Basic Features of a Residential Loan PDF

Basic Features 6 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, mortg...

Basic Features 6 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 re- view learning objectives for the chapter. © 2018 Rockwell Publishing  Financing Residential Real Estate Instructor Materials 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 2  Chapter 6: Basic Features of a Residential 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 responsibil- ity 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 lend- er 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, reflect- ing 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 3  Financing Residential Real Estate Instructor Materials 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. 4  Chapter 6: Basic Features of a Residential Loan 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? 5  Financing Residential Real Estate Instructor Materials 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 inter- est 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 pay- ments 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 in- vested 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 compa- rable 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. 6  Chapter 6: Basic Features of a Residential Loan Chapter 6 Quiz 1. With an adjustable-rate mortgage, the loan’s 6. The amount of the monthly payment is adjusted interest rate: according to the: A. may increase, but cannot decrease, during A. rate adjustment period the loan term B. mortgage payment adjustment period B. cannot increase after the first five years of C. discount period the loan term D. principal adjustment period C. may increase or decrease during the loan term 7. The purpose of a loan guaranty is to: D. is adjusted whenever the index rate changes A. protect the lender from foreclosure loss B. protect the borrower from a deficiency judgment 2. Which loan-to-value ratio poses the least C. protect the seller from foreclosure amount of risk to the lender? D. None of the above A. 80% B. 85% 8. When a borrower exercises the conversion op- C. 96% tion in an ARM, the new fixed interest rate is D. 90% usually: A. 2% above the loan’s original adjustable 3. The interest rate of an ARM is adjusted from rate time to time to reflect the: B. the index rate at the time of conversion A. note rate C. the market rate at the time of conversion B. amount the property value has appreciated D. the market rate at the time the loan was or depreciated originated C. margin D. cost of money 9. The Willards purchase a home with a $150,000 loan, at 4% interest. Over the next three years, 4. Which of the following statements regarding market interest rates rise to 6%. After three mortgage insurance is true? years, the lender raises the interest rate to A. The borrower must meet the insurer’s un- 5.75%. The Willards have a: derwriting standards A. wraparound mortgage B. The insurer agrees to reimburse the bor- B. blanket loan rower for interest paid on the loan C. hybrid ARM C. The lender ordinarily pays the insurance D. package mortgage premiums D. The insurance covers losses due to fire or 10. All of the following are advantages of a 15-year other hazards loan, except: A. borrower equity builds up quickly 5. All of the following are features of an ARM, B. a lower interest rate except a/an: C. lower monthly payments A. index D. a lower amount of total interest paid B. rate adjustment period C. discount rate D. note rate 7  Financing Residential Real Estate Instructor Materials 11. The purpose of a negative amortization cap is 15. The length of the repayment period of a loan to limit the: affects the: A. amount of interest paid over the life of the A. interest paid over the loan term loan B. origination fee B. amount of the borrower’s monthly pay- C. monthly payment ments D. Both A and C 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 8  Chapter 6: Basic Features of a Residential Loan Answer Key 1. C. The primary feature of an adjustable- 7. A. Mortgage insurance and loan guaran- rate mortgage (ARM) is that the ties are designed to protect the lender interest rate increases or decreases from foreclosure loss in the event that during the loan term to reflect any the borrower defaults on the mortgage. changes in the cost of money. 8. C. A conversion option allows a borrower 2. A. The lower the loan-to-value ratio, the to switch from an adjustable interest less risk to the lender. A buyer who rate to a fixed interest rate. The fixed makes a larger downpayment will rate is the current market rate at the work harder to avoid defaulting on the time of conversion. loan. This also makes it more likely that the lender will recover the princi- 9. C. The Willards have a 3/1 hybrid ARM. pal if foreclosure is necessary. After the initial fixed-rate period of three years, the lender is allowed to ad- 3. D. The lender adjusts the interest rate of just the interest rate to reflect changes an ARM periodically to reflect changes to the market interest rate once a year. in the cost of money. This means both parties share the risk of interest rate 10. C. The monthly payments for a 15-year fluctuations. loan are much higher than for a 30- year loan, which makes it difficult for 4. A. Because the insurer assumes much many buyers to qualify for a loan. of the risk of loan default, the insurer underwrites the loan. This means 11. D. A negative amortization cap limits that the borrower must also meet the the total amount a borrower can owe qualifying standards of the mortgage above the original loan amount. insurance company. 