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1 DISCLAIMER: This publication is intended for EDUCATIONAL purposes only. The information contained herein is subject to change with no notice, and while a great deal of care has been taken to provide accurate and current information, UBC, their affiliates, authors, editors and staff (collectively, the "UBC Group") makes no claims, representations, or warranties as to accuracy, completeness, usefulness or adequacy of any of the information contained herein. Under no circumstances shall the UBC Group be liable for any losses or damages whatsoever, whether in contract, tort or otherwise, from the use of, or reliance on, the information contained herein. Further, the general principles and conclusions presented in this text are subject to local, provincial, and federal laws and regulations, court cases, and any revisions of the same. This publication is sold for educational purposes only and is not intended to provide, and does not constitute, legal, accounting, or other professional advice. Professional advice should be consulted regarding every specific circumstance before acting on the information presented in these materials. Copyright: 2013 by the UBC Real Estate Division, Sauder School of Business, The University of British Columbia. Printed in Canada. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any means graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or used in any information storage and retrieval system without the prior written permission of the publisher.

2 LESSON 8 Loan Management and Refinancing Options Note: Selected readings can be found under "Online Readings" on your Course Resources webpage. Assigned Reading 1. UBC Real Estate Division BUSI 221 Course Workbook. Vancouver: UBC Real Estate Division. Lesson 8: Loan Management and Refinancing Options 2. UBC Real Estate Division Real Estate Finance in a Canadian Context. Vancouver: UBC Real Estate Division. Chapter 10: Loan Management and Refinancing Options Recommended Reading 1. Courchane and Giles "A Comparison of US and Canadian Residential Mortgage Markets". Property Management. 20(5). pp Mclister, Robert. "Ten questions to help you avoid mortgage-penalty shock". The Globe and Mail. September 14, McLister, Rob. "IRD Clarity has Cometh". Canadian Mortgage Trends. March 22, available at the following link: 4. Canadian Mortgage Trends. "Rising Rates and Mortgage Arrears". December 19, Canadian Mortgage Trends. "Interest Rate Differential (IRD)". Learning Objectives After completing this lesson, students should be able to: 1. explain how partial prepayment is handled in mortgage loans; 2. calculate the impact of partial prepayment on the outstanding balance of mortgage loans; 3. describe and calculate prepayment penalties assessed by lenders for full prepayment of mortgage loans; 4. explain and calculate how arrears and default impacts the outstanding balance of mortgage loans; 5. discuss situations where borrowers refinance mortgages and the options available; 8.1

3 Lesson 8 6. compare alternatives for refinancing on the basis of yield and the amount of additional funds available; 7. describe wrap-around mortgages; 8. define and calculate the book value, market value, and investment value of a mortgage; 9. calculate the cost of funds advanced for a borrower involved in a bonused mortgage; and 10. calculate the yield to a lender when a mortgage broker arranges the mortgage. Instructor's Comments This lesson shifts the discussion from loan origination to loan management, or what happens after the loan funds are advanced. If all payments are made on time, loan management is straightforward: processing payments and issuing periodic statements of account. However, several features now common in contemporary mortgage loans, such as allowing periodic prepayments, doubling up payments, skipping payments, and so on, have led to an irregular payment stream. The impact of these on the loan balance must be determined. Furthermore, if payments are made late or are missed, then these require administrative attention to follow up and ensure the payment stream is brought back on track and the loan brought current Mathematic calculations will also be necessary to determine the impact on the loan balance of unpaid interest and penalties. Loans that are in arrears or default require more advanced calculations to account for the late payments or payments not received at all. Given that most mortgages in Canada are partially amortized, refinancing is a decision faced by most borrowers at some point: whether to rollover the loan with the current lender or transfer to a new lender. The cost versus benefit of this decision can be evaluated by financial analysis techniques. An extension of this analysis involves borrowers that consider prepaying their loan in order to seek new loans terms, such as taking advantage of lower market rates or seeking a larger loan amount. The typical options available include arranging a new first mortgage, taking out a second mortgage, or arranging a "blend and extend" mortgage. A blend and extend mortgage is arranged to take advantage of a low existing first mortgage rate and obtain additional financing. The final topic covered in this lesson discusses how mortgages are priced when considering them as an investment. An investor who is considering purchasing a mortgage loan will evaluate the loan terms, in terms of cash flows generated, and compare this to his or her required yield or market rate of return to evaluate the investment's "worth". This will typically result in the purchase of an investment for either a discount (below) or bonus (above) the loan's face value. When a mortgage broker is involved, a bonus or brokerage fee paid by the lender will reduce the lender's yield; if instead the borrower pays the bonus, then the borrower's cost of funds advanced will increase (the borrower will pay a higher interest rate than that stated in the mortgage contract). 8.2

