John P. Wiedemer and J. Keith Baker

REAL ESTATE FINANCE Ninth Edition

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Chapter 7 Mortgage Repayment Plans

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LEARNING OBJECTIVES

At the conclusion of this chapter, students will be able to:

• Understand the concept of amortization and negative amortization.

• Describe how the components of an adjustable rate mortgage work,including the rate index, margin, and caps.

• Understand the key mortgage products and their features.

• Describe how a home equity revolving line of credit mortgage works.

• Explain the function and costs of a reverse annuity mortgage.

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Introduction

• The fixed rate, fully amortized payment plan has dominated lending.

• A number plans used in the past ten years were poorly thought out.

• Such as “stated income” loans, also known as “liar loans”—mortgages approved without requiring proof of the borrower’s income or assets.

• Or the “ninja loan,” short for “no income, no job, and (no) assets.”

• These loans were made to borrowers with credit scores as low as 500.

• In the past, such loans were for a borrower who put down 30% to 50%.

• Repayment plans can be classed as follows: (1) fixed-interest, constant-level plans(2) adjustable rate mortgages (3) graduated payment mortgages with lower early monthly payments (4) mortgages with total interest cost, and other alternatives

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Fixed-Interest, Constant-Level Plan

• FRM involves a constant payment for the life of the loan.

• Each payment is calculated so that all interest due to payment date is included, plus a portion of the principal.

• The periodic reduction of the principal balance is called amortization.

• The loan payment will not increase during the life of the loan.

• A popular design, with well over half the new loan origination market.

• There are two reasons for its continuing popularity.1. In periods of low interest rates, borrowers are reluctant to commit

to an adjustable-rate mortgage that might start increasing in cost.2. The growing use of mortgage pools to raise lendable funds in the

financial markets tends to encourage fixed-rate loans.

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Adjustable Rate Mortgage (ARM)

• Allows a lender to make a change in the rate of interest at periodic intervals without altering other conditions of the loan agreement.

• The change in the rate is tied to a regulator-approved rate index—one not under the control of the lender.

• The frequency of adjustment was limited to fixed time periods such as once a year.

• The interest rate change is limited by a period cap and a lifetime cap.

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Borrower Protection

• Protective measures have been added to residential ARM requirements.

• These go beyond simply limiting how interest rates can be changed.

• Truth-in- Lending regulations require lenders to provide more extensive information to borrowers.

• The requirements fall in two categories:(1) up-front information and (2) subsequent disclosures

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Up-Front Information Required

Certain information must be provided at the time an application form is provided or before a nonrefundable fee is paid, whichever comes first.

1. An educational brochure about ARMs must be given to the applicant.

2. The applicant must be shown by historical example how payments on a $10,000 loan would have changed in response to actual past historical data on the index to be applied.

3. A statement must be given to the applicant showing the payment amount on a $10,000 loan at the initial interest rate, and the maximum possible interest rate that could apply to the loan during its term.

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Subsequent Disclosure Requirements

• Notices must be given showing any adjusted payment amount, interest rate applied, index rate, and the loan balance at the time of adjustment.

• This notification must be made once each year during which there is a rate adjustment, whether or not there is a payment change.

• The notice must be mailed no less than 25 days and no more than 120 days before the new payment is due.

• The disclosure must indicate the extent to which any increase in the interest rate has not been fully implemented.

• Must also state the payment required to fully amortize the loan.

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Use of an Index

• Any change in rate of interest must be tied to the change in an index.

• An index is a published rate or yield approved by a regulatory authority.

• This rule applies to regulated lenders making residential loans.

• An ARM index cannot be controlled by the lender.

• Five indices have achieved the greatest popularity.1. Cost of funds2. Contract rate3. 11th District cost of funds4. One-year Treasury securities5. LIBOR

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Use of an Index

1. Cost of funds. The national median cost of funds as reported by the Office of Thrift Supervision.

2. Contract rate. The national average contract interest rate for major lenders as reported by the Federal Housing Finance Board.

