Types of Mortgages • Types of Collateral: • Residential • 1 to 4 family homes (up to 4 units) • Commercial • Larger apartments & non-residential • Permanent vs. Construction • Perm on completed existing buildings • Construction loans finance development projects
Government Involvement • Government-Insured (FHA, VA) • Include “mortgage insurance”, allows higher L/V ratio • More “red tape”, longer approval process • No “due-on-sale” clause, may be assumable • Conventional • Normally max L/V=80%, unless private mortgage insurance (PMI) • Majority of all loans
Terminology • Owner begins with "O", so: "...or" ===> Owner • "Lessor" is Owner (Landlord), "Lessee" is Renter. • "Mortgagor" is Owner (Borrower), "Mortgagee" is Lender.
Legal Structure of Mortgages • Mortgages have 2 parts (documents): • Promissory Note: Contract establishing debt. • Mortgage Deed: Secures debt with real property collateral (potentially conveys title). • Two legal bases of mortgages: • "Lien Theory" (most states): borrower holds title, lender gets lien. • "Title Theory" (a few states): Lender holds title.
TYPICAL COVENANTS & CLAUSES • Promise to Pay Specifies principal, interest, penalties, etc., along with date, names, etc. 2) Covenant to Avoid Liens w Priority over the Mortgage For example, if borrower fails to pay property tax, she is in default of mortgage too, because property tax lien has priority over mortgage lien.
3) Hazard Insurance Borrower must insure value of the property (at least up to mortgage amount) against fire, storm, etc. *4) Mortgage Insurance Borrower must hold mortgage insurance (usually only if loan is not Govt insured and Loan/Value ratio > 80%). In essence, mortgage insurance will pay lender the difference between foreclosure sale proceeds and the debt owed to lender, if any. In effect, Govt (FHA, VA) loans automatically have mortgage insurance from the Govt.
5) Escrow Borrower required to pay insurance and property tax installments to lender in advance, who holds funds in escrow until due to insurer and property tax authority, when lender pays these bills for the borrower. *6) Order of Application of Payments First to penalties and expenses, then to interest, then to principal balance. (This implements the “4 Rules”.) 7) Good Repair Clause Borrower must maintain property in good repair.
8) Lender's Right to Inspect Lender has right to enter property, with prior notice and at the owner’s convenience, to verify that borrower is keeping property in good repair. 9) Joint & Several Liability Each party signing the mortgage is individually completely liable for the entire mortgage debt.
*10) Acceleration Clauses Allow lender to make the entire outstanding loan balance due immediately under certain conditions. Normally applied to default (to enable lender to sue for entire loan balance in foreclosure) and to implement a “due-on-sale” clause.
*11) "Due-on-Sale" Clause Lender may accelerate loan when/if borrower transfers a substantial beneficial interest in the property to another party. This normally prevents mortgage from being “assumed” by a buyer of the property. Govt insured loans (FHA, VA) usually do not have this clause, but most conventional residential mortgages do. Results in “demographic prepayment” (as distinguished from “financial prepayment”) of residential mortgages.
*12) Borrower's Right to Reinstate Allows borrower to stop the “acceleration” of the loan under default, up to time of court decree, upon curing of the default (payment of all back payments and penalties and expenses required under the loan terms). 13) Lender in Possession Provision giving lender automatic right of possession of the property in the event of default on the loan. Enables lender to control leasing and care & maintenance of the building prior to completion of the foreclosure process.
*14) Release Clauses States the conditions for freeing the real property collateral from the loan security (e.g., when debt is paid off the lender must release the property by returning the mortgage deed and extinguishing the lien or returning the title to the borrower). More complicated release provisions are involved in loans in which the collateral will be sold of gradually in parts or parcels.
15) Estoppel Clause Requires borrower to provide lender with a statement of the remaining outstanding balance on the loan. This provision is necessary to enable loan to be sold in the secondary market, as the identity of the “lender” (that is, the current owner or holder of the mortgage asset) will change as the mortgage is sold in the secondary market.
*16) Prepayment Clause Provision giving the borrower the right (without obligation) to pay the loan off prior to maturity, like “callable” bonds. This effectively gives the borrower a call option on a bond, where the bond has cash flows equivalent to the remaining cash flows on the mortgage, and the exercise price of the option is the outstanding loan balance (plus prepayment penalties) on the mortgage (i.e., what one would have to pay to retire the debt).
*17) Lender's Right to Notice (Jr Loans) A provision in junior loans requiring the borrower to notify the lender if a foreclosure action is being brought against the borrower by any other lien-holder. Junior lien-holders may wish to help to cure the default or help work out a solution short of foreclosure, because junior lien-holders will stand to lose much more in the foreclosure process than the senior lien-holder.
*18) Subordination Clause A provision making the loan subordinate to (that is, lower in claim priority in the event of foreclosure than) other loans which the borrower obtains subsequent to the loan in question. Often used in seller loans and subsidized financing, to enable the recipient of such financing to still obtain a regular first mortgage from normal commercial sources.
*19) Future Advances Provision for some or all of the contracted principal of the loan to be disbursed to the borrower at future points in time subsequent to the establishment (and recording) of the loan. This is common in construction loans, where the cash is disbursed as the project is built. 20) Covenant against Removal Borrower (property owner) is not permitted to remove from the property any part of the collateral, such as fixtures attached to the building.
