Chapter 20: Financing the Real Estate Transaction

The Residential Lending Process

Pre-loan Process

Contract to purchase

Selection of lender

Mortgage application

Mortgage Underwriting

Property Appraisal

Title Quality Appraisal

Repayment assessment

Loan Commitment

The Residential Lending Process

Post-loan Process

Closing

Note Signed

Lien Given

Proceeds Advanced

Loan Repayment

Release of Mortgage or Satisfaction Piece (stamp)

Financing Options

All personal equity

All personal equity and partners' equity

Take over an existing mortgage liability and balance equity

Traditional debt financing

Contract for deed

Buy only a portion of the property

Equity Financing

Individual equity

Personal savings

Unsecured loan

Sweat equity

Group equity

Partnership

Syndication

Debt Financing

Primary Lenders

S&L

Commercial banks

Mutual savings banks

Life insurance companies

Mortgage companies

Mortgage bankers

Mortgage brokers

Sellers

Debt Financing

Secondary Lenders

FHLMC

FNMA

GNMA

Private markets

Loan Terminology

Loan-to-value ratio

Debt service

Loan Principal

Interest rate (APR)

Loan term (duration)

Amortization

Amortization period

Types of Mortgages and Notes

Fully amortized conventional

Partially amortized conventional

Purchase money mortgages (Priority)

Budget mortgages (PITI)

Package mortgages

Open-end Mortgage

Variable Rate Loans

Fixed rate vs Variable Rates

Fixed payment-variable term

Fixed term-variable payment

CAMEL

Graduated Payment

FLIP

Commercial Loan Forms

Construction loans

High risk

Installments paid upon item completion

Blanket mortgages--Partial release

Review of Mortgage Mathematics

Impact of interest rates and amortization term

Discount points

Buydowns

Balance outstanding

Loan Underwriting

Value of collateral security

Quality of title

Loan Underwriting

Likelihood of Timely Repayment

Quality of income

Credit report

Past payment and credit history

Quantity of income

PMI

Conventional

Expenses include obligations of > 10 mo.

Housing payment (PITI)/Income ratio = 28% (front-end ratio)

Housing and expenses/Income ratio = 36% (back-end ratio)

FHA

Expenses include obligations of > 6 mo.

Housing expense (PITI+maintenance)=29% (33%)

Total expense (housing + expenses)=41% (39%)

VA

Expenses include obligations of > 6 mo.

(PITI+maintenance + expenses)=41% and

Income available for family support= Gross income- Housing expense- SS- Federal and state withholding- Other obligations

Needed income given by local VA office but for a family of four approximates:

$893 if the loan amount is $70,000 or greater.

If the income available for family support exceeds the minimums by 20%, the 41% ratio may be waived.

Sources of Revenue

for Mortgage Business

Loan Application Fees

Loan Origination Fees

Interest

Marketing gains/losses

Loan service fees (1/4 to 3/8 % of loan payment)

Mortgage Departments

Marketing

Production

Packaging

Underwriting

Quality Control

Marketing Department

Responsible for product development and pricing

Responsible for sale of packaged loans to secondary market

Manages profitability through secondary market

Pipeline management (lock-in timing problem)

Forward (mandatory delivery--about 2 point)

Standby commitments (about 2-3 points)

Production Department

Solicits business

Takes loan applications

May assist with assembling loan package

Packaging Department

Responsible for assembling loan package

Loan package contains:

Loan application

Verifications of Employment (VOE)

Verification of Deposit (VOD)

Appraisal

Credit reports and explanations

Gift letters

Underwriting Department

Makes decision to approve (fund) the loan.

Assesses:

Quality of applicant’s income

Quantity of applicants income

Likelihood of prompt repayment

Sufficiency of collateral (appraisal)

Quality Control Department

Examines loan defaults

Closed loan audits

Customer satisfaction monitoring

Laws and Regulations Influencing Financing

Usury

Truth in Lending

Equal Credit Opportunity Act

RESPA--discussed in next chapter.

Usury Laws

Limit legal amount of interest charged

First mortgages are exempt in most states.

Truth in Lending

Regulation Z requires the disclosure of all finance charges (APR)

Three-day right of rescission for loans other than residential first mortgages

Equal Credit Opportunity Act

Prohibits discrimination against protected classes including marital status and pregnancy.