4 Loan Management and Refinancing Options Review and Discussion Questions 1. Mike Gilley has made an offer on Dave Muir's house. He has the following two financing options available to him: Option 1: Option 2: A $30,000 cash down payment with a vendor take-back mortgage of $80,000, written at j2 = 8%, with monthly payments over a five-year term, and an amortization period of 15 years. A $30,000 cash down payment with a first mortgage with First Bank in the amount of $75,000, written at the market rate of j2 = 10%, with monthly payments over a fiveyear term, and an amortization period of 15 years. Based on the market value of each offer, which option should Mike choose? Show all your calculations. 2. Middleman Mortgage Brokers has arranged a mortgage between Barry Borrower and Larry Lender with a face value of $90,000. The loan calls for equal monthly payments of $950 for a term of 5 years and an amortization period of 20 years. (a) (b) What is the contract rate of interest on this loan, expressed as an annual rate with semiannual compounding? If the broker charges the borrower a $1,500 fee for arranging this loan (deducted from the face value of the loan), what is the actual cost of this loan to the borrower, expressed as an annual rate with semi-annual compounding? 3. Last year, Davy Carillon started a new party consulting business called "Everybody Loves A Clown". He had such great success with his new business that he bought himself a house in Kerrisdale. He paid $625,000 and took out a mortgage on April 1 for a large portion of the purchase price. Mortgage terms: Face value: $550,000 Interest rate: j2 = 10.7% Amortization period: 20 years Term: 2 years Monthly payments, rounded up to next higher $10 Davy made his first 7 payments on time, but he has recently fallen on hard times, as winter is a slow season in the clown business. He has been late on one payment, paid only a portion of another, and has now defaulted on his February payment. After several warnings, the bank has decided to foreclose on Davy's mortgage on March 1. The following is the payment schedule required by the mortgagee and the payments made by Davy. 8.3

5 Lesson 8 Payment Schedule: Payment# Due Date Date Paid Notes: 1 May 1 May1 2 June 1 June 1 3 July 1 July 1 4 August 1 August 1 5 September 1 September 1 6 October 1 October 1 7 November 1 November 1 8 December 1 December 20 Warning sent: December 5 9 January 1 January 1 Only paid 1/2 of payment 10 February 1 Unpaid Warning sent: February 4 11 March 1 Unpaid Foreclosure proceedings initiated: March 13 (a) (b) (c) Calculate Davy's required monthly payment on this loan. Calculate the outstanding balance due on March 1, assuming all monthly payments were made in full and on time. Calculate the total amount due and payable by Davy on March 1, given his actual payment schedule. 4. Why would an investor (borrower) choose to refinance his property? 5. Jessie Broughton owns a property in Tofino with a $120,000 mortgage on it. Jessie would like to release some equity for renovations and thus is looking for refinancing. He is considering paying out the existing mortgage and replacing it with a new first mortgage at current rates and conditions. The existing mortgage began four years ago and has a 5-year term and a 15-year amortization. The loan called for monthly payments at an effective rate of 9% per annum. There is no prepayment penalty. The Tofino Trust Company has 5-year term mortgage loans available. The loan has a 10-year amortization period, monthly payments, and an interest rate of 4%, compounded semi-annually. They use a 75% loan-to-value ratio constraint. The Trust Company has assigned a lending value of $150,000 to Jessie's 2,000 square foot house. (a) (b) (c) What is the maximum loan Jessie will be able to obtain from the Tofino Trust Company if he does not want his monthly payments to exceed $1,150.00? If he takes the maximum loan available to him from the Tofino Trust Company, by how much does Jessie's monthly debt service change? What is the outstanding balance of the mortgage available through the Tofino Trust Company at the end of the term? 8.4

