Financial Concepts and the Conventional Fixed Rate Loan
Broker and sales associates have a responsibility to seller clients to be able to explain to them the advantages and disadvantages of various financing methods a prospective buyer might propose to use in buying a seller’s property. There is a similar responsibility shared by licensees to be able to explain to buyer clients and even customers the methods for financing the purchase of real estate available in the current market. Therefore brokers and sales associates must have a working knowledge of the various loan types lenders offer. This chapter seeks to provide a basis for building a working knowledge of the methods of financing property that buyers use most often.
INTEREST AND THE INTEREST RATE
Interest is the payment made for the use of money over time. It is expressed as an annual percentage of the loan amount such as 9% of $10,000.00. When one multiplies the 9% interest rate times the amount borrowed of $10,000.00, the resulting $900.00 is the interest payment. In another context, interest is the difference between the original principal amount of a loan and the total amount of the payments. Any money paid toward reducing the original amount of the loan is principal. It is important to be able to distinguish between principal and interest because these two components of loan payments have different legal and tax treatments.
LOAN TO VALUE RATIO
The loan to value ratio (LTV) is the relationship between the loan amount and the value of property that the borrower pledges as security for the loan. The actual calculation of the LTV very often uses the sales price of the property as the value of the property. If the buyer agrees to pay $100,000 for the property and he or she is able to borrow $90,000 from a lender, the loan to value ratio is 90%. As credit tightens in the economy or as the lender perceives more risk involved in the loan, the lender insists on more security and the loan to value ratio declines.
THE LOAN TERM
The loan term is the period that the lender grants the borrower to pay back the loan. Real estate loans tend to have long terms, often up to thirty years. Both the note and the security deed will usually state the term of the loan.
Amortization refers to reducing a loan amount by making periodic principal payments. In the most common method of fixed rate loan amortization, the fully amortizing loan, the borrower pays the same amount each month and pays off all principal by the last loan payment. For example, if a borrower borrows $120,000.00 to buy a house and the term of the loan is 30 years at 8 percent annual interest, the borrower’s payment is $880.52 per month. When the borrower makes the first monthly payment, $800.00 is interest; and $80.52 is principal. Therefore, after the first payment, the loan balance is $119,919.48. For the second month, the interest portion of the payment is smaller because the borrower has reduced the outstanding principal. The second month’s payment is the same as the first, $880.52, but this time the interest payment is $799.46, and the principal payment increases to $81.06. This process in which the interest portion of the payment decreases and the principal portion increases, continues through all 360 payments (if the borrower does not either sell or refinance the property and pay off the loan early), and the loan balance amortizes down to zero with the last payment. There are other forms of amortizing loans, but this loan form illustrates the process of amortization.
The amortization process illustrated in the previous paragraph is positive amortization. Each periodic loan payment reduces the loan balance and pays the interest on the loan. A different loan could reflect negative amortization, a situation in which the loan balance increases from one period to the next. Negative amortization occurs when the size of the payment is less than the interest payment that is due. The unpaid interest is added to the loan balance causing it to increase. The most prevalent loan exhibiting negative amortization is the graduated payment loan, a fixed rate loan in which the initial monthly payments are less than the interest due. In subsequent years, the payment amounts increase until they are sufficient to pay both the interest due and to amortize the larger than original loan balance.
THE FIXED RATE LOAN
The standard fixed rate real estate loan includes a repayment method with a positive loan amortization schedule. The monthly loan payments are a constant amount for the term of the loan. Each monthly payment consists of an interest payment and a repayment of principal. As demonstrated in the previous section, the interest and principal portions of the monthly payment change with each payment. The interest payment is the larger component of the first payments, and over time the allocation changes so that repayment of the principal becomes the larger component. A full understanding of the fixed rate loan requires an understanding of the financial calculations that generate the monthly loan payment, the loan balance at any point in the repayment process, and the pay off amount at any point in the stream of payments. A full discussion of these calculations is beyond the purpose of this reference book.
HISTORY OF THE FIXED RATE AMORTIZED LOAN
Before the 1930’s, real estate loans were usually straight loans. They were typically short term (one to five years) with periodic payments of “interest only” and a single large principal payment at the end. In practice homeowners frequently did not have all the cash necessary to pay off the loan at the end of its term, and the bank would usually renew the loan for another term. Since this method of financing required large payments, many loans went into foreclosure during the Great Depression when borrowers did not have the cash when the large payments came due, and the banks were unable or unwilling to extend the loans.
In the early 1930’s real estate financing changed significantly due to the wide acceptance of amortized loans and the federal government’s role in protecting lenders and in helping make home mortgage money available. The amortized loans became very popular with borrowers and lenders. Amortized loans were popular with borrowers because the term was initially 15 to 20 years, making the payments much smaller than with straight mortgage loans. The borrower made monthly payments (rather than annually as with straight loans) and in equal amounts. Each monthly payment would pay interest on the principal balance left after the previous month’s payment with the remaining portion of the payment going toward principal, thus reducing the interest required for the next month.