3. Eleventh District cost of funds. The cost of funds for the Eleventh District as released by the Office of Thrift Supervision.

4. One-year Treasury securities. The one-year constant maturity yield on U.S. Treasury securities as reported by the Federal Reserve Bank Board.

5. LIBOR. London Interbank Offered Rate. This rate is charged by London banks and used as the benchmark all over the world.

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Application of an Index

• Indexes are applied differently.

• Only the “contract rate” would normally be applied directly to the rate.

• Indexes other than the contract rate require the addition of a margin.

• The margin is determined by the lender and is not a regulated amount.

• Normally it amounts to 2 to 2½ percentage points added to the index.

• The margin remains fixed for the life of the loan.

• The most widely used index is the one-year Treasury security rate.

• Another way is to add or deduct the movement of an index.

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Limitations on Changes (Caps)

Caps now center on four aspects.

1. Periodic interest rate change.

2. Interest rate change over the life of loan.

3. Frequency of rate change.

4. Mortgage payment amount.

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• The cap may apply to the amount the borrower pays during the year, but may not limit the amount owed.

• There is no real standard on how the limits may be applied.

• Even though a rate change, or a payment amount, may show a specific limit on what the borrower pays, if the index shows a greater amount is actually due, the lender may add the unpaid amount to the principal.

• This is called negative amortization.

• Fannie Mae, for one, will not buy this kind of loan.

• This, too, must be disclosed and agreed to in the mortgage terms.

• Careful reading of these clauses is absolutely critical!

Negative Amortization

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Continued “Evolution” of ARM Offerings (Option ARM)

• Typically a 30-year ARM that offers four monthly payment options:1. The biggest payment is on a 15-year payoff schedule2. The next-biggest payment is on a 30-year payoff schedule3. An interest-only payment based on a 30-year payoff schedule4. The minimum payment that may have negative amortization

• In this “negative am” option, the mortgagor owes more at the end of the month than at the beginning because the unpaid interest is added to the outstanding principal.

• The next month’s interest-only payment will be calculated using the new, higher balance.

• Many lenders have underwritten consumers based on mortgage payments that are below the fully amortizing payment level.

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Graduated Payment Mortgage (GPM)

• Buyers pay lower monthly payments in the early years, with payments rising to a level sufficient to amortize the loan within a 30-year term.

• With a lower initial payment, the buyer with lower income might qualify for a loan, or be able to buy a larger house with the same income.

• Borrower must show reasonable expectation of an increase in annual income so as to meet the increase in monthly payments.

• There is an accumulation of unpaid interest, called accrued interest, in the early years of the mortgage term.

• This results in a specific amount of negative am in the early years.

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Buydown Mortgage

• Buydowns have been popular with builders on new construction.

• Buydowns can span any period, but are often for one to five years.

• The average buydown is for three years, amounting to a 3% less-than-market rate in the first year, 2% in the second, and 1% in the third.

• The procedure is sometimes called “3-2-1.”

• By encouraging buydowns, the seller opens a larger market of buyers.

• Seller is actually paying a portion of the interest cost in the early years.

• It is best to qualify the buyer at the note rate, not the first year’s rate.

• Also best to require borrower income qualification to be based on the payment amount that will amortize the loan within its term.

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Pledged-Account Mortgage

• Part of the down payment is placed in an escrow account with the lender, rather than paid to the seller.

• Then the lender makes a loan of sufficient size to cover the purchase.

• The lender considers the escrow deposit as additional collateral, which allows a larger loan amount.

• The borrower makes monthly payments in the early years of less than the full amortization payment amount.

• Each month the lender withdraws cash from the pledged account, adds the interest earned on that pledged account, and supplements the mortgage payment so that it equals a fully amortizing amount.

• It has the advantage of not creating negative amortization, and provides the lender with a new savings account.

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Balloon Payment Note

Balloon Due to Amortization• A balloon installment note product is only partially amortized over its

term since it reaches maturity with a balance due.

• A final payment larger than the previous payments comes due.