6 Loan Management and Refinancing Options 6. A borrower must decide between the following two mortgage loans: Loan A Loan B Face Value: $314,200 $310,000 Contract Rate (j2): 8.5% 8% Amortization Period: 20 years 25 years Term: 3 years 3 years Bonuses and Fees: $8,800 $3,100 Net Proceeds: $305,400 $306,900 (a) Calculate the monthly payment and outstanding balance required for Loan A. (b) Calculate the cost of funds advanced under Loan A, expressed as an effective annual rate. (c) Calculate the monthly payment and outstanding balance required for Loan B. (d) (e) Calculate the cost of funds advanced under Loan B, expressed as an effective annual rate. On the basis of effective annual rates, which option should the borrower choose? 7. Twelve years ago, two businessmen acquired a medical office complex and financed the purchase with a $2,450,000 first mortgage loan. This loan was made at an interest rate of j4 = 8% and required level quarterly payments adequate to fully amortize the principal over the 22 year term. The owners built up significant equity over the past twelve years and would now like to "free it up". They estimate that they can afford to increase their loan payments by $15,000 per quarter. The existing lender, a trust company, is willing to provide a blended rate mortgage with quarterly payments sufficient to fully amortize the replacement mortgage in 12 years (48 quarterly payments). The net operating income (NOI) of the complex is $350,000. The trust company requires a minimum safety margin of 15%. The lender is offering new funds at an interest rate of j4 = 12%. Calculate the amount of additional funds that could be raised through refinancing while satisfying the safety margin requirement (the existing first mortgage is surrendered). What is the effective annual rate of the fully amortized blended rate loan? 8.5

7 Lesson 8 ASSIGNMENT 8 CHAPTER 10: Loan Management and Refinancing Options Marks: 1 per question. 1. Which of the following is TRUE of an individual borrower's prepayment rights, as stated in the federal Interest Act? (1) The borrower has the right to tender all of the outstanding debt, with an additional three months' interest in lieu of notice, at any time after five years from the initial date of the mortgage. (2) The borrower has the right to tender all of the outstanding debt at any time during the term of the mortgage contract. (3) The borrower may be legally bound to a mortgage contract with a clause included stating "absolutely no prepayment whatsoever until the end of the 10-year term". (4) All of the above statements are true. 2. The prepayment privilege described in the federal Interest Act extends to: (1) the mortgagee. (2) companies. (3) individuals. (4) all of the above. 3. Which of the following statements about mortgages is TRUE? (1) A second mortgage commonly refers to the first equitable mortgage on a property. (2) A second mortgage is always considered junior to a first mortgage, unless the payments are higher. (3) A first mortgage is the largest loan registered against the property. (4) Possession and the right to eventually receive clear title remain with the lender until the mortgage is paid off. 4. Sally approached Happy Lenders and arranged a $245,000 mortgage loan, enabling her to purchase a house in Comox, BC. The mortgage allowed for additional payments of principal without penalty. The loan was written at 7.5% per annum, compounded semi-annually with a 25-year amortization period, 15-year term and monthly payments rounded up to the next higher dollar. Sally made a lump-sum payment of $6,000 at the end of the second year and a lump-sum payment of $11,000 at the end the eighth year. Calculate the balance due at the end of the contractual term. (1) $151, (2) $117, (3) $125, (4) $102, ***Assignment 8 continues on next page***