Because of the more liberal terms for repayment, the amortized loan helped to reduce the number of foreclosures while giving lenders stable income. These features made amortized loans very popular with lenders and borrowers. The fixed interest rate loan was the principal form of residential lending through the 1970s. Late in the 1970s two problems arose in residential lending. First, rising interest rates coupled with rising housing prices reduced the opportunity for first-time homebuyers to purchase a home. To help alleviate this problem, the FHA conceived and implemented the graduated payment mortgage arrangement, the GPM also known as an FHA section 245 loan. The discussion of this loan arrangement appears in the next chapter. Second, rising interest rates created an asset liability mismatch for the savings and loan associations. The lenders discovered that their portfolio of residential loans generated a low rate of return from low historic interest rates while they had to pay higher rates on their passbook accounts and their certificates of deposit in order to attract new funds to use for residential loans. The revenue stream for the lender came from assets which earned a low rate of return; but in order to attract new funds, the lenders had to pay high interest rates on savings accounts and other new deposit accounts such as certificates of deposits. To alleviate this problem, federal agencies conceived and implemented the early versions of the adjustable rate mortgage loans, the ARM. The ARM ties the lender’s return from loans (the assets) to the currently prevailing interest rate structure. The discussion of this loan arrangement also appears in the next chapter.
DISCOUNT POINTS ON A LOAN
Very often people use the terms “discount” and “points” interchangeably. However, they have distinctly different meanings. A discount point, also called a “point,” is 1 percent of the loan amount. The “discount” is the loan amount times the number of “points.” Therefore, if a lender charges three discount points on a $50,000.00 loan, the amount of the discount on the loan is 3% times $50,000.00 or $1,500.
When a lender makes a loan and charges discount points, the lender receives the discount at the time of loan closing. Either the buyer or seller pays the entire discount, or they each pay a proportion of the discount. This proportion is a point of negotiation in the sales contract for the property. There are two ways to make this payment of the discount to the lender. First, the parties to the contract can give the lender cash at the closing, and the lender then gives the seller of the property the amount of the loan in exchange for a note and a security deed from the borrower. Second, the lender can give the seller the amount of the loan less the amount of the discount (the net disbursement) in exchange for a note and a security deed from the borrower.
WHY THE LENDER CHARGES DISCOUNT POINTS ON THE LOAN
The lender charges discount points to obtain a return on a specific loan that is equal to the return on an alternate use for the funds that carries the same level of perceived risk. As an example, a loan of $100,000.00 to a creditworthy small business carries an interest rate of 11% while the market rate on a home loan is 9.5%. Since in most instances a loan to a small business faces more default risk than a residential loan, lenders often either make lower loan-to-value business loans or charge an interest premium. Therefore, assuming the lender evaluates the additional default risk on the small business loan to be 0.5 percent, the lender might charge discount points on the residential loan to equalize the return between 10.5 percent on the business loan and 9.5 percent on the residential loan. In this situation a charge of eight discount points on the residential loan would satisfy the lender’s goal of equalizing the return between the 9.5% home loan and the 10.5% business loan. If the market rates on the residential loan and on the business loan were equal, the home loan would carry no points.
The following example illustrates the equivalency between a 10.5 percent contract interest rate (the lender’s rate of return) with no points and a 9.5 percent contract interest rate with 8 points. On a $100,000.00 loan with 8 points, the lender loans $100,000.00, but the borrower pays $8,000.00 in discount, so the lender disburses $92,000.00 at the closing. At the same time, the borrower agrees to make monthly payments calculated at 9.5 percent on $100,000.00 for 360 months or $840.85 per month. When the lender’s outflow is $92,000.00 and the inflow is $840.85 per month for 360 months, the lender’s rate of return is 10.49 percent rounded to 10.5 percent. In this example, 100 basis points (one percent additional yield) over the contract interest rate is equivalent to 8 discount points. By either analogy or mathematics, 50 basis point is equal to 4 discount points and 25 basis points is equal to 2 discount points.
Equalizing contract interest rates using discount points is sensitive to the level of the contract interest rate. In periods of high interest rates the size of the equivalency declines. If market interest rates are 14 percent, the equivalency between 100 basis points on the contract and discount points is approximately 6.5 points not 8 points as is the case when interest rates are in the 10 percent range. For example, a loan for $100,000.00 at 13 percent for 30 years with 6.5 discount points yields a rate of return to the lender of 13.98 percent. Although the contract loan amount is 100,000.00, the lender only disburses $93,500.00 and receives $1,106.20 per month for 360 months. By comparison, a loan of $93,500.00 for 360 months with a payment of $1,106.20 produces a yield of 13.98 percent.
