Finance_06 Instructor Materials.docx

6. Basic Features of a Residential Loan Learning Objectives After completing this lesson, students should be able to… Identify the basic features of a mortgage loan, including amortization, repayment period, loan-to-value ratio, mortgage insurance or guaranty, and fixed or adjustable rate Explain ho...

6. Basic Features of a Residential Loan Learning Objectives After completing this lesson, students should be able to… Identify the basic features of a mortgage loan, including amortization, repayment period, loan-to-value ratio, mortgage insurance or guaranty, and fixed or adjustable rate Explain how different forms of amortization work, and the concept of a balloon payment Discuss the relationship between a loan’s repayment period and its interest rate Calculate a loan-to-value ratio Explain the purpose of mortgage insurance or loan guaranties Give an example of the restrictions a primary lender might place on secondary financing Name the issues adjustable-rate mortgages were designed to address List the features of an adjustable-rate mortgage, including those used to control interest rate and payment adjustments Describe the circumstances under which negative amortization can result Suggested Lesson Plan 1. Give students Exercise 6.1 to review the previous chapter, “Finance Instruments.” 2. Provide a brief overview of Chapter 6, “Basic Features of a Residential Loan,” and review learning objectives for the chapter. 3. Present lesson content: Amortization EXERCISE 6.2 Amortization Repayment Period Loan-to-Value Ratio Mortgage Insurance or Loan Guaranty Secondary Financing EXERCISE 6.3 Repayment period and loan-to-value ratio Fixed or Adjustable Interest Rate – How ARMs work – ARM features – Explaining ARMs EXERCISE 6.4 Adjustable-rate mortgages Loan Features and Financing Options 4. End lesson with Chapter 6 Quiz. Chapter 6 Outline: Basic Features of a Residential Loan I. Amortization A. An amortized loan involves regular payments of both principal and interest 1. Most home purchase loans are fully amortized 2. Alternatives to fully amortized loans are partially amortized loans and interest-only loans EXERCISE 6.2 Amortization II. Repayment Period A. The repayment period or loan term is how long the borrower has to pay off the loan 1. A 30-year loan term is regarded as standard, but other terms, such as 15 years and 20 years, are available 2. A 30-year loan has a lower monthly payment than a 15-year loan, but a 15-year loan will require paying much less interest over the life of the loan 3. A 15-year loan is likely to have a lower interest rate than a 30-year loan III. Loan-to-Value Ratio A. The loan-to-value ratio (LTV) reflects the relationship between the loan amount and the value of the home being purchased B. A loan with a lower LTV is less risky for the lender than one with a higher LTV IV. Mortgage Insurance or Loan Guaranty A. Mortgage insurance or a loan guaranty may be used to protect the lender from loss in the event of default B. Mortgage insurance 1. In exchange for mortgage insurance premiums, an insurer will indemnify a lender for any shortfall resulting from a foreclosure sale 2. Mortgage insurance is used in conventional and FHA loans C. Loan guaranty 1. In a loan guaranty (used in VA loans), a guarantor takes on secondary responsibility for a borrower’s obligation 2. If the borrower defaults, the guarantor will reimburse the lender for any resulting losses V. Secondary Financing A. A buyer may obtain, in addition to a primary loan, a secondary loan to cover part of the downpayment and closing costs B. Restrictions are placed on secondary financing, such as making sure that the borrower can afford payments on both loans EXERCISE 6.3 Repayment period and loan-to-value ratio VI. Fixed or Adjustable Interest Rate A. A loan’s interest rate can be fixed for the entire loan term, or adjustable B. Fixed-rate loans are regarded as the standard, and were used almost exclusively until high interest rates in the 1980s encouraged use of ARMs C. An adjustable-rate mortgage (or ARM) allows a lender to adjust the loan’s interest rate periodically to reflect changes in the cost of borrowing money D. Adjustable-rate mortgage features 1. Note rate: the initial rate stated in the promissory note is an ARM’s note rate 2. Index: a statistical report indicating changes in the cost of money, which the lender will use in order to adjust the ARM’s interest rate 3. Margin: the difference between an ARM’s interest rate and the index rate, reflecting the lender’s profit margin and administrative costs 4. Rate adjustment period: the period that determines how often a lender can adjust the interest rate on an ARM 5. Payment adjustment period: the period that determines how often a lender can adjust the payment amount on an ARM 6. Interest rate cap: a limit on how high the interest rate for an ARM can go, either limiting how high it can go in one adjustment or a maximum rate for the entire loan 7. Payment cap: a limit on how high the monthly payment for an ARM can go 8. Negative amortization: when monthly payments on an ARM don’t cover all of the monthly interest, thus adding to the principal balance instead of subtracting from it (which might occur if an ARM has a payment cap but no interest rate cap) 9. Conversion option: a feature that allows an ARM borrower to convert to a fixed-rate loan during certain years of the loan term VII. Loan Features and Financing Options A. Real estate agents may need to help home buyers evaluate the best financing option for their circumstances; differences in loan features will determine how much money the buyer can borrow and how affordable the loan will be EXERCISE 6.4 Adjustable-rate mortgages Exercises EXERCISE 6.1 Review exercise To review Chapter 5, “Finance Instruments,” have students answer these questions. 