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

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1 Chapter 19 Residential Real Estate Finance: Mortgage Choices, Pricing and Risks 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 1 Residential Financing: Loans Loans are classified according to whether any part of the loan or the borrower s payments are insured by a government backed agency or corporation or a private company The typical loan classifications are conventional loans (Jumbo loans), FHA loans, and VA loans 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 2 1

2 Conventional Loan Loans (Contd.) A conventional loan does not carry any government guarantees or insurance, although, depending on the loan to value ratio a conventional loan may be insured (by a private company) or uninsured If a borrower wishes to borrow more than 80% of the purchase price, up to 95% of purchase price could be offered as long as the borrower purchases Private Mortgage Insurance or PMI PMI protects the lender against the possibility that the loan might not be fully repaid by the borrower Jumbo loans with mortgage limit larger than secondary market sale to Freddie Mac 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 3 FHA Loan Loans (Contd.) The Federal Housing Authority (FHA) provides government insurance to lenders on loans made to home buyers that conform to its requirements These requirements include a maximum loan amount that varies by city from about $80,000 to $160,000 with a minimum down payment of about 3% and a maximum loan term of 30 years The FHA guarantee is basically an insurance program and the borrower must pay either a Mortgage Insurance Premium or a Funding Fee at closing 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 4 2

3 VA Loan Loans (Contd.) After World War II, Congress authorized the Veteran s Administration to guarantee loans made to veterans A veteran can purchase a home costing up to $240,000 with no down payment assuming income is sufficient to support the mortgage payment Lenders are willing to make these loans because the Veteran s Administration provides up to a $36,000 loan guarantee or up to $50,750 for certain loans over $144,000 to the lender in the event of default and foreclosure 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 5 Residential Mortgage 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 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 default and foreclosure loss risk 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 6 3

4 Assessing the Probability of Default There are five major criteria to assess this: 1. Income: Sources of income that are considered include wages from full time employment, part time employment, net rental property income, alimony and child support, expected sales commissions, bonuses, dividends or interest, retirement annuities 2. Other Debt Obligations: Examples are automobile loans, alimony requirements, and payments on credit card accounts 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 7 Assessing the Probability of Default (contd.) 3. Housing Expenses: the principal and interest payments on the mortgage requested, mortgage insurance premiums property taxes any association fees if the property is a condominium or in a planned development, expected utility payments sometimes a maintenance expense 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 8 4

5 Probability of Default (Contd.) 3. Housing Expenses (Contd.) For commercial property the debt coverage ratio is used instead of pmt to income ratio Higher risk will require a higher DCR DCR = NOI/Annual Debt Service 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 9 Probability of Default (Contd.) 4. Credit Evaluation Credit scoring has been shown to be a highly significant indicator of mortgage default 5. Net Worth The borrower s assets less debts are also assessed in since they provide an alternative source of funds for making mortgage payments 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 10 5

6 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 the cost of the appraisal, credit report, title insurance, surveys if required, other loan processing fees 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 11 The True Cost of Borrowing The effective borrowing cost calculation expresses all of the financial terms of the mortgage loan quote as a single annualized rate that can be used for comparison purposes Lenders use a similar calculation called the effective yield what return they expect to earn on a mortgage loan when the amortization term, points, contract rate and probable prepayment term are all considered Lenders are required to disclose the APR to residential mortgage borrowers under Truth in Lending Act 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 12 6

7 Tax Benefits of Mortgage Interest 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 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 13 After Tax Effective Borrowing Cost 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 14 7

8 After Tax Effective Borrowing Cost (Contd.) 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 15 10/25/2005 FIN Special Topics in Real Estate - Professor Rui Yao 16 8