Another reason for the lender to charge discount points is to allow the borrower to pay discount points and receive a lower contract interest rate on the loan. For example, a lender may offer the borrower two options:
|(a)||a 10.5 % interest rate and zero points or|
|(b)||a 10 % interest rate and four points.|
The lender can offer these two options because they each provide a 10.5% rate of return. However, a borrower who plans to be in the home only a short time because of an anticipated job transfer may prefer to pay the higher interest rate for the short period and avoid having to come up with a large cash outlay at the time of purchase. On the other hand, a buyer who plans to live in the house for a long time may see a financial advantage to “buying down” the long term interest rate by paying discount points at closing and having lower monthly payments.
WHY THE SELLER MIGHT CONSIDER PAYING THE DISCOUNT ON A LOAN
Obtaining the loan that enables the buyer to buy property and paying any discount on that loan are the buyer’s financial responsibility. However, the seller may enhance the prospects of selling his or her property by helping the buyer with the payment of the discount on the loan. Buyers of limited financial resources might have cash for the down payment but not enough for the discount. By paying part or the entire discount, the seller can attract a larger pool of prospects. Also, as explained in the previous section, the payment of discount can produce a loan with a below-the-market interest rate. If willing to pay the discount, the seller can make available attractive financing and help broaden significantly the number of prospective buyers for his or her home. When the seller pays a loan discount, he or she may have a possible tax advantage and should consult legal counsel or a CPA to determine what the tax consequences may be.
When the seller agrees to pay part or the buyer’s entire discount on the loan, he or she typically includes this additional cost in the asking price of the property, so in the end the buyer pays the discount on the loan. The buyer may be willing to pay the additional amount as part of the purchase price because of the benefits he or she receives and because the buyer can finance most of the additional amount rather than having to pay it in cash. However, a buyer typically is not willing to pay more for the property than its estimated current market value. So if adding the loan discount into the sales price results in an asking price that is significantly above the market, potential buyers will consider the property overpriced making it more difficult to sell. In this event, the seller may have to be willing to pay the discount without receiving a higher sales price just to increase the market potential of the property.
AMOUNT OF DISCOUNT
The number of points lenders charge varies. The cost of borrowing money goes up and down, depending on how much money is available and on how much money is required to meet loan application requests. Government controls of interest rates and the money it makes available to banks coupled with business demand for capital have a major effect on the availability of mortgage money. The result is that if money for the home mortgage market becomes scarce and more expensive, the cost of borrowing money rises.
WHEN TO GET DISCOUNT INFORMATION
Since most lenders set their discount rates as well as other costs of borrowing–interest rates, closing costs–each day, it is good business practice to call lenders daily to get this information. Licensees can also explain to buyers and sellers that discount points and other costs vary and discuss the effect such changes may have on them.
THE LOAN ORIGINATION FEE
Lenders who originate loans and mortgage brokers charge the borrower a loan origination fee when they process and approve a loan application. During the processing of the loan application, the lender incurs administrative expenses. The loan origination fee is revenue to the lender to offset these administrative costs. Mortgages broker typically either share the loan origination fee with the loan originator or charge the borrower an additional fee for their services.
THE ANNUAL PERCENTAGE RATE (APR)
The annual percentage rate (APR) is a measure of the full cost of a loan to the borrower. The APR calculation includes the contract interest rate on the loan plus all other finance charges on the loan. These finance charges include the discount, the loan origination fees, prepaid interest, and mortgage insurance. The APR combines these financial charges to obtain a single percentage rate that reflects all the financial costs for the full term of the loan. The simple concept underlying the calculation of the APR involves spreading the front end financial payments by the borrower (the discount, the loan origination fee, and prepaid interest) across the term of the loan and combining it with the ongoing payments of the contract interest rate for the loan and the mortgage insurance. As an example, if a loan has a contract rate of 9% per annum and if there are no discount points, loan origination fees, prepaid interest, or mortgage default insurance, the APR is equal to the contract rate of interest. The APR in this situation is 9% per year.
If a 30-year loan for $100,000.00 at a 9% contract interest rate also has four discount points, a one percent loan origination fee, and no other finance charge or mortgage default insurance, the APR is 9.58% per year since the effect of the $5000.00 for the discount and loan origination at the time of loan closing is to increase the effective rate of interest by .58 % per year. The Truth-in-Lending Legislation requires the calculation and reporting of the APR to the borrower.
TRUTH IN LENDING LAW AND REGULATION Z
The truth-in-Lending Law is a body of federal law effective July l969 as part of the Consumer Credit Protection Act, and implemented by the Federal Reserve Board’s Regulation Z. It was amended in 1982 by the Truth-in-Lending Simplification and Reform Act and later amendments. The main purpose of this law is to ensure that borrowers and customers in need of consumer credit are given meaningful information with respect to the cost of credit. In this way consumers can more readily compare the various credit terms available to them and thus avoid the uninformed use of credit. This law creates a disclosure device only, and does not establish any set maximum or minimum interest rates or require any charges for credit. In addition, some states have adopted their own truth-in-lending laws.
