Finance and Investment PDF

Finance and 1 Investment Learning Objectives After completing this lesson, students should be able to… Identify the key characteristics of any investment Explain how home buyers use loans to purchase homes, and how the principles of in...

Finance and 1 Investment Learning Objectives After completing this lesson, students should be able to… Identify the key characteristics of any investment Explain how home buyers use loans to purchase homes, and how the principles of invest- ment affect residential financing List the types of investments (ownership, debt, and securities) Distinguish between the features and benefits of each investment type Discuss how the key characteristics of investments (safety, liquidity, and yield) interact to affect investment risk Discuss the concept of diversification and how it affects risk Describe the types of risks assumed by mortgage lenders, including risk of default, risk of loss, interest rate risk, and prepayment risk Summarize how market interest rates affect mortgage lending Suggested Lesson Plan 1. Provide a brief overview of Chapter 1, “Finance and Investment,” and review the learning objectives for the chapter. 2. Present lesson content: Borrowing Money to Buy a Home – Mortgage financing and affordability © 2018 Rockwell Publishing  Financing Residential Real Estate Instructor Materials – How mortgage financing works – Loans as investments EXERCISE 1.1 Borrowing money to buy a home Investments and Returns – Investment capital – Return on investment vs. return of investment Types of Investments – Ownership investments – Debt investments – Securities EXERCISE 1.2 Types of investments Investment Risk – Safety, liquidity, and yield – Diversification – Lending risks – Misjudging risk EXERCISE 1.3 Lending risks Market Interest Rates – Factors that affect mortgage rates – How interest rates affect real estate activity 3. End lesson with Chapter 1 Quiz. Chapter 1 Outline: Finance and Investment I. Borrowing Money to Buy a Home A. Buyer’s ability to afford a home depends in part on the availability of mort- gage financing B. Principal refers to whatever remains to be repaid out of the original amount borrowed, while interest reflects the cost of borrowing money C. From lender’s point of view, a loan is an investment 1. Interest is lender’s primary return on the investment 2. Lender will make a loan only if it appears to be a profitable investment under prevailing economic conditions 2  Chapter 1: Finance and Investment EXERCISE 1.1 Borrowing money to buy a home II. Investments and Returns A. Investment capital is accumulated wealth (savings) made available to fund enterprises, projects, and transactions B. Investor supplies capital in the expectation that it will generate additional wealth for the investor C. Returns 1. Return on investment: a profit over and above the amount originally in- vested 2. Return of investment: recapturing the amount originally invested (break- ing even) III. Types of Investments A. Ownership investments: investor buys a property interest in an asset 1. Ownership investments may generate net income, pay dividends, and/or appreciate 2. Examples: purchase of real estate, purchase of corporate stock B. Debt investments: investor provides money that is to be paid back 1. Debt investments generate interest income 2. Examples: loans, bonds, savings accounts, certificates of deposit C. Securities: may be either ownership investments or debt investments 1. Examples: stocks, bonds, mortgage-backed securities 2. Designed to be liquid investments, easily bought and sold in established markets 3. Mutual funds: investor purchases shares in a mutual fund company; fund managers use the capital to buy and sell securities 4. Federal Securities and Exchange Commission (SEC) regulates issuance and trading of securities to protect investors; certain financial disclosures are required and insider trading prohibited EXERCISE 1.2 Types of investments IV. Investment Risk A. Key investment characteristics 1. Safety: low risk of losing part or all of original investment amount 2. Liquidity a. Liquid asset can be converted into cash (sold) quickly b. Liquidity tends to increase safety (reduce risk of loss) 3. Yield: rate of return a. Investor usually pays for safety and liquidity with lower yield 3  Financing Residential Real Estate Instructor Materials b. Generally, the greater the risk, the higher the yield investors will demand c. Investment’s yield is not necessarily fixed at outset; may change with econo- my, success or failure of enterprise, etc. B. Diversified investment portfolio reduces overall risk of loss 1. Portfolio: mix of investments along with cash reserves 2. Diversification: putting money in a variety of investment vehicles to reduce expo- sure to risks C. Lending risks 1. Risk of default: borrower might not repay loan 2. Risk of loss: foreclosure proceeds might not cover loan balance; property might be destroyed 3. Interest rate risk: market rates may rise while loan funds are tied up at low rate 4. Prepayment risk: loan may be