8 Loan Management and Refinancing Options 5. Bradley Hartfield received a mortgage loan with a face value of $180,000 written at 12% per annum, compounded semi-annually. The mortgage will be amortized over 25 years, with a 5-year term and calls for monthly payments. The loan allows Bradley to prepay the entire amount of the loan at any time, subject to a prepayment penalty of three months' interest. Assume that Bradley has just won the lottery and wishes to pay off the loan 14 days after the 9 th payment was made. Calculate the total amount that Bradley will pay. (1) $5, (2) $179, (3) $179, (4) $185, Alex initiated an $80,000 loan five years ago. The loan was written at 8% per annum, compounded semi-annually and provides for monthly payments over a 30-year amortization period. Today, the lender offered to renegotiate Alex's loan at a rate of 7.5% per annum, compounded semi-annually, to be fully amortized over 25 years providing Alex will pay a penalty equal to 3.5% of the outstanding balance. Should Alex accept the offer? (1) Alex should accept the offer since the present value of the savings exceed the penalty. (2) Alex should not accept the offer since the penalty is higher than the present value of the savings. (3) Alex will be indifferent between the two offers. (4) It cannot be determined from the provided information whether Alex should accept the offer. 7. If the borrower of a mortgage loan pays a bonus to have the loan arranged, which of the following statements is/are TRUE? A. The rate of interest that the borrower pays on the funds advanced to him or her will be lower than the contract rate of interest. B. The borrower will be advanced an amount which is higher than the face value of the loan. C. The length of the loan term will have no effect on the interest rate the borrower will pay on the funds advanced to him or her. D. The rate of interest paid by the borrower on the funds advanced to him or her will increase if fees in addition to the bonus are deducted from the face value of the loan. (1) Only statement D is true. (2) Only statements A and B are true. (3) Only statements B, C, and D are true. (4) Only statements A, C, and D are true. ***Assignment 8 continues on next page*** 8.7

9 Lesson 8 8. Lone Watie is considering a possible mortgage, arranged through a mortgage broker. It will have a face value of $3,500,000 with a contract rate of j2 = 10%, 25-year amortization period, 6-year term, and monthly payments rounded up to the next higher $100. The mortgage broker will take a brokerage fee of 3% of the loan's face value which will be deducted from the face value of the loan. What effective annual interest rate will Lone Watie be paying on the funds advanced? Answer is rounded to six decimal places. (1) % (2) % (3) % (4) % 9. Increasing the size of the bonus on a bonused mortgage loan (while keeping the face value and all other loan terms constant) will cause the interest rate charged to the borrower on funds advanced to: (1) not change. (2) increase. (3) decrease. (4) change, but the direction of the change cannot be determined from the information given. 10. Which of the following statements are TRUE? A. The method of accounting for arrears is similar to the methods used to account for balloon payments presented in the text. B. Market conditions and property values may change such that a borrower loses a financial incentive to honour the terms of his/her mortgage. C. In all arrears and default situations, lenders will use legal remedies to recover the amount of the principal, accrued interest, and costs. D. Arrears and defaults are common on mortgage loans. (1) All of the above statements are true. (2) Only statements A and B are true. (3) Only statements C and D are true. (4) Only statements A, C, and D are true. 8.8 ***Assignment 8 continues on next page***

10 Loan Management and Refinancing Options THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: A residential borrower arranged for a mortgage of $100,000 almost five years ago and has made all payments as due. The outstanding balance of $93,990 is due in the near future and the borrower has been offered the following alternatives. The original lender is willing to refinance for a further 5-year term and the payments are to be based on the remaining twenty years in the original amortization period. The rate required by the lender is 5.75% per annum, compounded semi-annually. Payments are to be rounded up to the next higher cent. A nominal renewal fee of $150 will be levied to contribute to the lender's legal and registration costs. An alternative has been offered by another lender. Under this option, funds will be advanced at 5% per annum, compounded semi-annually, again to be repaid over a 5-year term and based on a 20-year amortization period. Payments are to be rounded up to the next higher cent. The new lender will charge the borrower for legal and appraisal fees totalling $1,000. Assume that the borrower must pay the fees out of pocket in each case, i.e., the fees are not added to the face values of the loans. 11. Based on a cost of borrowing analysis, calculate the cost of borrowing if the borrower refinances with the existing lender. Express the rate as an effective annual rate (j1), rounded to six decimal places. (1) % (2) % (3) % (4) % 12. Based on a cost of borrowing analysis, calculate the cost of borrowing if the borrower refinances with the new lender. Express the rate as an effective annual rate (j1), rounded to six decimal places. (1) % (2) % (3) % (4) % 13. Which option should the borrower choose based on the cost of borrowing? (1) Choose existing lender (2) Choose new lender (3) It doesn't matter, as the costs are equivalent (4) Impossible to determine ***Assignment 8 continues on next page*** 8.9