All real estate credit is covered by Federal Reserve’s Regulation Z when it is extended to a natural person (the customer) and is not to be used for business, commercial or agricultural purposes. Personal property credit transactions over $25,000 are exempt from Regulation Z, as is the extension of credit to the owner of a dwelling containing more than four-family housing units or a construction loan to a builder (this is considered a business purpose). However, if the extension of credit is secured by real property or by personal property used or expected to be used as the principal dwelling of the consumer (mobile home), then the transaction is covered by Regulation Z. The credit offered must either involve a finance charge or, by written agreement, be payable in more than four installments.
Finance charge: The finance charge and the annual percentage rate are the two most important disclosures required. These disclosures provide a quick reference for customers, informing them how much they are paying for credit and its relative cost in percentage terms. Note that a cushion or tolerance is given of $5 if the transaction is less than $1,000 and $10 if it is more than $1,000. The finance charge is the total of all costs the customer must pay, directly or indirectly, for obtaining credit, and includes such costs as interest, loan fee, loan-finder’s fee, time-price differential, discount points, service fee and premium for credit life insurance if it is made a condition for granting credit. Real estate purchase costs that would be paid regardless of whether credit is extended—for example, legal fees to prepare deeds, taxes not included in the cash price, survey fees, recording fees, title insurance premiums, investigation or credit report fees—are not included in the finance charge, provided these fees are bona fide, reasonable in amount and are not excluded for the purpose of evading the law.
Annual percentage rate: The annual percentage rate as it is used in Regulation Z is not interest, although interest is figured in along with the other finance charges in computing the annual percentage rate. This rate is the relationship of the total finance charge to the total amount to be financed and must be computed to the nearest one-eighth of one percent. Note, however, that many real estate mortgages call for interest based on a simple annual rate, which is lower than the annual percentage rate because certain elements in addition to interest (for example, points or other fees) that must be included in the total finance charge are not included in the calculation of the simple annual interest rate.
Disclosure statement: The disclosure statement for real estate transactions must contain the following information:
|•The total dollar amount of the “finance charge,” using that term, and a brief description such as the “dollar amount the credit will cost you;”|
|•The “annual percentage rate,” using that term and a brief description such as “the cost of your credit as a yearly rate;”|
|•The number, amounts, and timing of payments;|
|•The “total of payments,” using that term, and a descriptive explanation such as “the amount you will have paid when you have made all scheduled payments;”|
|•The amount charged or method of computation for any late payment other than a deferred or extension charge;|
|•The fact that the creditor has or will acquire a security interest in the property being purchased;|
|•Whether the debtor has to pay a prepayment penalty and whether the debtor will be entitled to a refund of part of the finance charge;|
|•An identification of the method used to compute any finance-charge rebate that might arise, in the case of prepayment of contracts involving precomputed finance charges;|
|•The total amount of credit that will be made available to the borrower, including all charges (individually itemized) that are included in “amount financed;”|
|•Amounts that are deducted as prepaid finance charges (for example, points) and required deposit balances, such as tax reserves; and|
|•In the case of a contract for deed, the cash price (purchase price), total down payment, the unpaid balance of the cash price and the deferred payment price (which is the total of the cash price, finance, and all other charges). The deferred payment price, however, does not apply to the sale of a residential dwelling.|
Right to rescind: The customer has a limited right to rescind or cancel a credit transaction. This rescission is intended to protect the homeowner from losing his or her home to unscrupulous sellers of home improvements, appliances, or furniture who secure the credit advance by taking a second mortgage on the purchaser’s home. If a creditor extends credit and receives a security interest (nonpurchase-money mortgage, contract for deed, or mechanic’s lien) in any real property that is used or expected to be used as the principal residence of the borrower, the creditor must give the borrower the prescribed notice of right of rescission. The borrower then has the right to cancel the transaction (in writing) by midnight of the third business day (including Saturdays) following the date of consummation of the transaction, delivery of the notice of right to rescind, or delivery of all material disclosures, whichever is later. A transaction is considered consummated at the time a contractual relationship is created between a creditor and a customer, irrespective of the time of performance of either party. Further, the disclosures are now required to be made before the transaction has been consummated. Disclosures involving real property must be made at the time the creditor makes a firm loan commitment with respect to the transaction.
Note that the right to rescind does not apply to a “residential mortgage transaction,” defined as a transaction in which a mortgage, deed of trust, purchase-money security interest arising under an installment sales contract, or equivalent consensual security interest is created or retained in the consumer’s principal dwelling to finance the acquisition or initial construction of that dwelling.