paid off sooner than expected if market rates decline D. Misjudging risk 1. Various factors can lead to poor investment decisions, including inaccurate infor- mation or unrealistic assumptions EXERCISE 1.3 Lending risks V. Market Interest Rates A. Market rates are typical rates paid for a particular type of loan in the current market B. Factors that may affect market rates for mortgages include size of loan, fixed or ad- justable rate, length of loan term, region of country, and/or borrower’s credit score C. Real estate activity increases with low rates, decreases with high rates D. Market interest rates go up when demand for mortgage funds exceeds supply, and go down when supply exceeds demand Exercises EXERCISE 1.1 Borrowing money to buy a home Discussion Prompt: What does a lender look for in determining whether a mortgage loan is a suitable investment? What does a buyer look for, in terms of the financial investment, when deciding whether to purchase a house? Analysis: The lender’s main concern is whether the loan will be profitable. The lender wants an appropriate return on the investment, taking into account economic conditions, the risks involved in making the loan, and what other investment op- 4  Chapter 1: Finance and Investment portunities are available. The buyer would focus on issues such as whether the interest rate is reasonable and the payments affordable, and whether the potential appreciation of the property, balanced against the loan payments, means that buying a home instead of renting one appears to be a sound investment. EXERCISE 1.2 Types of investments Discussion Questions: 1. When an investor sells an asset, the amount the asset has appreciated is equal to the sales price: A. minus closing costs B. plus closing costs C. minus the original purchase price D. plus the original purchase price 2. Debt investments include: A. houses B. sports teams C. art D. bonds 3. The provision in a loan agreement that addresses the loan’s term establishes the: A. interest rate B. length of time allowed for repayment C. amount of the prepayment penalty D. amount of appreciation 4. The purchaser of a bond pays: A. half the face amount B. double the face amount C. the face amount D. the face amount plus ten percent 5. Which of the following is an ownership investment? A. Rental property B. Bonds C. Savings account D. Promissory note 5  Financing Residential Real Estate Instructor Materials 6. A mortgage loan is a debt investment for the: A. borrower B. lender C. appraiser D. buyer Answers: 1. C. To determine how much an asset has appreciated, subtract the amount the in- vestor originally paid for it from the price it sells for. 2. D. Bonds are essentially loans to a corporation or a governmental entity in return for payments of interest and principal. The investor doesn’t gain an ownership interest in the entity issuing the bond. 3. B. A loan’s term is the repayment period, the amount of time the borrower has to pay the lender back. 4. C. A bond buyer pays the face amount of the bond and then receives interest and, at maturity, the principal. 5. A. The purchase of a rental property (or any real property) is an ownership invest- ment for the buyer. The buyer’s return includes the rental payments (less the operating expenses), and it may also include the appreciation of the asset and the proceeds of a sale. 6. B. The lender makes a debt investment by loaning funds to the borrower in return for the borrower’s interest payments and principal payments. EXERCISE 1.3 Lending risks Discussion Prompt: How does diversification reduce risks for investors? What are the different types of risk associated with mortgage lending? List some of the ways lenders protect themselves against those risks. Analysis: Diversification makes it more likely that the investor’s portfolio will reflect the overall economy and match its performance. While any investment has risks, in a diversified portfolio it’s less likely that all risks will affect all of the investments at the same time. If one investment does poorly, there’s a fair chance that the other investments will offset that loss with good returns. 6  Chapter 1: Finance and Investment Risks associated with mortgage lending include the risk of default, the risk of loss in the event of a default, interest rate risk, and prepayment risk. Lenders protect themselves against these risks through: underwriting (which reduces the risk of default and the risk of loss); mortgage insurance (which reduces the risk of loss); loan features such as adjustable interest rates and in some cases, prepayment penalties (which reduce the interest rate risk and the prepayment risk); and selling loans on the secondary market, which shifts interest rate risk to the pur- chaser of the loans. 