• The final payment is called a balloon because of its greater size.

Balloon Allowing an Adjusted Rate• A new mortgage design, called a “five or seven-year balloon.”

• Payments are based on a 30-year amortization at an initial rate of 1 1/2 percentage points below the current 30-year market rate.

• At the end of five or seven years, the mortgage would be refinanced at current market rate that remains fixed for the remaining term.

• The refinancing is not automatic and requirements differ.

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Straight Note (Interest-Only Mortgage)

• A straight note is one that calls for payment of the interest only at periodic intervals and the principal balance due in full at maturity.

• Also known as an interest-only mortgage, interest-only note, term loan, or as a nonamortized note.

• Usually made for a short term, such as three to five years.

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The Piggyback Loan

• Uses more than one mortgage from two or more mortgagees.

• The most common types of piggyback loans are the 80-10-10 loan, the 80-20-0 loan, and the 80-15-5 loan.

• The first number indicates the amount financed by lender number one; the second number indicates amount financed by lender number two; and the third number indicates the down payment.

• If a GSE was sold the 80% first mortgage without full disclosure of the piggyback structure, did that constitute a misrepresentation to induce the GSE to purchase the mortgage?

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The Advantages and Disadvantages of Piggyback Loans

Advantages• Piggyback loans allow buyers to qualify for more expensive homes. • The entire loan risk is spread between two lenders. • Buyers with little down payment have a better chance of approval.• Allows a home buyer to purchase a home with less than 20% down. • These mortgages avoid a private mortgage insurance premium.

Disadvantages • Combined rates for piggyback loans are often higher regular loans. • Lender may not disclose lack of downpayment to secondary market. • Many piggyback loans attach a large balloon payment at end of loan.• Getting an additional mortgage or home equity loan could be difficult.• Loan problems are greatly complicated with as many as three lenders.

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Mortgages That Can Reduce Total Interest Cost

IT’S NOT THE PRINCIPAL OF THE THING…

IT’S THE INTEREST!

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Shorter-Term Loans

• For many years, little thought was given to the cost of long-term loans.

• Longer terms do achieve smaller monthly payments, but at a dramatic increase in the interest cost.

• The substantial cost of a long-term loan derives from the very small reduction of principal in the early years of repayment, not from interest.

• Interest for almost all mortgage loans is calculated as simple interest.

• Table 7-2 indicates the interest cost for loans of differing terms.

• As buyers have become more aware of the true cost of long-term loans, attention has focused on the savings with shorter-term loans.

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Biweekly Payment Plan

• Another method for reducing interest costs is the biweekly payment.

• For borrowers who are paid every other week, this is easier to budget.

• The payment is just one-half of a monthly payment, paid biweekly.

• For example, if the monthly payment for a 30-year loan amounts to $1,000, the borrower would pay $500 every other week.

• This amounts to 26 biweekly payments over the span of one year, amounting to $13,000.

• Compare this to 12 monthly payments, which would total $12,000.

• The additional payments are applied to principal reduction and will pay off the loan in about 17 to 20 years, depending on the rate of interest.

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Growing Equity Mortgage

• Still another method that can be used to shorten a loan term, thus reducing interest costs, is called a growing equity mortgage, or a graduated equity mortgage product, both having the acronym of GEM.

• Many variations may be found, but the basic pattern is to make certain increases in the payment amount each year.

• Then, the entire amount of the increase is applied to repayment of the principal.

• Depending on the interest rate, an increase of, say, 4% in the payment amount (not the interest rate) each year can reduce the term of a 30-year loan to 18 or 20 years.

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Opportunity Cost

• Critics of the 15- or 20-year loan, the biweekly loan plan, and GEM mortgages contend that any increase in the payment creates a loss for the borrower from the amount that might be gained had the payment increase been invested in order to earn interest.

• From a mathematical point of view, this is often true.

• If the difference in payments were deposited monthly in an interest-bearing account earning compound interest it could easily total a sum sufficient to pay off the balance due on that loan.