But all loans, secured or otherwise, to finance the acquisition of building lots or raw acreage where the buyer expects to use the lot as a principal residence must disclose the total payments and the finance charge and give notice of the three-day right of rescission. In this regard, a purchaser of unimproved land may have a basis to rescind his or her real estate purchase, since many subdividers who sell under a contract for deed do not give the purchaser a notice of the right of rescission. The prudent developer might have the prospective purchaser execute a statement to the effect that he or she purchased the lot for investment and resale and does not intend ever to use the lot to build his or her principal residence.
Without such a written declaration or other exemption, the developer must give the purchaser notice of the right to cancel by giving him or her two copies of a notice of rescission in the form prescribed by Regulation Z. One of these may be used to cancel the transaction. The customer may waive the right to cancel a credit agreement only if the credit is needed to meet a bona fide personal financial emergency, such as emergency repair work (for example, a flooded basement). The use of printed waiver forms for this purpose is prohibited.
If the required disclosures were not made or a notice of rescission was not given to a borrower, the borrower’s right to rescind continues for a period of three years after the date of consummation of the transaction or upon sale of the property, whichever occurs earlier. When a customer exercises the right to rescind under the federal truth-in-lending law, he or she must tender any property received to the creditor provided the creditor first returns the customer’s payments. The tender must be made at the location of the property or at the residence of a customer, at the customer’s option. If the creditor does not take possession of the property within 20 days after tender by the customer, ownership of the property rests in the customer without obligation on his or her part to pay for it. Upon rescission, the borrower is not liable for any charges. Also, the creditor must return all money within 20 days after the notice of rescission is received.
A first mortgage on a home, given to a contractor for home improvements, would be subject to both the finance charge and the notice of rescission requirements. In such a case, the contractor should not commence work until the expiration of the cancellation period, three business days. Many contractors are unaware that they are deemed to be creditors and subject to the law where they permit payment in more than four installments.
Creditors: This law requires compliance by all creditors who regularly extend credit. A person “regularly extends” credit only if the person extended credit more than 25 times (or more than 5 times for transactions secured by a dwelling) in the preceding calendar year. Thus, the owner/occupant of a single-family home ordinarily does not have to comply with the disclosure requirements of Regulation Z even when selling under a contract for deed payable in more than four installments. However, if such an owner/occupant were to prearrange to discount the contract for deed immediately to a lender, he or she may be deemed to be merely a straw man for the lender and thus lose the exemption. A broker who is an operative builder, a subdivider, a broker selling property on his or her own account (except for the sale of his or her own permanent dwelling), or a broker taking a second mortgage as a commission may be deemed to be a creditor and thus must comply with the law.
Advertising: Regulation Z also affects all advertising to aid or promote any extension of consumer credit, regardless of who the advertiser may be. All types of advertising are covered, including window displays, fliers, billboards, multiple-listing cards if shown to the public, and direct mail literature. The ad is subject to the full disclosure requirements if it includes any of the following information:
|•The amount or percentage of down payment (for example, 5 percent down),|
|•The amount of any installment payment,|
|•The dollar amount of any finance charge,|
|•The number of installments or the period of repayment, or|
|•that there is no charge for credit.|
If any of these items are included, the ad must disclose the amount or percentage of down payment, the terms of prepayment, the annual percentage rate and, if the rate may be increased after consummation, that fact. General terms such as “small down payment OK,” “FHA financing available,” or “compare our reasonable rates” are not within the scope of Regulation Z. When advertising an assumption of mortgage, the ad can state the rate of finance charge without any other disclosure. The finance charge, however, must be stated as an annual percentage rate, using that term and stating whether increase is possible. For example, “assume 8 percent mortgage!’ is improper, whereas “assume 81/,2 percent annual percentage rate mortgage” is permissible. The interest rate can be stated in advertisements in conjunction with, but not more conspicuously than, the annual percentage rate. Also, “annual percentage rate” is usually spelled out but it is permissible to abbreviate it to APR. Bait advertising is prohibited; thus, an advertisement offering new homes at “$1,000 down” is improper if the seller normally does not accept this amount as a down payment, even if all the other required credit terms are disclosed in the advertisement.
Certain credit terms, when mentioned in an ad, trigger the required disclosure of other items. The purpose of this requirement is to give the prospective purchaser a complete and accurate picture of the transaction being offered. The trigger terms and required disclosures are shown in the following table:
|Appearance of any of these items in column A requires inclusion of everything in Column B:|
|•The amount or percentage of down payment||•The amount or percentage of down payment|
|•The amount of any installment||•The terms of repayment|
|•The finance charge in dollars or that there is no charge for credit||•The annual percentage rate and whether increase is possible|
|•The number of installments|
|•The period of repayment|
Any advertisement that mentions an interest rate but omits the APR or omits the words annual percentage rate is in violation. Any advertisement that includes any trigger term (Column A) without all of the required disclosures (everything in Column B) is in violation.
Creditors should keep records of all compliance with the disclosure requirements of the federal Truth-in-Lending Law for at least two years after the date disclosures are required to be made or action is required to be taken. Truth-in-tending requires advance disclosure of any variable rate clause in a credit contract that may result in an increase in the cost of credit to the customer.
Where joint ownership is involved, the right to receive disclosures and notice of the right of rescission, the right to rescind, and the need to sign a waiver of such right applies to each consumer whose ownership interest is subject to the security interest.
Penalties: The penalty for violation of Regulation Z is twice the amount of the finance charge or a minimum of $100, up to a maximum of $1,000, Plus court costs, attorney fees and any actual damages. Willful violation is a misdemeanor punishable by a fine up to $5,000 or one year’s imprisonment, or both. The Federal Trade Commission is in charge of enforcing Regulation Z. “Truth in Lending Law.” Used with permission:
|The Language of Real Estate, 4th Edition, by John Reilly ©1993 by Dearborn Publishing, Inc. Published By Real Estate Education Company , a division of Dearborn Financial Publishing, Inc./Chicago. All rights reserved.|
PREPAYMENT PRIVILEGE AND PENALTY
Unless the contract so provides, the borrower has no right to repay the loan in any form other than then the manner in which the repayment scheme appears in the note. For example, in a fixed rate 30-year loan, the borrower agrees to make 360 monthly payments of $800.00 in each of the 360 consecutive months. The borrower receives the privilege to repay the loan early when the note contains a prepayment clause that identifies the prepayment privilege. If the prepayment privilege appears in the note, the borrower has several choices. He or she could
|(a)||make a single payment to close out the loan;|
|(b)||make payments from time to time in addition to the monthly payments to reduce the loan balance;|
|(c)||make an additional payment to principal with each month’s payment until the loan is repaid in full.|
A prepayment penalty may accompany the prepayment privilege. Depending on language in the note, the lender may require the borrower to pay a percentage of the existing loan balance or a percentage of the next year’s scheduled interest payment as an additional charge when the borrower decides to repay the loan in full. The prepayment penalty may also apply to any partial payments of the loan. The penalty may be a sliding scale in which there is no prepayment allowed in the first five years of the loan, but prepayment can occur at the end of the fifth year with the penalty being 5% of the loan balance and the size of the penalty declining to 4, 3, 2, 1 and 0% in the succeeding years. However, the nature of the penalty is a point of negotiation between the lender and the borrower, and the note spells out the terms.
The prepayment penalty also has an effect on the full cost of the loan to a borrower. If the contract rate on the loan is 9% and the loan has a prepayment penalty of 3% of the loan balance at the time of prepayment, the cost of the loan becomes more than 9% if the borrower exercises the prepayment privilege. If initially the loan was for $100, 000.00 for 30 years at 9% with no discount points and if the borrower repays the loan after 10 years of monthly payments, the loan balance is $89,429.74 and the penalty is $2682.89. The full cost of the loan is 9.52% per year.
INTEREST RATE DETERMINATION
Demand and supply for loanable funds are the basic determinants of the interest rate. If businesses and homeowners demand more money for loans to buy property and if the supply of loanable funds remains constant, the interest rate on loans increases. If, on the other hand demand for loans is constant while the supply of loanable funds increases, the interest rate declines. Increase in demand and decreases in supply cause an increase in the interest rate while decreases in demand and increase in supply cause a decrease in the interest rate.
The levels of savings by households, businesses and various governments generate the supply of loanable funds in the capital and money markets. As the level of savings increases, the supply of loanable funds increases. The use of the savings is the next determinant of the availability of loanable funds. If savings fund the purchase of art objects, collectibles, gem stones and precious metals, the supply of loanable funds to the capital and money markets declines.
Moreover, the application of the savings by the individual savers also has an effect on the supply of loanable funds for real property acquisition. If savers direct their savings to the stock and bond markets, fewer dollars are available for real property loans than if the savers had offered their savings directly to the market for loans on real property. In addition, the saver’s selection of a financial intermediary also affects the flow of funds to the market for real property loans. For example, putting money into a savings and loan directs more funds to the real property loan market than putting savings into a pension fund that does not fund real property loans.
