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Real estate finance 5

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Upper-level business finance expertise required for the attached assignment. Thank you

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2/27/2020 Sample Content Topic

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Loans Based on Client Needs

Introduction: Client needs are usually the driving force in
determining the best loan to use to acquire real estate. Some
loans require little or no down payment while others offer lower
interest rates that allow the client to obtain a larger loan. Still
others reduce the clients’ costs during the investment holding
period.

Read the scenario and respond to the checklist items.

Scenario: Henri and Lila are having second thoughts
regarding their choice of a home mortgage. They thought they
should just get a 15-year mortgage, but now they are not so
sure. The restaurant is doing alright so far, but they are not
sure about the future and they have had some recent flooding
on the restaurant property. The flooding may entail mitigation
work involving shutting down the restaurant for some period of
time. Because of the flooding issues, Henri and Lila now want
to keep as much cash in their pocket as possible to pay current
expenses. What are the couples best mortgage options if they
can put down $57,000 on their new home? The home price
agreed upon is $289,900 and this is the appraised price as
well.

Checklist:

Calculate the LTV for this home if they were to use a
conventional mortgage and explain the significance of your
findings.

Compare the mortgage options covered in the weekly reading
and recommend a mortgage option that would fit Henri and
Lila’s needs based on the scant information you have.

Explain the pros and cons of selecting whatever mortgage you
recommend to them.

Assignment Details

2/27/2020 Sample Content Topic

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Write a 2-page (minimum of 600 words) response with
additional title and reference pages using APA format and
citation style.

Access the Unit 5 Assignment grading rubric.

Submit your response to the Unit 5 Assignment Dropbox.

https://kapextmediassl-a.akamaihd.net/business/MT431/1904c/rubrics/u5_rubric

© 2018 Rockwell Publishing
Introduction
This lesson will cover:
types of finance instruments
how instruments work
common provisions

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Promissory Notes
Promissory note: written promise to pay money.
Maker: the one who makes the promise.
Payee: the one to whom the promise is made.
Note: evidence of the debt and a promise to pay.
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Promissory Notes
Can be brief, simple document. Usually contains:
names of parties
amount of debt
interest rate
how/when money is to be repaid
Basic provisions
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Promissory Notes
Must be signed by maker.
If certain requirements are met, it’s a negotiable instrument: right to receive payment can be transferred by endorsement.
Basic provisions
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Promissory Notes
Negotiable instrument requirements:
written, unconditional promise
to pay a certain sum of money
on demand or on a certain date
payable to order or to bearer
signed by maker
Negotiability
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Promissory Notes
“Without recourse” endorsement: issue of future payment strictly between maker and third party the instrument is endorsed to.
Original payee not liable if maker
fails to pay.
Without recourse
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Promissory Notes
Holder in due course: someone who buys negotiable instrument:
for value
in good faith
without notice of defenses
Even if maker has defense against original payee, maker still required to pay holder in due course.
Holder in due course
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Promissory Notes
Promissory notes classified as to how principal and interest are paid off.
Straight note: periodic payments are interest only, with principal due on maturity date.
Installment note: periodic payments include both principal and interest.
Types of notes
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Summary
Promissory Notes
Maker
Payee
Negotiable instrument
Without recourse
Holder in due course
Straight note
Installment note

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Security Instruments
In real estate transactions, promissory note is accompanied by security instrument:
mortgage
deed of trust

Gives lender security interest in property, enabling lender to foreclose if borrower defaults.
Purpose
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Security Instruments
If no collateral, lender can still enforce promissory note.
Lender sues borrower, obtains judgment.
But borrower may be “judgment-proof.”