1. What are the two primary kinds of real property security instruments? 2. Who are the parties to a mortgage? 3. Who are the parties to a deed of trust? 4. Which type of security instrument is usually foreclosed nonjudicially? 5. What is the purpose of an alienation clause? Answers: 1. Mortgage and deed of trust 2. Mortgagor (borrower) and mortgagee (lender) 3. Trustor (borrower), beneficiary (lender), and trustee (neutral third party) 4. Deed of trust 5. An alienation clause (also called a due-on-sale clause) allows the lender to call the note if the borrower sells or otherwise transfers the security property without the lender’s consent. This protects the lender against assumption of the loan by a buyer who isn’t creditworthy. EXERCISE 6.2 Amortization Fill in the blanks with the correct term. (Terms may be used more than once.) Fully amortized Increasing Partially amortized Decreasing Interest-only Balloon 1. A loan that requires payments of principal and interest during the loan term and a balloon payment at the end is a/an ______________ loan. 2. The regular payments for a/an ______________ loan will pay off all of the principal and interest by the end of the loan term without a balloon payment. 3. Over the course of an amortized loan’s term, the interest portion of the payment is ______________ and the principal portion of the payment is ______________. 4. A/an ______________ loan requires no principal to be paid during the loan term, or during a specified number of years at the beginning of the loan term. 5. A majority of mortgage loans made by institutional lenders are ______________. Answers: 1. Partially amortized 2. Fully amortized 3. Decreasing; Increasing 4. Interest-only 5. Fully amortized EXERCISE 6.3 Repayment period and loan-to-value ratio Discussion Prompts: Compare a 30-year loan with a 15-year loan. Why might a home buyer choose one over the other? What are the advantages and disadvantages of each? Why do lenders consider a loan with a lower loan-to-value ratio less risky? Analysis: The longer the term of an amortized loan, the lower the monthly payment amount. So a 30-year loan has the advantage of much smaller payments. The disadvantage is that the buyer will end up paying much more total interest with a 30-year loan. There are two reasons for that. First, the interest will be accruing for only half as long with a 15-year loan. Second, lenders charge lower interest rates on 15-year loans. However, since the payments for a 15-year loan are much larger than the payments for a 30-year loan for the same amount, a buyer who wants a 15-year loan may have to borrow a lot less money in order to keep the payments at an affordable level. To do that, it would be necessary either to make a much larger downpayment, or else to buy a much less expensive house. A lower loan-to-value ratio means a larger downpayment. The borrower has invested more money in the house, so she’s less likely to let the loan slip into default. Also, the lower LTV and larger downpayment mean a smaller loan amount; this makes it more likely that if a foreclosure sale eventually did become necessary, the proceeds would be sufficient to repay the entire amount still owing. EXERCISE 6.4 Adjustable-rate mortgages Discussion Prompt: What are the advantages and disadvantages of an ARM from the borrower’s point of view? What is payment shock? What two features of an ARM protect against payment shock? Analysis: From the point of view of most borrowers who choose an ARM, the chief advantage is that the initial interest rate is usually lower than the rate for a comparable fixed-rate loan. That’s because the borrower and the lender are sharing the risk of fluctuating interest rates. The lower initial rate allows a borrower to afford more house, or to have a more affordable payment. However, the disadvantage for the borrower is that the payment amount may increase. In some cases, it could increase so much that the borrower can no longer afford the payments, which is called payment shock. Interest rate caps and mortgage payment caps help protect the borrower against payment shock. Chapter 6 Quiz 1. With an adjustable-rate mortgage, the loan’s interest rate: A. may increase, but cannot decrease, during the loan term B. cannot increase after the first five years of the loan term C. may increase or decrease during the loan term D. is adjusted whenever the index rate changes 2. Which loan-to-value ratio poses the least amount of risk to the lender? A. 80% B. 85% C. 96% D. 90% 3. The interest rate of an ARM is adjusted from time to time to reflect the: A. note rate B. amount the property value has appreciated or depreciated C. margin D. cost of money 4. Which of the following statements regarding mortgage insurance is true? A. The borrower must meet the insurer’s underwriting standards B. The insurer agrees to reimburse the borrower for interest paid