USURY LAWS AND THE INTEREST RATE
The economics of the market for loanable funds determines interest rates, but usury laws can govern maximum interest rates. In 1983 the Georgia Legislature made broad changes in the usury laws. As a result of those changes, effective March 31, 1983, the Georgia Department of Banking and Finance no longer sets the maximum rate of interest on loans. At the same time, the Legislature imposed six limitations on loans.
|(a)||Written contracts with no rate of interest specified have an imputed rate of seven (7) percent per annum simple interest.|
|(b)||Written contracts where the principal amount is $3,000.00 or less cannot exceed sixteen (16) percent per annum simple interest.|
|(c)||In written contracts where the principal exceeds $3,000.00, the parties may decide the rate; and they must express it as simple interest. The law allows the computation and collection of interest at a variable rate, in negative amortization or equity participation, and on an appreciation basis.|
|(d)||Amounts paid or contracted to be paid as either an origination fee or discount points, or both, on any loan secured by real estate are not defined as interest and are not considered in the calculation of interest and are not subject to rebate. Note: this provision does not affect the tax deductibility of origination fees or discount points.|
|(e)||Unless agreed to in the contract, there can be no prepayment penalty.|
|(f)||Any rate of interest advertised must be in terms of simple interest, or a rate stated in terms that would comply with the federal Truth-in-Lending Simplification and Reform Act.|
CONVENTIONAL RESIDENTIAL LOANS
A conventional residential loan is a loan made by a private sector financial institution or an individual to a borrower. The lender makes the loan decision based upon information about the borrower’s ability to repay and likelihood of repaying based upon his or her credit history as well as upon the value of the property. Lending practices and the terms for conventional loans vary with each conventional lender.
Lenders making conventional loans can insure the loan against the borrower’s default. Lenders require mortgage default insurance when the loan to value ratio exceeds 80 percent. Firms in the private sector rather than governmental agencies provide this insurance for a conventional loan. Discussions of federal government loan insurance and guarantee programs, FHA and VA respectively, appear in the next chapter.
CONVENTIONAL LOAN CHARACTERISTICS
Conventional loans have the following components and characteristics:
|(a)||THE INTEREST RATE ON THE LOAN – The interest rate on a conventional loan is set by the demand and supply factors in the market for loanable funds. Lenders freely quote these rates.|
|(b)||LOAN ORIGINATION FEES AND DISCOUNT POINTS – Conventional loans typically carry a loan origination fee and may also require the payment of discount points. See sections 42.09 and 42.13.|
|(c)||LOAN TO VALUE RATIO AND THE DOWNPAYMENT – All new conventional loans require a downpayment. The lender determines the acceptable amount of downpayment by stating the acceptable loan to value ratio for that loan. The loan to value ratio will depend on the nature of the loanable funds market, the type of real property, the financial characteristics of the borrower, and the lender’s perception of the risk associated with the loan.|
|(d)||CONFORMING VERSUS NONCONFORMING LOAN AMOUNTS – Conventional loan amounts are either conforming or nonconforming (jumbo) loans depending on the size of the loan relative to some predetermined dollar amount which can change over time. The threshold for a conventional single family conforming loan amount changes over time. If a loan exceeds this threshold, it is a nonconforming or jumbo loan which typically has a higher interest rate and a different set of loan origination fees and discount points than a conforming loan.|
|(e)||TERM OF THE LOAN – Terms of conventional loans are negotiable between the borrower and the lender. For residential loans, 30-year and 15-year terms are the most prevalent. Loans for many commercial property purchases are 20 year loans.|
|(f)||PRIVATE MORTGAGE DEFAULT INSURANCE – Conventional lenders typically require the borrower to obtain private mortgage default insurance when the loan to value ratio exceeds 80 percent. The borrower pays the insurance premium monthly with the loan payment. Depending on the arrangement with the insurance firm, the borrower can request an end to the mortgage insurance payments when the loan to value based on the unpaid balance and the property’s current market value drops below the 80 or 75 percent level.|
|(g)||PREPAYMENT PRIVILEGE AND PENALTY – A conventional loan can have a prepayment privilege allowing the borrower to pay off the loan early for which the lender may be able to charge a prepayment penalty.|
|(h)||ESCROW ACCOUNT – If the loan to value ratio exceeds, 80% or if the loan is for income property, the lender requires the borrower to establish and maintain an escrow account for the monthly payment of property taxes, hazard insurance, and mortgage insurance if the borrower finances part of the PMI. The borrower establishes this account at the loan closing by paying the lender several months’ payments of taxes, hazard insurance premiums, and possibly mortgage insurance premiums in advance. The amount of the advance payment for taxes will vary with the time of the year the loan closes.
