Fundamentals of Real Estate

Lecture 25 Spring, 2002

Copyright © Joseph A. Petry www.cba.uiuc.edu/jpetry/Fin_264_sp02

Housekeeping

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Mid-term Exam #3 on Wednesday, April 24 th . – – – – MC, 30-40 questions, similar to homework, class examples.

Exam will cover Ch. 13-17, 19. We will go over Chapter 19 on Monday. Read over weekend. Homework will be assigned for all remaining chapters. Plan on doing it for all remaining chapters.

This will be the last of the new material.

Pat Fitzgerald, Monday, April 29 th , 7:00pm, 66 Library.

Project Due Wednesday, May 1 st . Final, Wed., May 8 th , 1:30-4:30, 134 Buell Hall. – The final will be comprehensive Final Conflict, Thurs, May 9 th , 1:30-4:30, 119 DKH.

Chapter 15: Residential Mortgages

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Borrower’s Mortgage Loan Decisions

A. Mortgage Choice 1.

Up-front financing costs Lenders charge points to: – – Generate income Increase the yield on the loan – Reduce the incentive for borrowers to refinance Lenders usually charge loan origination fees of 1 – 2% of loan Other fees include: – Loan application fees and document preparation fees ($200-700) – – – Appraisal fees ($150-300) Credit check fees ($35-75) Mortgage insurance (.5-1.0 percent of loan amount)

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Chapter 15: Residential Mortgages

Borrower’s Mortgage Loan Decisions

2.

– – charges to transfer the deed and record the mortgage ($40-200) Survey costs ($200-300) – – Pest inspection ($25-75) Attorney’s fees The effective cost of borrowing —your

actual

interest rate – What is the effective cost of borrowing on a $100,000 FPM, amortized monthly over 30 years, at 8.5%. Assume all up-front financing costs are $2000 and that the borrower repays the mortgage after two years.

– – First find your payments = Then find RMB = – – (N=24, I=?, PV=98,000, PMT=-PMT, FV=-RMB); I = Now assume, the borrower also paid 1 point to close the loan. I = ??

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Chapter 15: Residential Mortgages

Borrower’s Mortgage Loan Decisions

3.

Estimating Closing Costs – – The Real Estate Settlement and Procedures Act requires lenders to provide a “good faith” estimate on all costs associated with closing a residential loan within three days of loan application The Truth in Lending Act requires lenders to provide borrowers with estimates of total finance charges and the annual percentage rate (APR) 4. Comparing Mortgage Options – – Compare

effective

borrowing costs For very short holding periods, effective cost on ARMs < FPMs – Consider affordability/liquidity needs and opportunity cost of funds

Chapter 15: Residential Mortgages

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Borrower’s Mortgage Loan Decisions

B. Loan Size – – – Relative costs of debt and equity financing Household’s current and expected future income constraints Household’s wealth constraints C. Refinancing Decision – “Rule of thumb” refinance when rates are 150-200bps below current mortgage rate – Compare present value of the payment reductions to present value of the cost of obtaining a new loan. The one thing that this can miss is postponing refinancing until even lower rate can be achieved.

D. Default Decision – Usually arises from change in borrower’s ability to pay or low equity in the home. Default is usually not immediate even if home value is greater than the loan amount.

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Chapter 16: Sources of Funds for Residential Mortgages

Market for Residential Financing

The residential (home) mortgage debt exceeds $4.6trl, and represents 75% of total mortgage debt (‘99). – US debt in 1999 was $5.6trn

– – US corporate bond debt was $2.0trn

US consumer debt was $1.3trn

Depository Lenders in the Primary Market

Depository lenders--S&Ls, savings banks, credit unions, commercial banks —are financial intermediaries because they bring together depositors and borrowers A. Savings Institutions – S&Ls were highly specialized home mortgage lending institutions, they have evolved toward more general financial institutions.

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Chapter 16: Sources of Funds for Residential Mortgages

– – – – In the late 1980s, S&Ls originated ~50% of all conventional mortgage loans. By the early 1990s, this had fallen to about 25%.

The Financial Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 to cope with the massive losses and closure of S&Ls. It affected aspects of mortgage lending, lender regulation, and real estate appraiser licensing requirements.

Saving Banks used to have wider investment powers than S&Ls, but now are indistinguishable from S&Ls.

Credit Unions charter restricts them to serving a group of people who can show a common bond (such as employees of a corporation), but have the same authority to make all kinds of loans. B. Commercial Banks involvement in housing market – Originate and sell home mortgage loans (have picked up the slack of S&Ls in this area), buy mortgage backed securities, provide short term funds to mortgage banking companies, make short-term construction loans.

Chapter 16: Sources of Funds for Residential Mortgages

9 Non-depository Lenders in the Primary Market

A. Mortgage Bankers – Full service mortgage companies —processing, closing, funding, servicing, and selling the loans they originate.

– 1.

2.

Increasingly displacing depository lenders as the dominant source of home mortgage loans.