Requires notification of reasons for denying credit.

Tables, Calculators, Equations, and Spreadsheets

Tables preceded modern calculators/computers

Tables pre-calculated results for equations

Most calculations today done by calculators or computers

Calculators and computers merging

Calculators

Constant memory

Multiple functions of keys

Algebraic or Reverse Polish Notation

Clearing the calculator

Changing Sign

Financial Tour

Calculator Financial Tour

n

I/Yr

PV

PMT

FV

P/Yr

xP/Yr

Calculating the Future Value of a Lump Sum

Enter the proper payments per year. You first must type in the appropriate number (eg. monthly would be 12, quarterly would be 4, etc.), then push the cream colored key, then the P/YR key .

The order of the next three steps is not important, but I recommend that you follow across the financial tour of your calculator from left to right. If you do this, then the next step would be to enter in the proper number of years.

Future Value of a Lump (Continued)

Next, You first type the appropriate number of years, then push the cream colored key, then the xP/YR key.

Future Value of a Lump Continued

Next enter the lump sum amount you are beginning with, then press the PV key.

Future Value of Lump Sum Example

Now let's try a problem. Consider that you invest $1000 in a CD earning 8% annual interest for 3 years. What would your CD be worth at the end of the three years?

First let's see what we know. We know that the CD worth $1000 today. That indicates that the present value (PV) of that CD is $1000. We know that the number of years (xP/YR) is 3. We know that the annual interest rate is 8% (8 is the I/YR). Finally, we may assume that the periods per year is one since we are not told it is monthly, quarterly, etc. (If the payments per year would have been, for example, monthly, the problem would have read, ". . . earning 8% annual interest, compounded

monthly.")

Future Value Example Continued

First we must enter the appropriate payments per year by pushing 1, then the P/YR key.

Future Value Example Continued

Next we enter the Present Value by pressing 1000, then the key (to show that this is paid to the bank), and then the PV key

Calculating the Present Value of a Lump Sum

Calculating the Present Value of a Lump Sum is almost the same as for a Future Value

Now let's try a problem. Consider that you buy a $1000 US Savings Bond that will mature in five years and paid 8% interest per year. How much should you pay today for the bond?

First let's see what we know. We know that the bond will be worth $1000 in five years. That indicates that the future value (FV) of that bond is $1000. We know that the number of years (xP/YR) is 5. We know that the annual interest rate is 8% (8 is the I/YR). Finally, we may assume that the periods per year is one since we are not told it is monthly, quarterly, etc. (If the payments per year would have been, for example, monthly, the problem would have read, ". . . paid 8% per year, compounded

monthly.")

Present Value Example Continued

First we must enter the appropriate payments per year by pushing 1, then the P/YR key.

Present Value Example Continued

Next we enter the Future Value by pressing 1000 and then the FV key.

Annuities

An annuity payment is a series of equal payments that reoccur every period such as making monthly payments on a loan. To enter an annuity press the amount of the annuity and then press the Payment key.

Calculating the Present Value of an Annuity

Calculating the present and future values of annuities are basically the same as the calculations for lump sums except that you now must enter the amount of the annuity.

Let's try a problem. Consider that you invest $1000 in a bank account at the end of every year for 3 years. The bank will pay 8% annual interest on the deposits. How much would your bank account be worth at the end of the three years?

Present Value of an Annuity Problem

First let's see what we know. We know that there will be three deposits of $1000 at the end of each year for three years. That indicates that the payment (PMT) is $1000 since it is a recurring payment every period. We know that the number of years is 3. We know that the annual interest rate is 8% (8 is the I/YR). Finally, we may assume that the periods per year is one since we are not told it is monthly, quarterly, etc. (If the payments per year would have been, for example, monthly, the problem would have read, ". . . pay 8% annual interest, compounded

monthly.")

Annuity Problem (Continued)

First we must enter the appropriate payments per year by pushing 1, then the P/YR key .

Annuity Problem (Continued)

Next we enter the Payment by pressing 1000, then the key (to show that this is paid to the bank), and then the PMT key.

Solving for Other Factors

In solving for n or I/YR, it is critical that you be careful to indicate the direction of outgoing cash flows by hitting the +/- key to make the amount negative.

n

To solve for n (number of periods) enter the rest of the problem information and then press n

number of years

After solving for n, simply hit the RCL key and then the n key.