12. C. A 7/1 ARM means that the initial rate 5. C. An ARM has a number of special adjustment period is seven years and features including an index, a rate all subsequent periods are each one adjustment period, and a note rate. year. The first number is the number of A discount rate is the interest rate years in the initial period. The second charged when a member of the Federal number is the length of the subsequent Reserve System borrows money from rate adjustment periods. a Federal Reserve Bank. 13. D. A partially amortized loan requires 6. B. The mortgage payment adjustment regular payments of principal and period determines when the lender interest, as well as a final balloon pay- changes the amount of the borrower’s ment of the remaining principal at the monthly principal and interest payment. end of the loan term. 9  Financing Residential Real Estate Instructor Materials 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 bor- rower will pay over the life of the loan and the size of the monthly payment. 10  Chapter 6: Basic Features of a Residential Loan PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Financing Residential Real Estate Lesson 6: Basic Features of a Residential Loan © 2018 Rockwell Publishing Introduction This lesson will cover: ⚫ amortization ⚫ repayment periods ⚫ loan-to-value ratios ⚫ mortgage insurance and loan guaranties ⚫ secondary financing ⚫ fixed and adjustable interest rates © 2018 Rockwell Publishing Amortization Loan amortization refers to how principal and interest are paid to lender during loan term. Amortized loan: borrower required to make regular installment payments that include principal as well as interest. © 2018 Rockwell Publishing 11  Financing Residential Real Estate Instructor Materials Amortization Fully amortized loan Payments for fully amortized loan are enough to pay off all principal and interest by end of loan term. ⚫ Payment amount same throughout term. ⚫ Every month, interest portion of payment gets smaller, principal portion gets larger. © 2018 Rockwell Publishing Amortization Partially amortized loan Partially amortized loan: requires regular payments including principal and interest. ⚫ But payments not enough to pay off debt by end of loan term. ⚫ Balloon payment required to pay remainder of principal. © 2018 Rockwell Publishing Amortization Interest-only loan Interest-only loan: calls for regular payments that cover only interest accruing, without paying any of principal, either: ⚫ during entire loan term, or ⚫ during specified interest-only period at beginning of term. © 2018 Rockwell Publishing 12  Chapter 6: Basic Features of a Residential Loan Amortization Interest-only loan If payments interest-only during limited period: ⚫ at end of that period, amortized payments must begin ⚫ payment may increase sharply at end of interest-only period © 2018 Rockwell Publishing Repayment Period Number of years borrower has to repay loan. ⚫ Also called loan term. © 2018 Rockwell Publishing Repayment Period Until 1930s, typical repayment period for mortgage was 5 years. ⚫ If lender didn’t renew loan, balloon payment required. Now 30 years is standard repayment period. ⚫ 15-, 20-, and 40-year loans also available. © 2018 Rockwell Publishing 13  Financing Residential Real Estate Instructor Materials Repayment Period Length of repayment period affects: ⚫ amount of monthly payment ⚫ total amount of interest paid over life of loan May also affect interest rate charged. © 2018 Rockwell Publishing Repayment Period Monthly payment amount Longer repayment period reduces amount of monthly payment. ⚫ 30-year loan more affordable than 15- year loan. Shorter repayment period: ⚫ higher payment amount ⚫ equity builds faster ⚫ more difficult to qualify for © 2018 Rockwell Publishing Repayment Period Total interest Shorter repayment period substantially decreases total amount of interest paid on loan. ⚫ Total interest for 15-year loan less than half total interest for 30-year loan. © 2018 Rockwell Publishing 14  Chapter 6: Basic Features of a Residential Loan Repayment Period 15-year vs. 30-year loan Advantages of 15-year loan: ⚫ lower interest rate ⚫ total interest much less ⚫ clear ownership in half the time Disadvantages of 15-year loan: ⚫ higher monthly payments © 2018 Rockwell Publishing Repayment Period 20-year loans 20-year loan is compromise between 15-year and 30-year loan. ⚫ Monthly payments higher than 30-year