Secured lender much more likely to collect payment.
Purpose
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Security Instruments
Personal property used as collateral for early forms of secured lending.
Borrower gave lender possession of collateral property until loan repaid.
Lender kept property if loan wasn’t repaid.
Historical background
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Security Instruments
Hypothecation: pledging property as collateral without giving up possession of it.
For real property loans, became standard arrangement for borrower to retain possession of land.
Lender held title until debt repaid.
Historical background
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Security Instruments
Legal title: title transferred only as collateral, without possessory rights.
Equitable title: property rights retained by borrower, without legal title.
Historical background
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Security Instruments
Eventually, transfer of legal title wasn’t necessary. More common to place lien against borrower’s property.
Lien: financial encumbrance on owner’s title, allowing lienholder to foreclose on property to collect debt.
Historical background
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Security Instruments
Two-party security instrument in which borrower mortgages his property to lender.
Mortgagor = borrower
Mortgagee = lender
Mortgage
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Also must identify promissory note it secures.
Basic provisions
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Mortgages
Mortgagor promises to:
pay property taxes
keep property insured against
fire and other hazards
maintain structures in good repair

Mortgagee has right to inspect property.
Covenants
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Mortgages
Satisfaction of mortgage: document given to mortgagor by mortgagee after mortgage is paid off, releasing property from lien.
Mortgagor records document.
Satisfaction
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Security Instruments
Similar to mortgage, but involves three parties, rather than two.
Grantor/trustor = borrower
Beneficiary = lender
Trustee = neutral third party

Trustee arranges for release of property or foreclosure, as necessary.
Deed of trust
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Deed of Trust
Deed of trust usually includes same basic provisions found in mortgage:
names of parties
property description
identification of promissory note
grantor’s promises to pay taxes and insure property
beneficiary’s right to inspect property

Basic provisions
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Deed of Trust
Deed of reconveyance: document releasing property from lien, executed by trustee when loan is paid off.
Recorded by grantor.
Reconveyance
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Summary
Security Instruments
Hypothecation
Legal title
Equitable title
Lien
Mortgage
Satisfaction of mortgage
Deed of trust
Deed of reconveyance

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Security Instruments
Key difference between deeds of trust and mortgages: procedures used for foreclosure.
Foreclosure
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Foreclosure
At one time, judicial foreclosure was only option.
Lender filed lawsuit against borrower.
Sheriff’s sale ordered by court if borrower found to be in default.

Alternative to judicial foreclosure was eventually developed.
Methods
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Methods of Foreclosure
Nonjudicial foreclosure is generally associated with deeds of trust.
Lender doesn’t have to file lawsuit.
Trustee arranges for property to be
sold at trustee’s sale.
Property sold to highest bidder.
Judicial vs. nonjudicial
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Methods of Foreclosure
Nonjudicial foreclosure requires power of sale clause in security instrument.
Power of sale clause: authorizes trustee to sell property in event of default.
All deeds of trust contain one.
May be included in mortgage, but usually not.
Power of sale
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Methods of Foreclosure
Judicial foreclosure used when:
state law doesn’t allow nonjudicial foreclosure
there’s no power of sale clause in security instrument
circumstances make it better choice for lender
Judicial foreclosure
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Judicial Foreclosure
Acceleration of debt
Foreclosure lawsuit
Equitable redemption or
cure and reinstatement
Writ of execution
Sheriff’s sale
Statutory redemption
Sheriff’s deed
Steps in judicial foreclosure
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Judicial Foreclosure Steps
1. Acceleration of debt: if mortgagor defaults, mortgagee notifies mortgagor that entire outstanding loan balance is due.
2. Foreclosure lawsuit: unless mortgagor pays off accelerated debt, mortgagee files foreclosure action.
Acceleration and lawsuit
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Judicial Foreclosure Steps
3. Equitable redemption vs. cure & reinstatement: while lawsuit is pending, mortgagor has right to stop proceedings by paying mortgagee.
Depending on state law, may be:
equitable right of redemption, or
right to cure and reinstate.
Stopping a pending foreclosure
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Judicial Foreclosure Steps
Equitable right of redemption: mortgagor’s right to stop proceedings by paying entire amount owed, plus costs.
Loan is paid off and property is redeemed.
Stopping a pending foreclosure
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Judicial Foreclosure Steps
Cure and reinstatement: mortgagor may “cure” default by paying just delinquent amount plus costs.
Foreclosure proceedings terminate and loan is reinstated.
Stopping a pending foreclosure
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Judicial Foreclosure Steps
4. Writ of execution: if loan not cured or redeemed, judge schedules hearing to determine if default exists.
If so, judge issues writ of execution.
Directs sheriff to seize and sell property.
Court order
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Judicial Foreclosure Steps
5. Sheriff’s sale: public auction where property is sold to highest bidder.
Purchaser given certificate of sale.
Proceeds of sale pay costs and debt.
Sale of property
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Judicial Foreclosure Steps
If proceeds aren’t enough to pay off foreclosed mortgage, court may award deficiency judgment against debtor for amount of deficiency.
Sale of property
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Judicial Foreclosure Steps
6. Statutory right of redemption: additional period after sheriff’s sale to redeem property.
Must pay purchaser amount paid at auction, plus interest.
Many states do not allow; states that do limit period to 6 months – 2 years.
After sheriff’s sale
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Judicial Foreclosure Steps
7. Sheriff’s deed given to purchaser at end of redemption period.
State law may allow purchaser to:
take possession of property immediately, or
collect rent from debtor during redemption period.
Rights of sheriff’s sale purchaser
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Nonjudicial Foreclosure
Notice of default
Notice of sale
Cure and reinstatement
Trustee’s sale
Trustee’s deed
Steps
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Nonjudicial Foreclosure Steps
1. Notice of default: to begin, trustee must give notice of default to grantor.

