“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Chapter 19

Residential Real Estate Finance: Mortgage Choices, Pricing and

Risks

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Major Topics

Primary and secondary mortgage markets

FRMs and ARMs

Conventional, FHA and VA mortgages

The Effect of Points on Mortgage Choice

Tax Effects of Mortgage Deductions

Mortgage Underwriting Criteria

Impact of the Internet on Residential Finance

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Introduction

Home ownership is a national policy in the United States

Instruments such as the adjustable rate mortgage which reduce interest rate risk for lenders and increase this risk for borrowers are a common alternative to fixed rate loans

Another major development impacting the way home purchases are financed today is the emergence of a dominant secondary market for home mortgage loans and the securitization of these loans

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Residential Financing

The fully amortizing fixed rate loan or FRM is the most traditional loan format for residential mortgages

It is characterized by loan payments (usually paid monthly) that are constant throughout the term of the mortgage

The typical loan classifications are conventional loans, FHA loans, and VA loans

There are also “jumbo loans” that are based on the mortgage limit for secondary market sale to Freddie Mac

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Loan Fees and Costs

In addition to the interest charged on the money borrowed and any insurance premiums for loan guarantees, the financial institution typically charges the borrower points, which are prepaid interest, and out of pocket costs for administrative and third party closing costs

Out of pocket costs include the cost of the appraisal, credit report, title insurance, surveys if required, environmental phase one reports if required, and other loan processing fees

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

The True Cost of Borrowing

The table below compares two loans of $240,000 where the APR is not the best indicator of the best consumer choice if the loan is to be held 5 years or less

The quicker the loan is to be repaid the better choice A becomes even though the initial contract rate is higher

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Tax Benefits of Mortgage Interest Rate Deductions

One of the key advantages of US home ownership is that interest on the mortgage loan is fully tax deductible

This is one of the remaining few tax shelters available to the typical consumer

In addition, any points paid in connection with the loan may also be tax deductible in the year points are paid

These tax deductions create a cash benefit to the borrower which directly impacts the effective borrowing cost

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Mortgage Buy Downs

When mortgage lending environments are competitive, lenders offer borrowers many choices in terms of points and interest rate combinations

Often, the borrower may “buy down” the interest rate by paying lender more points

Example: What is the max points needed to pay to buy down rate to 7.5% on a No points loan @ 8.5%, 30 yr amortization. Assume they plan to hold loan to maturity

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Mortgage Buy Down Example

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Residential Mortgage loan Underwriting

Borrower defaults on a loan can occur if the borrower may lose the ability to make the required loan payments or when a borrower is in a negative equity situation

Regardless, however, of who bears the risk of default, the loan originator must adhere to underwriting standards that seek to minimize the likelihood of default

Underwriting is the lender’s process of evaluating the borrower and the property offered as security for the mortgage to determine the transaction’s level of default and foreclosure loss risk

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Assessing the probability of default

There are five major criteria to assess this:

1. Income:

2. Other Debt Obligations

3. Housing Expenses

4. Credit Evaluation

5. Net Worth

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Mortgage Buy Downs In evaluating the property, the lender wants to

determine that the property provides adequate security for the debt

The value of the security is established by an appraisal on the property which includes market data on comparable sales

Acceptable loan to value ratios for conventional loans are typically 75% or 80% for non-insured mortgages and up to 95% for private insured mortgages

In the property evaluation process, the practice of redlining is prohibited, i.e. the lender is not permitted to make blanket designations of geographic areas that are considered to be unacceptable loan risks

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Future of Residential Finance Efficiency and speed of processing loans will

play a greater role in attracting business in a market that is already very thin on margins

Loan applications can actually be taken online using pre-formatted forms

Credit checks can be ordered on line, employment verified or financial reports accessed

An appraisal can be ordered on line and in some cases performed without the need for physical inspections using fully computerized data bases, geographic information systems or GIS and property address electronic photo banks

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

END