on the loan C. The lender ordinarily pays the insurance premiums D. The insurance covers losses due to fire or other hazards 5. All of the following are features of an ARM, except a/an: A. index B. rate adjustment period C. discount rate D. note rate 6. The amount of the monthly payment is adjusted according to the: A. rate adjustment period B. mortgage payment adjustment period C. discount period D. principal adjustment period 7. The purpose of a loan guaranty is to: A. protect the lender from foreclosure loss B. protect the borrower from a deficiency judgment C. protect the seller from foreclosure D. None of the above 8. When a borrower exercises the conversion option in an ARM, the new fixed interest rate is usually: A. 2% above the loan’s original adjustable rate B. the index rate at the time of conversion C. the market rate at the time of conversion D. the market rate at the time the loan was originated 9. The Willards purchase a home with a $150,000 loan, at 4% interest. Over the next three years, market interest rates rise to 6%. After three years, the lender raises the interest rate to 5.75%. The Willards have a: A. wraparound mortgage B. blanket loan C. hybrid ARM D. package mortgage 10. All of the following are advantages of a 15-year loan, except: A. borrower equity builds up quickly B. a lower interest rate C. lower monthly payments D. a lower amount of total interest paid 11. The purpose of a negative amortization cap is to limit the: A. amount of interest paid over the life of the loan B. amount of the borrower’s monthly payments C. total amount the interest rate can increase over the life of the loan D. total amount the borrower can owe above the original loan amount 12. The Mitchells are financing the purchase of their first home with a 30-year ARM. It has an initial rate adjustment period of seven years, with annual rate adjustments from then on. This loan is which type of ARM? A. 5/1 ARM B. 10/1 ARM C. 7/1 ARM D. 3/1 ARM 13. A loan has a fixed interest rate and level monthly payments; a portion of each month’s payment is applied to interest and the remainder is applied to principal, but a balloon payment will be due at the end of the term. This loan is: A. unamortized B. negatively amortized C. fully amortized D. partially amortized 14. Which loan repayment period would involve paying the least amount of interest? A. 20 years B. 15 years C. 30 years D. 35 years 15. The length of the repayment period of a loan affects the: A. interest paid over the loan term B. origination fee C. monthly payment D. Both A and C Answer Key 1. C. The primary feature of an adjustable-rate mortgage (ARM) is that the interest rate increases or decreases during the loan term to reflect any changes in the cost of money. 2. A. The lower the loan-to-value ratio, the less risk to the lender. A buyer who makes a larger downpayment will work harder to avoid defaulting on the loan. This also makes it more likely that the lender will recover the principal if foreclosure is necessary. 3. D. The lender adjusts the interest rate of an ARM periodically to reflect changes in the cost of money. This means both parties share the risk of interest rate fluctuations. 4. A. Because the insurer assumes much of the risk of loan default, the insurer underwrites the loan. This means that the borrower must also meet the qualifying standards of the mortgage insurance company. 5. C. An ARM has a number of special features including an index, a rate adjustment period, and a note rate. A discount rate is the interest rate charged when a member of the Federal Reserve System borrows money from a Federal Reserve Bank. 6. B. The mortgage payment adjustment period determines when the lender changes the amount of the borrower’s monthly principal and interest payment. 7. A. Mortgage insurance and loan guaranties are designed to protect the lender from foreclosure loss in the event that the borrower defaults on the mortgage. 8. C. A conversion option allows a borrower to switch from an adjustable interest rate to a fixed interest rate. The fixed rate is the current market rate at the time of conversion. 9. C. The Willards have a 3/1 hybrid ARM. After the initial fixed-rate period of three years, the lender is allowed to adjust the interest rate to reflect changes to the market interest rate once a year. 10. C. The monthly payments for a 15-year loan are much higher than for a 30-year loan, which makes it difficult for many buyers to qualify for a loan. 11. D. A negative amortization cap limits the total amount a borrower can owe above the original loan amount. 12. C. A 7/1 ARM means that the initial rate adjustment period is seven years and all subsequent periods are each one year. The first number is the number of years in the initial period. The second number is the length of the subsequent rate adjustment periods. 13. D. A partially amortized loan requires regular payments of principal and interest, as well as a final balloon payment of the remaining principal at the end of the loan term. 14. B. One advantage of a shorter loan term is that the borrower pays less total interest on the loan. Lenders are more inclined to offer lower interest rates for loans with shorter terms. 15. D. The length of a loan’s repayment period affects the amount of interest the borrower will pay over the life of the loan and the size of the monthly payment.