2. Notice of sale: trustee must wait certain time after notice of default before issuing notice of sale. Usually 3 to 6 months.
Notice to borrower
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Nonjudicial Foreclosure Steps
3. Cure and reinstatement: grantor allowed to cure default and reinstate loan by paying delinquent amounts plus costs.
Right ends shortly before trustee’s sale.
No right of redemption after trustee’s sale.
Stopping the foreclosure
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Nonjudicial Foreclosure Steps
4. Trustee’s sale: like sheriff’s sale, trustee’s sale is public auction.
Proceeds first applied to costs, then to
debt, then junior liens.
Sale of property
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Nonjudicial Foreclosure Steps
5. Trustee’s deed: highest bidder receives trustee’s deed immediately after sale.
Debtor’s title terminates immediately.
Must vacate property within short period (such as 30 days).
No redemption period
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Nonjudicial Foreclosure
State law may place restrictions on nonjudicial foreclosures, such as:
requiring post-sale redemption period for agricultural property
prohibiting beneficiary from obtaining
deficiency judgment after sale
Restrictions
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Judicial vs. Nonjudicial
Judicial foreclosure advantages:
borrower can’t reinstate loan
right to deficiency judgment

Nonjudicial foreclosure advantages:
quick and inexpensive
Lender’s point of view
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Nonjudicial foreclosure advantages:
right to cure and reinstate
Borrower’s point of view
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Summary
Foreclosure
Judicial foreclosure
Equitable right of redemption
Sheriff’s sale
Deficiency judgment
Statutory right of redemption
Nonjudicial foreclosure
Power of sale
Cure and reinstatement
Trustee’s sale

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Alternatives to Foreclosure
Three alternatives allow borrowers who can no longer make payments to avoid foreclosure:
loan workout
deed in lieu
short sale

Lender’s incentives to cooperate:
avoiding foreclosure costs
ending money-losing situation
more quickly
Lender’s consent needed
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Alternatives to Foreclosure
First step for borrower hoping to avoid foreclosure: asking lender for loan workout.
Borrower will need to demonstrate inability to make current payments.

Two types of workouts:
repayment plan
loan modification
Workouts
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Workouts
With repayment plan, lender allows borrower to change timing of limited number of payments.
Borrower in more dire situation may need loan modification: permanent change in terms of repayment (like reduced principal or interest rate).
Repayment plans / loan modifications
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Alternatives to Foreclosure
If borrower can’t negotiate workout and will lose property anyway, can offer lender deed in lieu.
If lender accepts deed in lieu:
borrower deeds property to lender
debt satisfied

Deed in lieu of foreclosure
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Deed in Lieu of Foreclosure
Lender agrees to release borrower even though property is usually worth less than amount owed.
Lender could require borrower to sign
promissory note for shortfall, but that isn’t typical.

Settlement of debt
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Borrower’s credit rating suffers almost as much as from foreclosure.

Impact on borrower
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Deed in Lieu of Foreclosure
Lender takes title subject to other liens.
Not like foreclosure, which extinguishes
junior liens.