7  Financing Residential Real Estate Instructor Materials Chapter 1 Quiz 1. Which of the following statements about the 5. One characteristic that distinguishes securities Securities and Exchange Commission is NOT from other types of investments is that securi- true? ties: A. The SEC regulates securities trading to A. don’t put the investor at risk of losing the protect investors capital originally invested B. Companies are required to disclose their B. don’t give the investor direct managerial financial information to the public control over the enterprise invested in C. SEC regulations prohibit insider trading C. are debt investments, not ownership invest- D. Those securities regulated by the SEC in- ments clude stocks, bonds, and savings accounts D. are illiquid 2. Market interest rates generally respond to: 6. An investor may expect a return on an invest- A. capital turnover ment, which may be all of the following, B. diversification except: C. appreciation A. rental income D. changes in supply and demand B. interest C. principal D. All of the above 3. Jenny has saved up $4,000 over the past year. She would like to invest the money, but is concerned about the stability of her job. She 7. A borrower defaults on a loan when: would like to be able to recover the money in A. the borrower fails to make the scheduled the event of an emergency. She is primarily payments interested in an investment’s: B. the value of the property decreases A. safety C. the market interest rate decreases B. rate of return D. None of the above C. liquidity D. All of the above 8. A potential borrower may receive a low interest rate on a loan for all of the following reasons, 4. Which of the following statements is true? except: A. Investment opportunities compete for avail- A. the borrower has a poor credit score able investment funds B. the loan has a short repayment period B. The availability of investment funds is C. the loan is for a small amount directly related to the return on a type of D. All of the above investment C. The SEC controls those funds available for 9. When a borrower gets a new mortgage and uses investment the proceeds to pay off an old mortgage, this is D. Low yield investments have a high degree called: of risk A. disintermediation B. refinancing C. appreciation D. diversification 8  Chapter 1: Finance and Investment 10. Which one of the following statements is NOT 15. An example of a liquid asset is a: a characteristic of an ownership investment? A. parcel of real estate A. Real estate is an ownership investment B. bond B. The possible returns on an ownership C. certificate of deposit investment include rental income and ap- D. None of the above preciation C. Someone who invests in an ownership investment acquires an asset or property interest D. None of the above 11. All of the following statements regarding cer- tificates of deposit are true, except: A. a CD is an ownership investment B. the holder of a CD agrees to keep funds on deposit with the financial institution during a specified period C. the holder of a CD may be charged a penalty for early withdrawal D. a CD generates interest in return for the depositor’s investment 12. An investor’s mix of investments is referred to as a: A. portfolio B. mutual fund C. security D. reserve 13. The interest a lender receives on a mortgage loan is the: A. measurement of the liquidity of the loan B. net income of the lender C. return on the lender’s investment D. rate of capital turnover 14. Which of the following statements about securi- ties is true? A. Securities give the holder a property interest or right of payment B. The holder of a security has managerial control of the entity C. Savings accounts are a form of security D. Securities are not easily bought or sold 9  Financing Residential Real Estate Instructor Materials Answer Key 1. D. The SEC regulates securities, which 9. B. Refinancing involves a borrower ob- are instruments that give the holder an taining a new loan at a lower interest interest or right to payment. Savings rate and using the new loan proceeds accounts are examples of a debt invest- to pay off the old mortgage. ment, rather than a security. 10. D. An ownership investment is either an 2. D. Mortgage “prices” (market interest asset or property interest that produces rates) respond to changes in the supply returns in the form of rental income, ap- and demand of the mortgage market. If preciation, or dividends. An example of supply exceeds demand, rates general- an ownership investment is real estate. ly decrease. If demand exceeds supply, rates increase. 11. A. A certificate of deposit (CD) is a debt investment that generates interest for 3. C. A liquid investment allows an investor the depositor in exchange for the de- to easily convert the investment into positor agreeing to keep the funds on cash. It will often involve much less deposit for a certain period of time. risk than a less liquid investment. 12. A. An investor’s portfolio is made up of a 4. A. Investment funds are not unlimited and mix of investments and cash reserves. different investment opportunities com- pete for those funds that are available. 