The Real Estate Settlement Procedures Act (RESPA) and the Department of Housing and Urban Development (HUD) through its rule making power, set the maximum number of months the lender can require the borrower to pay into the account in advance. These costs are called prepaid items. The borrower maintains the account by paying 1/12 of the annual property tax assessment, hazard insurance, and mortgage insurance each month along with the principal and interest payment.
|(i)||SECONDARY FINANCING AND PURCHASE MONEY MORTGAGES – If the purchaser is unable to pay all of the downpayment in cash at closing, he or she may, under some circumstances, take out a second mortgage for part of it. Possible sources for second mortgages are finance companies, commercial banks, individuals, or the seller. If the seller agrees to finance part of the seller’s downpayment, this mortgage is called a purchase money mortgage. Lending practices vary on second mortgages. Most lenders do not permit secondary financing unless the purchaser pays at least 10% down and the second mortgage does not exceed the amount of cash invested by the purchaser. The lending institution making the new first loan must approve secondary financing for the purchaser.|
|(j)||LOAN PROCESSING – A reasonable estimate of the time required for processing a conventional loan is four to six weeks from the loan application date, but the time will vary among lenders and with different market conditions.|
QUALIFYING THE BORROWER FOR A CONVENTIONAL LOAN
The process of qualifying a borrower for a loan depends on an evaluation of the loan applicant’s “stable monthly income,” “housing expenses,” and “total recurring financial obligations.” These three concepts establish or determine the loan applicant’s financial capability to carry the loan payment and to repay the loan according to the loan agreement.
Most lenders use the loan underwriting guidelines established by the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), two entities that operate in the secondary mortgage market. A discussion of their nature and operations appears in a subsequent chapter.
|(a)||STABLE MONTHLY INCOME – The loan applicant’s stable monthly income is the total of his or her regular earnings from one primary income source plus earnings from acceptable secondary sources of income. In addition to wages and salary from a full-time job, stable monthly income can include the income from secondary sources: bonuses, commissions, overtime pay, part-time employment earnings, self-employment income, and retirement income from private pensions and social security ; investment income such as dividends, interest revenue and rents; alimony, spousal maintenance, and child support income; and public assistance income. The loan underwriter will ask the loan applicant to verify the quantity and stability of the secondary income by providing at least a two-year history of this income, usually in the form of federal income tax returns for the previous two years.
Unacceptable forms of income which underwriters tend to exclude are wages from any form of employment that an employer classifies as temporary in nature even if there is no definite termination date for the job, unemployment compensation, and income from other members of the family who are not loan applicants such as teenage children or other adults whose employment could be temporary.
|(b)||HOUSING EXPENSES AND THE HOUSING EXPENSE RATIO – Housing expenses are the monthly loan payment which includes the interest payment and the principal repayment, the monthly real property tax, and the monthly payment for homeowner’s or hazard insurance. Housing expenses can also include mortgage default insurance premiums and homeowner’s or condominium association dues. The housing expense ratio is the total monthly housing expenses divided by the total monthly stable income. As an industry norm, the acceptable housing expense ratio is 28%. If a loan applicant’s housing expense ratio exceeds this figure, the perceived risk of default by the loan applicant in the mind of the loan underwriter increases. The ratio can and does change as market circumstances change. Lenders in a market area can provide the currently accepted housing expense ratio.|
|(c)||TOTAL OBLIGATIONS AND THE TOTAL OBLIGATIONS RATIO – A loan applicant’s total obligations include the housing expenses plus all installment debts, revolving debts, and other recurring financial obligations. Installment debts are debts that have a fixed beginning and ending date such as a loan to purchase an automobile. Total obligations include installment debts with more than ten remaining payments. Revolving debts are open-ended loans that generally require minimal monthly payments such as credit card accounts or department store charge accounts. Total obligations include all such accounts that are active and in which there has been any activity in the last six months. The loan underwriter will apply the most recent required minimum payment stated for the account. The category of other recurring financial obligations includes alimony, spousal support, child support and any other such recurring payments. As an industry norm, the total obligations ratio should not exceed 36% of the loan applicant’s stable monthly income. If a loan applicant’s total obligation ratio exceeds this figure, the perceived risk of default by the loan applicant in the mind of the loan underwriter increases. The figure of 36% can change as market circumstances change. Lenders in the market area can provide the currently acceptable housing expenses ratio.|
|(d)||HIGHER RATIOS AND COMPENSATING FACTORS – The housing expense and/or the total obligations ratio can exceed the guideline percentages of 28 and 36 percent respectively if special circumstances exist that the lender thinks justify or warrant making the loan. These special circumstances are the compensating factors that include the following circumstances:|
|(1)||a large downpayment,|
|(2)||a potential for increased earnings based on education, job training, or employment history,|
|(3)||a substantial net worth that indicates the ability to repay the loan even if income is deficient,|
|(4)||a history of carrying few debts and of accumulating savings,|
|(5)||a history of allocating a higher than normal portion of stable monthly income to cover housing expenses,|
|(6)||a high amount of short term income that does not qualify as part of stable monthly income such as a one-time capital gain or a royalty payment, and|
|(7)||property that qualifies as an energy-efficient structure.|
Probably more than in any other area of the real estate industry, real estate finance practices, regulations, and limitations change over a period of time. While the publishers of this information make an effort each year to update the material in the chapters on finance, we can not guarantee the accuracy of the information. The best sources for information on real estate finance at any particular time are practicing lenders and the private and public institutions which provide funds and parameters for real estate loans.