loan. ⚫ But not as high as 15-year loan. © 2018 Rockwell Publishing Repayment Period 40-year loans Some lenders offer 40-year loans, but they aren’t common. ⚫ Monthly payments even more affordable than 30-year loan. ⚫ Most commonly used in areas with very high housing costs. © 2018 Rockwell Publishing 15  Financing Residential Real Estate Instructor Materials Summary Amortization & Repayment Period Amortization Fully amortized Partially amortized Balloon payment Interest-only loan Loan term © 2018 Rockwell Publishing Loan-to-Value Ratio Loan-to-value ratio (LTV): expresses relationship between loan amount and value of home being purchased. ⚫ With 80% LTV, loan amount is 80% of home’s value. Higher LTV = smaller downpayment © 2018 Rockwell Publishing Loan-to-Value Ratio Higher LTV = higher risk Because downpayment is smaller, higher LTV loans riskier than lower LTV loans. ⚫ Borrower has less money invested, won’t try as hard to avoid default. ⚫ If foreclosure necessary, property may not sell for enough to pay off debt and costs. © 2018 Rockwell Publishing 16  Chapter 6: Basic Features of a Residential Loan Loan-to-Value Ratio Maximum LTV Lenders set maximum LTV for particular loan program or loan type. In transaction, maximum LTV determines: ⚫ maximum loan amount ⚫ minimum downpayment Key factor in determining “how much house” borrower can buy. © 2018 Rockwell Publishing Loan-to-Value Ratio Maximum LTV Lenders traditionally protected themselves by setting low LTV limits. ⚫ Traditional maximum: 80% ⚫ Higher LTVs allowed only in special programs (FHA, VA). © 2018 Rockwell Publishing Loan-to-Value Ratio Maximum LTV In recent years, loans with higher LTVs widely available. ⚫ With higher maximum LTVs, people without much cash can buy homes. © 2018 Rockwell Publishing 17  Financing Residential Real Estate Instructor Materials Mortgage Insurance/Loan Guaranty Purpose of mortgage insurance or guaranty: to protect lender from foreclosure loss. ⚫ Also encourages lenders to make loans that would otherwise be too risky. © 2018 Rockwell Publishing Mortgage Insurance/Guaranty Mortgage insurance Mortgage insurance works like other insurance: ⚫ policyholder pays premiums ⚫ insurer provides coverage for certain losses, up to policy limit © 2018 Rockwell Publishing Mortgage Insurance/Guaranty Mortgage insurance Policy protects lender against losses from borrower default and foreclosure. ⚫ Mortgage insurance company agrees to indemnify lender. ⚫ If foreclosure sale proceeds fall short, insurer will make up difference. © 2018 Rockwell Publishing 18  Chapter 6: Basic Features of a Residential Loan Mortgage Insurance/Guaranty Loan guaranty With loan guaranty, third party (guarantor) takes on secondary legal responsibility for borrower’s obligation to lender. ⚫ If borrower defaults, guarantor must reimburse lender for losses. © 2018 Rockwell Publishing Secondary Financing Secondary financing: second loan obtained to pay part of downpayment or closing costs required for primary loan. ⚫ May be provided by institutional lender, private third party, or property seller. © 2018 Rockwell Publishing Secondary Financing Lender of primary loan often restricts type of secondary financing borrower can use. ⚫ Intended to prevent secondary loan from increasing default risk. ⚫ Borrower must qualify for combined payment on both loans. ⚫ Borrower still required to make small downpayment from own funds. © 2018 Rockwell Publishing 19  Financing Residential Real Estate Instructor Materials Summary LTV Ratio and Other Features Loan-to-value ratio Maximum loan amount Minimum downpayment Mortgage insurance Indemnify Loan guaranty Guarantor Secondary financing © 2018 Rockwell Publishing Fixed or Adjustable Interest Rate Fixed-rate mortgages Fixed-rate mortgage: interest rate charged on loan remains constant throughout loan term. ⚫ When market rates rise or fall, loan rate stays the same. ⚫ Considered standard. © 2018 Rockwell Publishing Fixed or Adjustable Interest Rate Adjustable-rate mortgages Adjustable-rate mortgage (ARM): allows lender to adjust loan’s interest rate to reflect changes in cost of money. ⚫ Transfers rate fluctuation risk to borrower. ⚫ ARM’s initial interest rate often lower than market rate for fixed-rate loan. © 2018 Rockwell Publishing 20  Chapter 6: Basic Features of a Residential Loan Adjustable-Rate Mortgages How ARM works Borrower’s initial rate determined by market rates at time loan is made. Interest rate on loan tied to index. ⚫ Index: published statistical report used as indicator of changes in cost of money. ⚫ Lender chooses index when loan is made. © 2018 Rockwell Publishing Adjustable-Rate Mortgages How ARM works Loan’s interest rate periodically adjusted to reflect changes in index rate. ⚫ If index rate has increased, lender raises interest rate charged on loan. ⚫ If index rate has decreased, lender lowers interest rate charged on loan. © 2018 Rockwell Publishing Adjustable-Rate Mortgages ARM features ARM may have some/all of these features: ⚫ note rate ⚫ interest