• Whether or not a net savings would result varies with each borrower, as the analysis must include any gain or loss of savings resulting from the tax-deductible nature of home loan interest.

• In the current interest rate environment for deposit accounts, refinancing to reduce interest paid would make more economic sense.

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Home Equity Revolving Loans

• Pledging the property to secure a revolving line of credit.

• It gives the borrower more flexibility.

• These are a one of the reasons for reduced net worth of individuals.

• Many borrowers used home equity loans as a way of consolidating other debts and receiving a tax deduction.

• Some states refer to home equity revolving mortgage loans as open-end home equity loans because the balance can go up and down.

• This fact has caused increasing concerns about abusive practices against consumers.

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Shared Appreciation Mortgage (SAM)

• A portion of the collateral’s appreciation is accepted as “contingent interest.”

• Lenders take a portion of the expected return of their money from the appreciation.

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Shared Equity Mortgage

• The lender holds a claim on that portion of the property value that represents an increase from the time of loan origination.

• This claim or lien falls short of title to the property.

• Recently, net investment income has been redefined to include shared equity interest resulting in more income tax to be paid.

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A New Income Tax

• The Health Care and Education Reconciliation Act of 2010 imposes an unearned income Medicare contribution in 2013 on wages in excess of $200,000 for single taxpayers and $250,000 for married couples.

• Also, for the first time ever, a Medicare tax will apply to the net investment income of high earners.

• The 3.8% levy will hit the lesser of (1) their net investment income, or (2) the amount by which their adjusted gross income exceeds the $200,000 or $250,000 threshold amounts.

• The new law defines net investment income as interest, dividends, capital gains, annuities, royalties, rents, and other such income derived in the normal course of business.

• Tax-exempt interest will not be included, nor will income from retirement accounts.

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Reverse Annuity Mortgage (RAM)

• Does not finance the acquisition of real estate.

• Utilizes the equity in a home to finance living expenses for the owner.

• The basic purpose is to assist older home owners on fixed incomes.

• The equity may be utilized without the owner being forced to sell.

• A lender advances monthly payments to the home owner.

• RAMs require extensive disclosures and a 7-day rescission period.

• A statement must be signed by the borrower acknowledging all contractual contingencies that might force a sale of the home.

• Repayment of the loan must be allowed without penalties.

• Interest on this type of loan is added to the principal amount along with each monthly payment.

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Reverse Annuity Mortgage (RAM)

• The amount of the loan is based on the equity value of the home.

• The monthly advances, plus accrued interest added each month, are designed to reach the maximum loan amount in 3 to 12 years.

• Several different repayment plans are offered, including a sale of the property at time of death.

• To qualify, borrowers must be 62 years or older and living in the home, and have little or no mortgage debt.

• The market for this type of loan has been expanding as more seniors take advantage of its possibilities.

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Fannie Mae’s Home Keeper for Home Purchase Mortgage

• Another type of mortgage aimed at the senior citizen market.

• It allows senior citizens (62 or older) to obtain a mortgage against the equity in a home if they make a substantial down payment.

• Repayment of this mortgage is deferred until the borrower no longer occupies the principal residence.

• The borrower cannot be forced to sell or vacate the property to pay off the loan.

• If the loan balance does exceed the value of the property, the borrower, or the estate, will owe no more than the value of the property.

• The program was discontinued in 2008 but one must be aware that such loans are still outstanding.

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Questions for Discussion

1. What are the advantages to a home buyer of a graduated payment mortgage?

2. What is the major constraint on lenders in setting new interest rates for an adjustable rate mortgage?

3. Discuss the quality of the major indexes cited in the text.4. Identify the limits or caps placed on changes in the interest rate on an

adjustable rate mortgage.5. What is the difference between amortization and negative

amortization?6. Distinguish between the two types of balloon mortgages.7. What is the difference between a permanent and temporary buydown

mortgage?8. Discuss the advantages and disadvantages found in shorter-term

mortgage loans.9. What is a home equity line of credit?10. Describe the FHA/HUD reverse mortgage program.