 75% or 80% for non-insured mortgages and up to 95% for private insured mortgages • In the property evaluation process, the practice of redlining is prohibited, i.e. the lender is not permitted to make blanket designations of geographic areas that are considered to be unacceptable loan risks “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

13. Future of Residential Finance • Efficiency and speed of processing loans will play a greater role in attracting business in a market that is already very thin on margins • Loan applications can actually be taken online using pre-formatted forms • Credit checks can be ordered on line, employment verified or financial reports accessed • An appraisal can be ordered on line and in some cases performed without the need for physical inspections using fully computerized data bases, geographic information systems or GIS and property address electronic photo banks “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

14. END “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner