DISCLAIMER: Copyright: 2013

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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 7 Mortgage Loan Repayment Plans 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 7: Mortgage Loan Repayment Plans 2. UBC Real Estate Division Real Estate Finance in a Canadian Context. Vancouver: UBC Real Estate Division. Chapter 9: Mortgage Loan Repayment Plans Recommended Reading 1. Reverse Mortgages: CanEquity Mortgage Rate History: "Fixed Rates vs. Variable Rates" Woolwich: Mortgages from Barclays Shared Appreciation Mortgages Haurant, S. September "Shared appreciation mortgage customers could sue". The Guardian Seniors' Lending Centre. "How Does a Canadian Reverse Mortgage Work?". seniorslendingcentre.com 6. Carrick, Rob. "For the cheapest mortgage, go variable". The Globe and Mail. December 3, Financial Consumer Agency of Canada. "Paying Off Your Mortgage Faster". acfc.gc.ca Learning Objectives After completing this lesson, students should be able to: 1. discuss borrower and lender objectives in mortgage financing; 2. evaluate various mortgage repayment plans introduced by lenders; 3. describe and perform calculations on interest accruing loans, interest only loans, straight line principal reduction loans, and constant blended payment repayment schemes; 7.1

3 Lesson 7 4. explain how payment frequency can impact the amortization on a loan; 5. describe common features of variable rate mortgages and summarize their advantages and disadvantages; 6. analyze VRMs with amortization period adjustments, payment adjustments, and outstanding balance adjustments; 7. calculate payments and outstanding balances on "teaser rate" VRMs; 8. describe graduated payment mortgages and calculate a GPM's payments; 9. describe sinking fund assisted mortgages and perform basic calculations related to them; 10. describe the advantages and disadvantages of reverse mortgages and perform basic calculations related to them; 11. explain and calculate how participation loans and shared appreciation mortgages can increase lender's yield; and 12. explain how inflation affects mortgages and describe how a price level adjusted mortgage addresses inflation. Instructor's Comments In this lesson, we examine the wide variety of ways that mortgage loans can be structured to meet the needs of both borrowers and lenders. Borrowers are primarily concerned with affordability, while lenders are primarily concerned with balancing return on investment, capital risk, and income risk. By varying the terms of the loans, the needs of each can be met for a variety of different lending situations. These mortgage repayment plans range from very basic interest only or interest accruing loans, to the commonplace constant payment and variable rate mortgages, and on to some unusual and complex innovative arrangements such as graduated payment or shared appreciation loans. Each of the mortgage repayment plans presented has been developed to achieve a specific purpose, for lenders, borrowers, or both. In examining each repayment plan, we look at the underlying reasons for their introduction before delving into the associated calculations. Our goal is to go beyond the technical applications of these repayment plans, look at why they exist, and critically analyze their success in achieving the intended objectives. There are many creative and diverse ways to structure mortgage loans and there are innumerable variations to be invented. 7.2

4 Mortgage Loan Repayment Plans Review and Discussion Questions 1. In an attempt to meet the requirements of both borrowers and lenders, a number of different repayment schemes have been developed. Explain when a borrower would prefer each of the following types of repayments schemes for mortgage loans, and discuss how the lender's risk is affected in each case: (a) (b) (c) An interest only mortgage loan A graduated payment mortgage loan A straight principal reduction loan 2. Recently, Kevin negotiated a pure graduated payment mortgage in the amount of $100,000. The loan is written at an annual interest rate of 12.78%, with weekly compounding, and has monthly payments calculated over a 20-year amortization period. Payments are to grow at 5% per annum, compounded weekly. (a) (b) Kevin is preparing his budget for the year and would like to know what his payments will be in the: (i) 6 th month (ii) 12 th month (iii) 24 th month As well, Kevin would like to know the month in which the payment on his GPM is at least equal to the payment on a standard fully amortized mortgage. 3. An innovative lender has agreed to grant a residential borrower a price level adjustment mortgage (PLAM) with the following terms: the initial loan amount is to be $120,000 and the mortgage is fully amortized with annual payments in 5 years. The interest rate will be 5% per annum, compounded annually; however, all payments and outstanding balances are to be adjusted each year according to the annual rate of inflation. The expected inflation rates are: Lender's Expectation Borrower's Expectation Year for Inflation for Inflation 1 8% 8% 2 9% 8% 3 10% 7% 4 10% 6% 5 12% 6% (a) (b) Based on the lender's expected inflation rates, calculate the amount of each annual payment for the PLAM and create an amortization schedule similar to the one outlined in this chapter. Based on the borrower's expected inflation rates, calculate the amount of each annual payment for the PLAM and create an amortization schedule similar to the one outlined in this chapter. 7.3

5 Lesson 7 4. A borrower arranges for a sinking fund assisted mortgage loan at a rate of 5.5% per annum, compounded semi-annually with a 25 year amortization period and 5 year term. The mortgage has a face value of $55,000 but the borrower is only advanced $50,000. The remaining $5,000 is to be placed in a fund earning interest at 3.5% per annum, compounded annually, and is to be withdrawn by constant monthly withdrawals over a five-year period, such that no balance remains after 60 months. (a) (b) (c) (d) Calculate the monthly payments on the mortgage. Calculate the amount of the monthly withdrawals from the savings account. (Hint: calculate these withdrawals as you would the payments on any regular fully amortized mortgage loan.) Calculate the net monthly payment on the mortgage during the first 60 months. Determine how much the payments on the sinking fund assisted mortgage loan are reduced relative to those required on a $50,000 conventional mortgage loan also at 5.5% per annum, compounded semi-annually, and with a 25-year amortization period. 5. Carolyn has arranged a reverse annuity mortgage that provides $950 at the end of each month. The mortgage bears interest at 7% per annum, compounded semi-annually. The lender will provide these payments until the amount owing reaches $120,000, at which time a "regular" mortgage must be arranged to amortize the accumulated debt. How many complete payments will be forwarded? 6. A lender is prepared to grant a loan to finance the purchase of an industrial building. The lender is willing to advance $750,000 at 10% per annum, compounded semi-annually to be repaid by monthly payments and calculated on a 25-year amortization period. The lender is also to receive 6% of the monthly net operating income. If the present annual net operating income is $105,000 and it remains constant for 5 years, what yield will the lender receive if the mortgage has a 5-year term? Express the yield as a nominal rate with semi-annual compounding. 7. A lender offers a loan in the amount of $240,000, which is to be fully amortized over 25 years with monthly payments. The loan bears interest at 6% per annum, compounded semi-annually, but the lender also wants to receive 22% of all increases in the value of the property when it is sold. The property is presently worth $300,000. What price must the property be sold for at the end of 5 years if the lender is to earn an effective annual rate of 8% per annum on the loan? 7.4

6 Mortgage Loan Repayment Plans ASSIGNMENT 7 CHAPTER 9: Mortgage Repayment Plans Marks: 1 per question 1. Consider the following statements about interest only loans: A. Interest only loans are attractive to borrowers because there is no need to make periodic payments. B. Real estate developers often prefer this type of loan because financing payments are kept to a minimum when they need their resources to finance construction. C. Lenders often approve these loans because a longer period of repayment reduces risk. D. Interest only loans are never fully repaid because they accrue interest indefinitely. E. Lenders are able to lessen the amount of income risk associated with a loan when they agree to accept interest only payments. Which of the above statements are TRUE? (1) Only statements B and E are true. (2) Only statements A, B, and C are true. (3) Only statements B, C, and E are true. (4) None of the above statements are true. 2. On an interest accruing loan: (1) the interest earned on the outstanding principal is paid periodically as charged. (2) no payments of interest and no repayments of principal are due until maturity. (3) a longer term reduces the risk to the lender. (4) a constant amount of principal is repaid every interest compounding period. 3. An interest only loan in the amount of $350,000 was issued January 1, three years ago. The interest rate charged on the loan is 6% per annum, compounded semi-annually with semi-annual payments. If the term of the loan is 3 years, what amount will be due and payable on January 1, this year? (1) $10,500 (2) $21,000 (3) $350,000 (4) $360,500 ***Assignment 7 continues on next page*** 7.5

7 Lesson 7 4. There are three innovative mortgage repayment schemes discussed in the course manual: Graduated Payment Mortgages (GPM); Variable Rate Mortgages (VRM); and Reverse Mortgages (RM). Which of these would be the most appropriate to recommend in each of the following situations? A. Grania has just retired from 30 years of teaching in Richmond and wishes to supplement her pension income. She owns and occupies a reasonably expensive waterfront property in Vancouver. B. Mike and Sarah have just graduated from school and want to purchase a house and start a family. However, their current low income does not allow them to meet the payments required for a large enough loan to purchase their dream home. They expect their income to increase quickly in the near future. C. George and Angela have been saving for a long time and now want to invest their savings in a mortgage loan. However, they are very concerned about locking their investment in at current interest rates because rates may rise in the future. (1) A = GPM; B = VRM; C=RM (2) A = VRM; B = GPM; C=RM (3) A = RM; B = GPM; C=VRM (4) A = RM; B = VRM; C=GPM 5. Which of the following statements regarding alternative repayment and refinancing methods is/are FALSE? A. To a borrower, inflation can cause a serious problem known as "wilting". B. In graduated payment mortgages, payments are increased during the loan term. C. In a variable rate mortgage, the interest rate is changed periodically but the required payment is never changed. D. From the borrower's perspective, the reverse mortgage allows a means by which the equity rich mortgagor may postpone selling his/her residence. (1) Only statement B is false. (2) Only statements A and C are false. (3) Only statements A, C, and D are false. (4) All of the above statements are false. 6. Kenji and Tricie are looking to buy their first home in Nanaimo. They have been saving money for a long time but they will need a mortgage loan to help with the purchase. They believe that current interest rates will decrease in the future. Given the information presented, which of these mortgage options would be the most appropriate to recommend in this situation? (1) Graduated Payment Mortgage (2) Sinking Fund Assisted Mortgage (3) Reverse Mortgage (4) Variable Rate Mortgage 7.6 ***Assignment 7 continues on next page***

8 Mortgage Loan Repayment Plans 7. Mr. Jones, a senior citizen, would like to improve his current pension with some additional income. As a result, he initiated a reverse mortgage that will help supplement his income by adding an additional $900 per month on the security of his $300,000 home. The mortgage is written at 8% per annum, compounded semi-annually. The outstanding balance is not to exceed 45% of the market value of the home at the time the loan was written. What is the maximum contractual term the loan may have? (1) The loan term must not exceed 105 years. (2) The loan term must not exceed 9 years. (3) The loan term must not exceed 104 months. (4) The loan term must not exceed 2 years, as this is the longest reverse mortgage contract allowed by the BC Mortgage Broker's Act. 8. A $265,000 variable rate mortgage was written at 9.5% per annum, compounded semi-annually, to be amortized over 25 years with monthly payments rounded to the next higher dollar. The mortgage contract specified that the interest rate could be adjusted, on each anniversary of the mortgage to the current market rate. Two years later, the market rate decreased to 8.5% per annum, compounded semi-annually. Calculate the required payments, rounded to the next higher dollar, after the second year, assuming the amortization period is not to be extended and that the contract specified variable payments are allowed. (1) $2,116 (2) $2,141 (3) $1,967 (4) $2, Straight line principal reduction loans are: (1) attractive to most borrowers. (2) useful where the borrower expects an increase in income over time. (3) beneficial to individuals drawing near to retirement and expecting a significant drop in income and purchasing power. (4) common in real estate. 10. In a constant payment blended payment repayment scheme: (1) the interest portion of the payment gradually decreases and the amount to principal increases. (2) the early payments are usually comprised largely of principal with little interest being paid. (3) interest risk is maximized. (4) the outstanding balance will always to zero at the end of the term. 11. Partially amortized constant payment mortgages: (1) are the most common form of mortgage repayment in the United States. (2) have payments set to repay the whole of the debt over the loan's amortization period. (3) have the loan's amortization set for a shorter duration than the contractual term. (4) are rarely used in Canada. ***Assignment 7 continues on next page*** 7.7

9 Lesson Which of the following statements about variable rate mortgages are TRUE? A. Variable rate mortgages are popular for individuals who are risk-adverse. B. Borrowers have the advantage of lower interest costs when mortgage rates stay flat or decline. C. Variable rate mortgages allow lenders to better match assets and liabilities, reducing interest rate risk. D. For variable rate mortgages, interest rate changes are reflected in one or more changes to the amortization period, the repayment schedule, or the outstanding balance. (1) All of the above statements are true. (2) Only statements A, B, and C are true. (3) Only statements A, C, and D are true. (4) Only statements B, C, and D are true. 13. Which of the following statements about graduated payment mortgages is TRUE? A. GPM payments are constant over the initial term of the mortgage. B. Early payments on a GPM are typically lower than payments on a standard blended rate repayment loan. C. In a GPM, the total indebtedness of the borrower often continues to grow until the gradually increasing periodic payments become large enough to pay all interest charged in a payment period and make some contribution to debt repayment. D. GPMs represent a high degree of capital risk unless extremely large loan-to-value ratios are used. (1) All of the above statements are true. (2) Only statements A and B are true. (3) Only statements B and C are true. (4) Only statements A and D are true. THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: A borrower has arranged a sinking fund assisted mortgage (SFAM) at a rate of 8% per annum, compounded monthly. This loan will be amortized over 20 years, a 5-year term, and monthly payments. The face value of the mortgage is written at $250,000 and the amount advanced to the borrower is $200,000. The amount of the bonus deposit ($50,000) is placed in an interest bearing account at a rate of 5% per annum, compounded monthly. Constant monthly withdrawals will be made over the 5-year period which will deplete the fund. 14. Calculate the amount of the SFAM payment. (1) $2, (2) $1, (3) $1, (4) $1, ***Assignment 7 continues on next page***

10 Mortgage Loan Repayment Plans 15. Calculate the amount of the monthly withdrawal. (1) $1, (2) $ (3) $ (4) $ What is the difference between the net payment and the payment on a standard constant blended payment mortgage at a rate of 8% per annum, compounded monthly (based on a 20-year amortization with monthly payments)? (1) There is no difference in payments (2) $ (3) $1, (4) $ Which of the following statements are TRUE? A. Under CHIP, homeowners can receive up to 50% of the value of their home with the specific amount to be based on the homeowner's age, the location of the property, the type of home, and the home's current appraised value. B. Since reverse mortgages are rising debt loans, it is important that seniors' children or estate also understand the process involved in a reverse mortgage because an inheritance can be substantially reduced upon repayment of the debt. C. The PLAM scheme presents great risk to borrowers, with a large and possibly unwarranted assumption that borrowers' income will increase with inflation. D. In a zero inflationary environment, the nominal payment and "real" payment on a standard constant payment mortgage will be the same. (1) Only statements A, B, and C are true. (2) Only statements B and D are true. (3) Only statements A, C, and D are true. (4) All of the above statements are true. 18. An institutional lender is offering a shared appreciation mortgage (SAM) to a home owner. The borrower wants to obtain a $275,000 mortgage loan. The interest rate on the mortgage is set at 7.5% per annum, compounded monthly and payable with monthly payments over a 25-year amortization. In addition, the lender will receive 20% of any increase in property value. The participation is to be payable whenever the property is sold or, if the property is not sold within 6 years, then the property is deemed to be sold after 6 years. The lender agrees to grant the mortgage against the property which has a current market value of $350,000 (and both lender and borrower agree to this amount). If the market value at the end of 6 years is $475,000, calculate the expected yield that the lender will earn on this investment, expressed as an annual rate, compounded monthly (rounded to six decimal places). (1) % (2) % (3) % (4) % ***Assignment 7 continues on next page*** 7.9

11 Lesson 7 THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: A lender has recently approved a $300,000 participation loan at a rate of 7% per annum, compounded quarterly. This loan will have a 15-year amortization and quarterly payments, rounded up to the next higher dollar. In addition to the regular quarterly payment, the lender will receive 10% of the quarterly NOI. Assume that the NOI is distributed evenly throughout the year. 19. If the current annual NOI is $100,000 and is expected to remain at this level for the duration of a 3- year term, calculate the lender's yield, expressed as an annual rate with quarterly compounding (rounded to six decimal places). (1) % (2) % (3) % (4) % 20. Assume that the current annual NOI will remain at $100,000 per annum for 3 years, then will increase to $115,000 and remain at that level for the next three years. What will happen to the lender's yield? (1) The lender's yield will increase (2) The lender's yield will decrease. (3) The lender's yield will be unchanged. (4) It is impossible to determine what will happen to the lender's yield. 20 Total Marks Planning Ahead Go to Project 2 and read what is required. There are a series of in-depth mortgage finance calculations required. You may wish to review these at the same time you are working on this assignment ***End of Assignment 7***