13. C. The interest rate is the lender’s return on the investment of making the loan 5. B. A security is an investment instrument to the borrower. that gives the holder an interest or a right to payment, without giving the 14. A. The definition of a security is an holder any direct managerial control instrument that gives the holder a over the enterprise in question. property interest or a right to payment, but no managerial control over the en- 6. C. Debt investments provide a return in terprise. the form of interest. Ownership invest- ments may provide a return in the form 15. D. Real estate is considered an illiquid as- of appreciation, dividends, or rental in- set because it is not easily convertible come (if the asset is income-producing). into cash. Bonds and certificates of deposit are investments where the in- 7. A. A borrower who fails to make the vestor’s money is tied up for a specific scheduled loan payments has defaulted period of time. As a result, the liquid- on the loan. ity of these investments is less than stocks or mutual funds. 8. A. A borrower with a poor credit score can expect to pay a higher interest rate than an applicant with a good credit score. 10  Chapter 1: Finance and Investment PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Financing Residential Real Estate Lesson 1: Finance and Investment © 2018 Rockwell Publishing Introduction This lesson will cover: ⚫ mortgage financing ⚫ investments and returns ⚫ types of investments ⚫ investment risks ⚫ market interest rates © 2018 Rockwell Publishing Borrowing for Home Purchase Buyer’s ability to afford a home depends on: ⚫ housing prices ⚫ income level ⚫ tax considerations ⚫ mortgage financing available ⚫ many other factors © 2018 Rockwell Publishing 11  Financing Residential Real Estate Instructor Materials Borrowing for Home Purchase Typical loan transaction: ⚫ Lender loans buyer portion of purchase price. ⚫ Buyer makes downpayment. ⚫ Buyer executes security instrument (mortgage or deed of trust), creating lien. ⚫ Lien released when loan paid off. © 2018 Rockwell Publishing Borrowing for Home Purchase Buyers repay loan with monthly payments over specified period. ⚫ Loan term: period of loan repayment. ⚫ Principal: amount borrowed. ⚫ Interest: cost of borrowing money. © 2018 Rockwell Publishing Borrowing for Home Purchase Lender sees loan as an investment. ⚫ Interest paid by buyer is lender’s profit from investment. © 2018 Rockwell Publishing 12  Chapter 1: Finance and Investment Investments and Returns National economy is driven in part by investment capital: money used to fund business enterprises, ventures, projects. © 2018 Rockwell Publishing Investments and Returns Investor’s return takes various forms: ⚫ Return on investment: profit over and above the amount originally invested. ⚫ Return of investment: getting full amount originally invested back (also called recapture). © 2018 Rockwell Publishing Summary Investments and Returns Principal Loan term Interest Investment capital Return on investment Return of investment © 2018 Rockwell Publishing 13  Financing Residential Real Estate Instructor Materials Types of Investments Two general categories of investments: ⚫ ownership investments ⚫ debt investments © 2018 Rockwell Publishing Types of Investments Ownership investments Ownership investment: asset (or property interest in an asset) purchased by investor: ⚫ generates income, and/or ⚫ appreciates in value over time. Return in the form of appreciation ordinarily not realized by investor until asset is sold. © 2018 Rockwell Publishing Ownership Investments Real estate Real estate is example of ownership investment. It may: ⚫ produce income (rent), and/or ⚫ appreciate in value. © 2018 Rockwell Publishing 14  Chapter 1: Finance and Investment Ownership Investments Corporate stock Corporate stock another example of ownership investment. ⚫ Shares = ownership interest in corporation. ⚫ Stockholder’s return may take form of: ⚫ dividends, and/or ⚫ appreciation of stock value. © 2018 Rockwell Publishing Types of Investments Debt investments Debt investment: investor provides money to individual or company that will repay money along with interest. Examples: loans, bonds, savings accounts. © 2018 Rockwell Publishing Debt Investments Loans Loan that earns interest for lender is debt investment. Includes residential mortgage loans. ⚫ Bank makes debt investment by loaning money to home buyers. ⚫ Home buyers make ownership investment by investing money to purchase asset. © 2018 Rockwell Publishing 15  Financing Residential Real Estate Instructor Materials Debt Investments Bonds Bond: certificate of indebtedness issued by governmental body or business entity. ⚫ Coupon rate: interest rate paid on bond. ⚫ Principal: face amount of bond. © 2018 Rockwell Publishing Debt Investments Savings accounts Funds deposited into savings accounts are used by bank to make loans to other borrowers. ⚫ Depositor loans money to bank and receives interest in return. ⚫ Bank makes another debt investment (loan to another customer). © 2018 Rockwell Publishing Debt Investments Certificates of deposit Certificates of deposit (CDs): similar to savings accounts. ⚫ Depositor agrees to keep funds on deposit for certain time period in return for interest payments. ⚫ Bank can charge penalty for early