Junior liens
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Alternatives to Foreclosure
Short sale: when borrower sells property to third party for less than amount owed.
Borrower facing foreclosure may ask lender to approve short sale.
If lender approves buyer, lender receives sale proceeds and releases lien.

Short sales
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Short Sales
Like ordinary sale, short sale doesn’t extinguish junior liens.
If there are junior liens, short sale must be approved by all lienholders.
Junior lienholders unlikely to consent.

Junior liens
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Alternatives to Foreclosure
To arrange workout, deed in lieu, or short sale, borrower contacts loan servicer.
May need approval from more than one
department or entity.
Obtaining lender’s consent
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Obtaining Lender’s Consent
Borrower wanting help with process for modification or other alternatives should contact nonprofit HUD-approved housing counseling service.
Problems with predatory for-profit loan modification companies.
Many states now have “distressed property laws” regulating them.
Assistance for borrowers
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Obtaining Lender’s Consent
If loan has been securitized, it’s difficult to obtain consent.
Under some MBS contracts, any purchaser (investor) can object and prevent loan modification or settlement.
Impractical to obtain consent of all investors.
Securitized loans
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Alternatives to Foreclosure
Generally, IRS views debt relief (reduction in amount owed) as income.
Borrower who enters arrangement reducing amount owed may have to pay income tax on debt relief.
Income tax implications
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Alternatives to Foreclosure
Exceptions: debt relief not taxed if:
debt was secured by principal residence
and forgiven between 2007-2017
debtor was insolvent when debt forgiven
Income tax implications
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Summary
Alternatives to Foreclosure
Loan workout
Repayment plan
Loan modification
Deed in lieu
Short sale
Housing counseling service
Distressed property laws
Debt relief

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Finance Instrument Provisions
Rights and responsibilities of borrower and lender may be affected by:
subordination clause
late charge provision
prepayment provision
partial release clause
acceleration clause
alienation clause

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Finance Instrument Provisions
Subordination clause: gives a mortgage lower priority than another mortgage that will be recorded later on.
Common in construction financing.
Subordination clauses
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Finance Instrument Provisions
Promissory notes usually provide for late charges if borrower doesn’t make payments on time.

State laws may override late charge provision, to protect borrowers from excessive charges.
Late charge provisions
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Finance Instrument Provisions
Prepayment provision: imposes penalty on borrower who repays some or all of principal before due.
Prepayment deprives lender of some of interest it expected to receive over loan term.
Prepayment provisions
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Finance Instrument Provisions
Most residential loan agreements don’t have.
Mortgages with prepayment penalties aren’t eligible for sale to Fannie Mae/Freddie Mac.
Prepayment penalties prohibited with FHA and VA loans.
Dodd-Frank Act places restrictions on prepayment penalties.
Prepayment provisions
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Finance Instrument Provisions
Partial release clause: obligates lender to release part of property from lien when part of debt is paid.
Typically found in deed of trust or mortgage that covers subdivision, allowing release of individual lot from lien when lot is sold.
Partial release clauses
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Finance Instrument Provisions
Acceleration clause: allows lender to declare outstanding loan balance due immediately in event of default.
Most lenders wait 90 days before
accelerating.
Some states now have laws requiring
specific waiting period.
Acceleration clauses
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Finance Instrument Provisions
Alienation clause: prevents borrower from selling security property without lender’s permission unless loan paid off at closing.
If title transferred without permission, lender can accelerate loan.
Also called due-on-sale clause.
Alienation clauses
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Alienation Clauses
Most alienation clauses triggered by transfer of any significant interest in property.
Includes long-term leases, or leases with
options to purchase.
Lender can’t forbid transfer, but can demand payment of loan.
Triggered by transfer of any interest
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Alienation Clauses
To understand purpose of alienation clause, consider what happens when borrower sells property without paying off loan.
Transfer of title without loan payoff
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Alienation Clauses
Three possibilities:
1. New owner takes title subject to loan but
does not assume it.
2. New owner assumes loan but original
borrower is not released.
3. New owner assumes loan and lender
agrees to release original borrower.
Transfer of title without loan payoff
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Summary
Finance Instrument Provisions
Subordination clause
Late charge provision
Prepayment provision
Partial release clause
Acceleration clause
Alienation clause
Assumption