11 Lesson 8 THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: A borrower wants to obtain additional mortgage funds by renegotiating the first mortgage, adding a second mortgage, or taking out a "blend and extend" mortgage. The borrower's annual income is $100,000. The current outstanding balance on the borrower's loan is $150,000. The borrower is currently making payments of $1,500 per month and will continue to make those payments for 12 more years. Based on a 30% gross debt service ratio, the maximum annual payment is $28,000 (after annual property taxes of $2,000). The current interest rate is 8% per annum, compounded monthly. New funds will be charged at a rate of 10% per annum, compounded monthly. Any new funds will be calculated based on a 20-year amortization. 14. Calculate the maximum amount of additional funds that can be acquired (rounded to the nearest dollar) with a new first mortgage where the penalty for prepayment is $3,000. (1) $241,791 (2) $91,791 (3) $88,791 (4) $269, Calculate the maximum amount of additional funds that can be acquired (rounded to the nearest dollar) with a second mortgage where the second mortgage rate is 12% per annum, compounded monthly. Assume that the maximum second mortgage payment is the differential payment over a 20- year amortization. (1) $211,912 (2) $61,912 (3) $75,683 (4) $225, Calculate the maximum amount of funds that can be acquired using a "blend and extend" option. (1) approximately $69,731 (2) approximately $142,939 (3) approximately $46,546 (4) approximately $116, Which of the following statements is TRUE? A. Wrap-around mortgages are commonly used in contemporary mortgage lending in Canada. B. With a wrap-around mortgage, the borrower makes only one payment to the wraparound lender. C. The wrap-around lender charges a higher interest rate on the wrap-around mortgage than a lender would charge on a conventional second mortgage. D. Wrap-around mortgages are mathematically similar to blended rate financing. (1) All of the above statements are true. (2) Only statements A and B are true. (3) Only statements C and D are true. (4) Only statements B and D are true ***Assignment 8 continues on next page***

12 Loan Management and Refinancing Options THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Consider a 3-year old mortgage that originally had a face value of $200,000 over a 20-year amortization period, 5-year contractual term, monthly payments rounded up to the next higher dollar, and interest at 7% per annum, compounded semi-annually. 18. Calculate the book value of this mortgage today. (1) $184, (2) $172, (3) $190, (4) $178, Calculate the market value of this mortgage if an investor purchases the remaining mortgage and wants to earn a yield of 5% per annum, compounded semi-annually. (1) $216, (2) $191, (3) $199, (4) $204, Assume that a lender has $175,000 available to lend at a rate of 4.5% per annum, compounded semi-annually. The lender is willing to amortize repayment of the funds over 25 years with monthly payments, but will limit the loan term to 5 years. If a mortgage broker charges the lender 12% of the face value of the loan to find a qualified borrower for these funds, what yield, expressed as an annual rate, compounded semi-annually, would the lender actually earn over the term of the loan? The answer is rounded to six decimal places. (1) % (2) % (3) % (4) % 20 Total Marks Planning Ahead Go to Project 2 and read what will be required for this project. Because this project addresses the readings required in Lessons 7-10, it is worthwhile to begin thinking of what you plan to do for this assignment well in advance. As well, the second part of this project requires you to carry out some research outside of the course materials, so you are advised to begin this research well in advance of the project's due date. This project is more comprehensive than the weekly assignments and will require considerable time and effort to avoid anxiety in completing this project, please begin this work ahead of time. ***End of Assignment 8*** 8.11