rate cap ⚫ index ⚫ payment cap ⚫ margin ⚫ negative ⚫ rate adjustment amortization cap period ⚫ conversion option ⚫ payment adjustment period ⚫ lookback period © 2018 Rockwell Publishing 21  Financing Residential Real Estate Instructor Materials ARM Features Note rate Note rate: ARM’s initial interest rate, as stated in promissory note. Some ARMs have teaser rate: discounted initial rate that doesn’t include the margin typically added to the index rate. © 2018 Rockwell Publishing ARM Features Index When loan is made, lender chooses one of several published indexes, such as: ⚫ Treasury securities index ⚫ 11th District cost of funds index ⚫ LIBOR index © 2018 Rockwell Publishing ARM Features Margin Margin: difference between index rate and interest rate lender charges borrower. ⚫ Lender adds margin to index to cover administrative expenses and provide profit. ⚫ Margin stays same throughout loan term, even when interest rate changes. © 2018 Rockwell Publishing 22  Chapter 6: Basic Features of a Residential Loan ARM Features Rate adjustment period ARM’s interest rate adjusted only at specified intervals. ⚫ For example, every 6 months, once a year, or every 3 years. ⚫ One-year adjustment period most common. © 2018 Rockwell Publishing ARM Features Rate adjustment period At end of period, lender: ⚫ checks index for increase or decrease ⚫ raises or lowers loan’s rate based on change in index rate © 2018 Rockwell Publishing ARM Features Rate adjustment period Hybrid ARM: combination of ARM and fixed- rate loan, with two-tiered adjustment structure. ⚫ Longer initial period, with more frequent adjustments after that. ⚫ Example: 3/1 hybrid ARM © 2018 Rockwell Publishing 23  Financing Residential Real Estate Instructor Materials ARM Features Mortgage payment adjustment period Determines when lender changes payment amount to reflect change in interest rate. ⚫ Most ARMs have payment adjustment at same time as rate adjustment. ⚫ With some loans, payment adjusted less frequently than interest rate. © 2018 Rockwell Publishing ARM Features Lookback period Typical lookback period is 45 days. ⚫ Loan’s rate and payment adjustments determined by what index was 45 days before end of adjustment period. © 2018 Rockwell Publishing ARM Features Interest rate cap When ARM’s payment amount is adjusted, borrower may experience payment shock. Occurs when: ⚫ market rates/index rise dramatically ⚫ sharp increase in loan’s interest rate ⚫ payment amount increases drastically © 2018 Rockwell Publishing 24  Chapter 6: Basic Features of a Residential Loan ARM Features Interest rate cap To protect borrower from payment shock, most ARMs have interest rate cap: ⚫ limits how much loan’s interest rate can increase per adjustment period and over life of loan © 2018 Rockwell Publishing ARM Features Mortgage payment cap Payment cap: directly limits how much loan’s payment amount can increase. ⚫ Cap applies only to principal and interest payment, not tax and insurance portion. ⚫ Many ARMS have only interest rate cap, with no payment cap. © 2018 Rockwell Publishing ARM Features Negative amortization Negative amortization: when unpaid interest is added to loan’s principal balance, increasing amount owed. ⚫ Normally, balance goes down steadily as principal is paid off. ⚫ Negative amortization causes principal balance to go up. © 2018 Rockwell Publishing 25  Financing Residential Real Estate Instructor Materials Negative Amortization Features causing NA ARM features that can lead to negative amortization: ⚫ payment cap without rate cap ⚫ payments adjusted less often than interest rate © 2018 Rockwell Publishing Negative Amortization Negative amortization cap Many ARMs structured to prevent negative amortization. But if NA is possible, loan may have negative amortization cap. ⚫ Limits amount of unpaid interest that can be added to principal balance. ⚫ When limit is reached, loan must be recast. © 2018 Rockwell Publishing Negative Amortization Option ARMs Each month, borrower chooses payment option: ⚫ P&I payment based on 15-year amortization ⚫ P&I payment based on 30-year amortization ⚫ interest-only payment ⚫ minimum (limited) payment © 2018 Rockwell Publishing 26  Chapter 6: Basic Features of a Residential Loan Negative Amortization Option ARMs Minimum payment option doesn’t cover interest, resulting in negative amortization. ⚫ After negative amortization limit reached and loan recast, many borrowers default. ⚫ Option ARMs no longer widely available. © 2018 Rockwell Publishing ARM Features Conversion option If ARM has conversion option, borrower allowed to convert loan to fixed-rate mortgage. ⚫ Conversion typically can take place only during limited period ⚫ Lender usually charges conversion fee. © 2018 Rockwell Publishing Summary Fixed or Adjustable Interest Rate Fixed-rate mortgage Adjustable-rate mortgage Index Note rate Margin Rate and payment adjustment periods Lookback period Interest rate and mortgage payment caps Negative amortization Option ARM Conversion option © 2018 Rockwell Publishing 27