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Types of Real Estate Loans
Junior mortgage: mortgage with lower lien priority than another against same property.
Senior mortgage: mortgage with higher lien priority than another on same property.
At foreclosure, junior mortgage paid only after senior has been paid in full.
Junior or senior mortgage
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Types of Real Estate Loans
Lien having most senior (first) position is called first mortgage.
Junior mortgages may be referred to as second mortgage, third mortgage, etc.
First mortgage
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Types of Real Estate Loans
Purchase money mortgage: any mortgage loan used to finance purchase of property that is collateral for loan.
A mortgage that buyer gives to seller in seller-financed transaction.
Purchase money mortgage
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Types of Real Estate Loans
Home equity loan: loan secured by mortgage against borrower’s equity in home she already owns. (Interest rates higher than on purchase loans.)
Equity: difference between property’s market value and total liens against it.
Home equity loan
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Types of Real Estate Loans
Home equity line of credit (HELOC): line of credit with limit and minimum monthly payments; homeowner can draw upon as needed.
Automatically secured by borrower’s home.
Home equity loan
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Types of Real Estate Loans
Refinancing: new loan used to pay off existing mortgage against same property.
Often used:
to take advantage of market interest rate decrease
when balloon payment due on existing loan
Refinance mortgage
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Types of Real Estate Loans
Bridge loan: provides cash for purchase of new home pending sale of old home.
Secured by equity in old home.
Usually has interest-only payments.
Also called swing loan or gap loan.
Bridge loan
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Types of Real Estate Loans
Budget mortgage: loan with monthly payments that include property taxes and hazard insurance.
Lender holds tax and insurance portions
of borrower’s payments in impound account until payments due.
Budget mortgage
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Types of Real Estate Loans
Package mortgage: loan secured by personal property as well as real property.

Alternatively, personal property may be financed separately, using separate security agreement.
Lender must file financing statement with Secretary of State.
Package mortgage
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Types of Real Estate Loans
Bi-weekly mortgage: requires a payment every two weeks, so that loan is paid off on accelerated schedule.

Borrower pays off loan faster and with less total interest.
Bi-weekly mortgage
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Types of Real Estate Loans
Blanket mortgage: loan secured by more than one parcel of land; contains partial release clause.
Partial release clause: requires lender to release some of security property from lien when portion of debt is paid off.
Blanket mortgage
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Types of Real Estate Loans
Construction loan: short-term loan used to finance construction on land already owned by borrower.
Once construction completed, construction loan replaced by take-out loan.
Borrower repays amount over specified term.
Construction loan
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Types of Real Estate Loans
Nonrecourse mortgage: loan that gives lender no recourse against borrower.
Lender’s only remedy in event of default is foreclosure on collateral property.
Borrower not personally liable for loan
repayment.
Nonrecourse mortgage
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Types of Real Estate Loans
Participation mortgage: allows lender to participate in earnings generated by mortgaged property, in addition to collecting interest payments.

Shared appreciation mortgage: entitles lender to share of increase in property’s value.
Participation / shared appreciation
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Types of Real Estate Loans
Wraparound mortgage: new mortgage that includes existing first mortgage on property.
Used almost exclusively in seller-financed transactions.
Wraparound mortgage
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Types of Real Estate Loans
Reverse mortgage: provides elderly homeowners source of income, without requiring sale of home.
Homeowner borrows against equity.
Can get a monthly check from lender.
Borrower required to be over certain age.
Home sold after death to repay loan.
Reverse mortgage
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Summary
Types of Real Estate Loans
Purchase money mortgage
Home equity loan or HELOC
Refinancing
Bridge loan
Budget mortgage
Package mortgage
Bi-weekly mortgage
Blanket mortgage
Construction loan
Nonrecourse mortgage
Wraparound mortgage
Reverse mortgage

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Financing Residential Real Estate
Lesson 6:
Basic Features of a Residential Loan
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Introduction
This lesson will cover:
amortization
repayment periods
loan-to-value ratios
mortgage insurance and loan guaranties
secondary financing
fixed and adjustable interest rates

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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.
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Amortization
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.
Fully amortized loan
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Amortization
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.
Partially amortized loan
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Amortization
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.
Interest-only loan
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Amortization
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
Interest-only loan
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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.