I/Yr

To solve for I/YR enter the rest of the problem information and then press I/YR

Payments (PMT)

Loan payment (mortgage payment)

What is the monthly mortgage payment on a $100,000 loan at 12% annual interest amortized over 30 years?

12 (monthly payments); 30 ; 12 (annual interest); 100000 (loan amount received initially)

To solve for the payment, push ; PMT=-1028.61

Sinking fund

What is the monthly payment necessary to accumulate $15,000 to replace a roof in 20 years if the reserve fund pays 8% annually?

12 (monthly payments); 20 ; 8 (annual interest); 15000 (amount to be received in the future)

To solve for the payment, simply push ; PMT=$25.46

Loan Amortization

Consider the monthly mortgage payment on a $100,000 loan at 12% annual interest amortized over 30 years from the previous slide.

If the interest rate is 12% over 12 months, then the monthly interest rate is 1%

For the first month:

$1,028.61 = the monthly payment

$1,000.00= the first month’s interest (1%*100000)28.61 = the first month’s principal reduction

$99,971.39 = remaining balance = $100,000 - $28.61

For the second month:

$1,028.61 = the monthly payment

$ 999.71= the second month’s interest (1%* 99,971.39 )28.90 = the second month’s principal reduction

$99,942.49 = remaining balance = $ 99,971.39 - $28.90

The Amortization Function

First calculate the mortgage payment

12 (monthly payments); 30 ; 12 (annual interest); 100000 (loan amount received initially)

To solve for the payment, push ; PMT=-1028.61

The press the cream colored key and the AMORT key . The display shows PEr 1-12 (The amortization schedule for the first 12 months of payments.)

Pressing the = key will give you the interest paid during the year. The display briefly flashes Int then shows -11,980.47.

Pressing the = key again will give you the principle paid. The display briefly flashes Prin then shows –362.88

Pressing the = a third time will give you the remaining balance. The display briefly flashes bal then shows 99,637.12.

Remaining Balance

Either use the amortization function shown on the previous slide or enter the number of years remaining on the loan and solve for PV.

For example, after solving for the mortgage in the previous slide, if you wished to know the balance on that loan after paying for one year, you would simply enter the years remaining—29 . Then press PV to solve for the remaining balance. The result shown is 99,637.12.

APR

The "true" interest rate charged by the lender

Calculate the mortgage payment ignoring the points.

Calculate the amount of the points

Subtract the amount of the points from the amount of the loan (the PV)

Reenter the result into PV

Solve for I/YR

Uneven Cash Flows

Calculating time value of money problems with uneven cash flows is considerably more difficult than for simple TVM problems.

Net present value

Net present value is the present value of all of the future cash flows less the initial cost.

IRR

IRR is that interest rate that exactly equates the present value of all of the future cash flows with the initial cost. In other words, the NPV=0

Calculation of NPV and IRR

The basic steps in calculating the Net Present Value and Internal Rate of Return are as follows:

NPV and IRR (Continued)

Next, if you wish to compute a Net Present Value, you must enter the investor's cost of capital and then press the I/YR key. If you are only interested in calculating an internal rate of return, this step is omitted.

NPV and IRR (Continued)

Now enter the cash flow for the first year and then press the cash flow key. If this cash flow remains the same for any number of consecutive years, you enter the number of consecutive years and then press the cream colored key and then the repeat Nj key.

NPV and IRR (Continued)

After all of the cash flows are entered, press the cream colored key and then the NPV key. If you wish to compute the Internal Rate of Return, simply press the cream colored key and then the IRR key.

Impact of Interest Rates

The monthly payment for a $100,000 loan at various interest rates:

8% = $733.76

9% = $804.62

10% = $877.57

11% = $952.57

12% = 1,028.61

Impact of Amortization Term

The monthly payment for a $100,000 loan at 12% annual interest at various maturities:

Number Total Interest

of YearsPaymentPaid During Loan30 years = $1,028.61 $370,300.53

15 years = $1,200.17 $216,030.25

Most lenders charge about ½ point interest less for a 15 year loan so that would be 11.5%

15 years = $1,168.19 $210,274.17

Thus, increasing your payment by $139.58 per month would save $160,026.36 of interest over the life of the loan.