– – Loan commitments and funds Primary source of funds are bank lines of credit Lock-in period occurs once the lender commits to a specific rate – Servicing Includes collecting monthly payments and managing escrow accounts. Most mortgage bankers reserve the right to provide this service to the loan purchaser (for a fee of 0.25-0.5% of loan amnt)

Chapter 16: Sources of Funds for Residential Mortgages

10 Non-depository Lenders in the Primary Market

3.

– – – – Sales of mortgage loans Mortgage banks continually originate loans, take on short-term loans to finance their commitment, sell the originated loans, pay off the warehouse loans, and restart the process If interest rates rise after they have made their loan commitment, but prior to closing, they will have to sell the newly originated loan at a discount Forward commitments give mortgage bankers the right to sell a pre-specified amount of a certain type of loan at a pre-specified price to a secondary mortgage purchaser Standby forward commitments give mortgage bankers the right, but not the obligation, to sell a pre-specified dollar amount of a certain loan type to the seller of the standby commitment

Chapter 16: Sources of Funds for Residential Mortgages

11 Non-depository Lenders in the Primary Market

4.

– Sources of Revenues Mortgage bankers earn revenues from application fees, origination fees, and servicing fees. Servicing fees have been the most profitable aspect of the mortgage banking business.

B. Mortgage Brokers – Serve as intermediaries between borrowers and lenders. They receive compensation for finding low cost loans for borrowers, or borrowers for lenders.

C. Other Nongovernment-sponsored Lenders – As the secondary mortgage market has grown, a wide variety of non-depository lending firms have entered the market (GMAC, AT&T Capital, and some Wall Street Firms)

Chapter 16: Sources of Funds for Residential Mortgages

12 Government Sponsored Mortgage Programs

A. FHA-Insured Loans – – – – – – FHA loans are made by private lenders FHA insurance protects lenders from all losses experienced after foreclosure and conveyance of title to HUD FHA borrowers pay an up-front insurance premium equal to 2.20% of the loan amount, plus a monthly premium FHA loan amounts are limited to a max of $115,200 to 208,800 depending upon the area For properties costing < $50,000 or less, 3% downpayment is required For properties > $50,000, 3% is required for first 25,000, with 5% required for the remaining amount of property value

Chapter 16: Sources of Funds for Residential Mortgages

13 Government Sponsored Mortgage Programs

B. VA-Guaranteed Loans – – – – – – – VA loans are made by private lenders (available to US vets) VA guarantees the lender against loss up to 100% of property’s value VA charges a fee depending upon the LTV (2.0% w/ no down payment, 1.5% w/ 5-9.99% down, and 1.25% with a 10% or higher down payment) Funding fee can be financed Closing costs cannot be included in the amount of the loan Lenders cannot charge points; however, sellers may pay points to help enable the veterans qualify VA sets maximum loan limits

Chapter 16: Sources of Funds for Residential Mortgages

14 Purchasers of Residential Mortgages in Secondary Mkt

– – Fannie Mae, and Freddie Mac are largest purchasers of residential mortgages in the secondary market They are also the largest issuers of MBSs A. Federal National Mortgage Association (FNMA), Fannie Mae – – – – – Originated in 1938 to provide secondary mkt for FHA, then VA loans Reorganized in 1968 into a semi-private corporation Authorized to purchase conventional loans in 1970 Obtains funding from sale of its stock, its MBSs, bond issuances and from its earnings Mortgages and MBSs owned by Fannie Mae = 23% of res mkt

Chapter 16: Sources of Funds for Residential Mortgages

15 Purchasers of Residential Mortgages in Secondary Mkt

B. Federal Home Loan Mortgage Association (FHLMC), Freddie Mac – – – – Originally created in 1970 to provide secondary market for savings and loan association products Currently buys both government-underwritten and conventional loans Freddie Mac, and Fannie Mae now operationally similar MBSs and mortgages of Freddie Mac = 17% of residential mkt C. Importance of Fannie Mae, Freddie Mac – 2 of the country’s largest financial institutions – Forward commitments they make to buy conventional loans – Served to standardize loan docs, and underwriting procedures

Chapter 16: Sources of Funds for Residential Mortgages

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D. Government National Mortgage Association (GNMA), Ginnie Mae – – – – Created in 1968, when Fannie Mae was reorganized Guarantees timely payment of principal on MBSs (primarily FHA and VA pools) Does not buy and sell large numbers of mortgages Purchases below-market mortgages, at par value, from originating lenders. These mortgages generally designed by the FHA for low- and moderate-income buyers E. Life Insurance Companies – – One of the largest sources of funds for commercial mortgages, almost non-existent in the home market (<1% of originations) they do provide funds indirectly through purchase of MBSs

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Chapter 16: Sources of Funds for Residential Mortgages

F.

Other Secondary Market Purchasers – – – – – A variety of other government sponsored entities also active Farm credit system Federal Agricultural Mortgage Corporation (Farmer Mac) Farmers Home Administration (FmHA) Financing Corporation (FICO) – Federal Financing Bank (FFB)

Lender’s Mortgage Loan Decisions (on your own)