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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.
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Repayment Period
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
Monthly payment amount
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Repayment Period
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.
Total interest
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Repayment Period
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
15-year vs. 30-year loan
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Repayment Period
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.
20-year loans
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Repayment Period
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.
40-year loans
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Summary
Amortization & Repayment Period
Amortization
Fully amortized
Partially amortized
Balloon payment
Interest-only loan
Loan term

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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
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Loan-to-Value Ratio
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.
Higher LTV = higher risk
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Loan-to-Value Ratio
Lenders set maximum LTV for particular loan program or loan type.
In transaction, maximum LTV determines:
maximum loan amount
minimum downpayment

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Loan-to-Value Ratio
Lenders traditionally protected themselves by setting low LTV limits.
Traditional maximum: 80%
Higher LTVs allowed only in special
programs (FHA, VA).
Maximum LTV
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Loan-to-Value Ratio
In recent years, loans with higher LTVs widely available.
With higher maximum LTVs, people without much cash can buy homes.
Maximum LTV
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© 2018 Rockwell Publishing
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 works like other insurance:
policyholder pays premiums
insurer provides coverage for certain
losses, up to policy limit
Mortgage insurance
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© 2018 Rockwell Publishing
Mortgage Insurance/Guaranty
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.
Mortgage insurance
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© 2018 Rockwell Publishing
Mortgage Insurance/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.
Loan guaranty
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© 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
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 mortgage: interest rate charged on loan remains constant throughout loan term.
When market rates rise or fall, loan rate
stays the same.
Considered standard.
Fixed-rate mortgages
© 2018 Rockwell Publishing

© 2018 Rockwell Publishing
Fixed or Adjustable Interest Rate
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.
Adjustable-rate mortgages
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© 2018 Rockwell Publishing
Adjustable-Rate Mortgages
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.
How ARM works
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© 2018 Rockwell Publishing
Adjustable-Rate Mortgages
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.
How ARM works
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© 2018 Rockwell Publishing
Adjustable-Rate Mortgages
note rate
index
margin
rate adjustment period
payment adjustment period
lookback period
interest rate cap
payment cap
negative amortization cap
conversion option
ARM features
ARM may have some/all of these features:
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© 2018 Rockwell Publishing
ARM Features
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.
Note rate
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© 2018 Rockwell Publishing
ARM Features
When loan is made, lender chooses one of several published indexes, such as:
Treasury securities index
11th District cost of funds index
LIBOR index
Index
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© 2018 Rockwell Publishing
ARM Features
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.
Margin
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© 2018 Rockwell Publishing
ARM Features
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.
Rate adjustment period
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© 2018 Rockwell Publishing
ARM Features
At end of period, lender:
checks index for increase or decrease
raises or lowers loan’s rate based on
change in index rate
Rate adjustment period
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© 2018 Rockwell Publishing
ARM Features
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
Rate adjustment period
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© 2018 Rockwell Publishing
ARM Features
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.
Mortgage payment adjustment period
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© 2018 Rockwell Publishing
ARM Features
Typical lookback period is 45 days.
Loan’s rate and payment adjustments determined by what index was 45 days before end of adjustment period.
Lookback period
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© 2018 Rockwell Publishing
ARM Features
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
Interest rate cap
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© 2018 Rockwell Publishing
ARM Features
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
Interest rate cap
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© 2018 Rockwell Publishing
ARM Features
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.
Mortgage payment cap
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© 2018 Rockwell Publishing
ARM Features
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.
Negative amortization
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© 2018 Rockwell Publishing
Negative Amortization
ARM features that can lead to negative amortization:
payment cap without rate cap
payments adjusted less often than interest rate
Features causing NA
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© 2018 Rockwell Publishing
Negative Amortization
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.
Negative amortization cap
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© 2018 Rockwell Publishing
Negative Amortization
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
Option ARMs
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© 2018 Rockwell Publishing
Negative Amortization
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.
Option ARMs
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© 2018 Rockwell Publishing
ARM Features
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.
Conversion option
© 2018 Rockwell Publishing

© 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

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