withdrawal of funds. © 2018 Rockwell Publishing 16  Chapter 1: Finance and Investment Types of Investments Securities Securities: investment instruments that grant holder interest or right to payment, but no managerial control. ⚫ May be ownership or debt investments. ⚫ Liquid assets = quickly converted to cash. ⚫ Traded in established financial markets. ⚫ Examples: stocks, bonds. © 2018 Rockwell Publishing Securities Mutual funds Mutual fund: company that buys and sells stocks, bonds on behalf of investors. ⚫ Investors purchase shares in company. ⚫ Company uses capital to invest in securities. ⚫ Fund managers choose which securities to buy and sell. © 2018 Rockwell Publishing Securities Regulation of securities Issuance and trading of securities regulated by federal Securities and Exchange Commission (SEC). ⚫ Requires companies to disclose financial information to public. ⚫ Enforces insider trading rules. © 2018 Rockwell Publishing 17  Financing Residential Real Estate Instructor Materials Securities Securities and the mortgage industry Securities trading affects mortgage lending in two ways: ⚫ Mortgage lending competes with other investments for funds. ⚫ Mortgages can be pooled together and “securitized” for sale to investors as mortgage-backed securities. © 2018 Rockwell Publishing Summary Types of Investments Ownership investments Debt investments Corporate stock Savings accounts Securities Liquid assets Mortgage-backed securities © 2018 Rockwell Publishing Key Investment Characteristics Investors look at three potential investment advantages: ⚫ safety ⚫ liquidity ⚫ yield © 2018 Rockwell Publishing 18  Chapter 1: Finance and Investment Key Investment Characteristics Safety Investment is safe if there’s little risk that investor will actually lose money. Investor can count on return of investment, if not return on investment. © 2018 Rockwell Publishing Key Investment Characteristics Liquidity A liquid investment can be converted into cash (liquidated) quickly. Illiquid investments “lock up” investor funds, making them unavailable for other purposes. © 2018 Rockwell Publishing Key Investment Characteristics Yield Investment’s yield is its rate of return. ⚫ Low yield = safe and liquid investments. ⚫ High yield = high risk/illiquid investments. Yield isn’t necessarily fixed when investment is made. © 2018 Rockwell Publishing 19  Financing Residential Real Estate Instructor Materials Key Investment Characteristics Diversification Investor diversifies portfolio by putting money into variety of different investments. Portfolio: a mix of investments and cash reserves. © 2018 Rockwell Publishing Investment Risk Lending risks From lender’s point of view, risks involved in mortgage lending include: ⚫ risk of default ⚫ risk of loss ⚫ interest rate risk ⚫ prepayment risk © 2018 Rockwell Publishing Lending Risks Risk of default Degree of risk for loan depends on likelihood of borrower default. ⚫ Underwriting process screens loan applicants for risk. Lender may charge borrower more to compensate for extra risk. © 2018 Rockwell Publishing 20  Chapter 1: Finance and Investment Lending Risks Risk of loss Lenders take steps to limit risk of financial loss in event of default/foreclosure or damage to collateral property. Steps include: ⚫ appraising property ⚫ requiring borrower to maintain hazard insurance ⚫ requiring mortgage insurance for some loans © 2018 Rockwell Publishing Lending Risks Interest rate risk If market rates rise after loan is made at a certain interest rate, lender can’t reinvest money at higher rate. ⚫ Risk increases with length of loan term. ⚫ Lenders deal with risk by: ⚫ using adjustable-rate mortgages ⚫ selling loans on secondary market © 2018 Rockwell Publishing Lending Risks Prepayment risk Prepayment: borrower repays all or part of principal before it’s due. ⚫ Decline in interest rates = borrowers refinance and prepay existing loans. ⚫ Prepayment = lender’s yield is less. Some lenders compensate for reduced yield by charging prepayment penalty (restrictions apply). © 2018 Rockwell Publishing 21  Financing Residential Real Estate Instructor Materials Investment Risk Misjudging risk Investors who underestimate risk of particular investment may get lower yield than expected or even lose money. Poor investment decisions may result from: ⚫ inaccurate information ⚫ deception ⚫ bad judgment © 2018 Rockwell Publishing Market Interest Rates Market interest rates: typical rates lenders are currently charging borrowers for loans. Can be influenced by: ⚫ size of loan ⚫ whether rate is fixed or adjustable ⚫ loan term ⚫ borrower’s credit score © 2018 Rockwell Publishing Market Interest Rates Mortgage rates have considerable impact on real estate activity. ⚫ High rates cause slowdowns in real estate activity. ⚫ Low rates spur market. Mortgage rates also respond to changes in supply and demand. © 2018 Rockwell Publishing 22  Chapter 1: Finance and Investment Summary Investment Risk Safety Liquidity Yield Diversification Risk of default Risk of loss Prepayment Market interest rates © 2018 Rockwell Publishing 23