21) Personal Property Clauses Provisions including in the collateral specified items of personal property (as opposed to the real property that is automatically included in the mortgage deed). “Real property” includes land and any structures and fixtures attached to the land. “Personal property” includes movable, non-fixed items such as furniture, most appliances, cars, boats, etc. 22) Owner Occupancy Clause Requires borrower to live in the house.
23) Sale in One Parcel Clause Prevents the collateral property from being broken up into parcels sold separately. *24) Exculpatory Clause Removes the borrower from responsibility for the debt, giving the lender “no recourse” beyond taking possession of the collateral which secures the loan. Without an exculpatory clause, the lender can obtain a “deficiency judgment” and sue the borrower for any remaining debt owed after the foreclosure sale.
etc., etc. . . .Anything the borrower and lender mutually agree on to include in the contract.
More Terminology “Purchase Money Mortgage" vs Refinancing "Land Contract" Title does not pass until contract paid off "Wraparound Mortgage" ("wrap") 2nd Mortgage issued by seller to buyer, seller keeps 1st Mortgage alive, using wrap pmts to cover (smaller) 1st Mortgage pmts.
Priority of Claims in Foreclosure Lien Priority established by Date of Recording, except: Property Tax Lien comes firstSometimes Mechanics LiensExplicit Subordination ClauseBankruptcy Proceedings may modify debtholder rights "First Mortgage" (earlier recording) = "Senior Debt“ "2nd (etc) Mortgage" = "Junior Debt“
Example: 1st Mortgage = $90,000 2nd Mortgage= $20,000 3rd Mortgage = $10,000 Property sells in foreclosure for $100,000: 1st Mortgagee gets $90,000 2nd Mortgagee gets $10,000 3rd Mortgagee gets 0.
"Redeem up, Foreclose down" • Senior Lien Holders obtain their claim (to the extent foreclosure sale proceeds and their priority allows), even if they did not bring the suit. • Junior Lien Holders lose claims after foreclosure, provided they are included in the foreclosure suit. • Lien Holder bringing foreclosure suit normally buys the property in the foreclosure sale, for amount sufficient to cover its claim.
Mortgage Math • What is PV of $1000 per month for 15 months plus $10,000 paid 15 months from now at 10% nominal annual interest? = (14.045)1000 + (0.8830)10000 = $14,045 + $8,830 = (PVIFA.00833,15)*PMT + (PVIF.00833,15)*FV
(With calculator set to pmts at “END” of periods, and P/YR=12…) Mortgage Math Keys: DCF Keys: 15----> N key 10----> I/YR key 10----> I/YR key 0 ----> CFj key 1000 ----> PMT key 1000----> CFj key 10000----> FV key 14 ----> Nj key PV ----> -22,875 11000---->CFj key NPV ----> 22,875
How the Calculator "Mortgage Math" Keys Work. . . The five "mortgage math" keys on your calculator (N,I,PV,PMT,FV) solve:
or:0 = -PV + (PVIFAr,N)*PMT + (PVIFr,N)*FV where: r = i / m, where: i = Nominal annual interest rate m = Number of payment periods per year (mP/YR).
Example: 10%, 20-yr fully-amortizing mortgage with payments of $1000/month. The calculator solves the following equation for PV: The result is: PV = 103625.
THE BASIC RULES OF CALCULATING LOAN PAYMENTS & BALANCES Let: P = Initial Contract Principal (Loan Balance at time zero, when money is borrowed) rt = Contract Interest rate (per payment period, e.g., =i/m) applicable for payment in Period "t“ IEt = Interest portion of payment in Period "t“ PPt = Principal paid down ("amortized") in the Period "t" payment OLBt = Outstanding loan balance after the Period "t" payment has been made PMTt = Amount of the loan payment in Period "t“
THE FOUR BASIC RULES: • IEt = rt(OLBt-1) • PPt = PMTt – IEt • OLBt = OLBt-1 - PPt Equivalent to PV of remaining loan payments • OLB0 = P Know how to set up these rules in a spreadsheet, so you can calculate payment schedule, interest, principal, and outstanding balance after each payment, for any type of loan that can be dreamed up! (See “schedpmt.xls”, downloadable from course web site.)
APPLICATION OF THE FOUR RULES TO SPECIFIC LOAN TYPES • Fixed-Rate loans (FRMs): The contract interest rate is constant throughout the life of the loan: rt=r, all t. 2) Constant-Payment loans (CPMs): The payment is constant throughout the life of the loan: PMTt=PMT, all t.
3) Constant-Amortization loans (CAMs): The principal amortization is constant throughout the life of the loan: PPt=PP, all t. 4) Fully-Amortizing loans: Initial contract principal is fully paid off by maturity of loan: PPt=P over all t=1,…,N. 5) Partially-Amortizing loans: Loan principal not fully paid down by due date of loan: PPt<P, so OLBN must be paid as “balloon” at maturity.
6) Interest-Only loans: The principal is not paid down until the end: PMTt=IEt, all t (equivalently: OLBt=P, all t, and in calculator equation: FV = -PV). 7) Graduated Payment loans (GPMs): The initial payment is low, usually initial PMT1 < IE1, so OLB at first grows over time (“negative amortization”), followed by higher payments scheduled later in the life of the loan.
8) Adjustable-Rate loans (ARMs): The contract interest rate varies over time (rt not constant, not known for certain in advance, loan payment schedules & expected yields must be based on assumptions about future interest rates).
Classical Fixed-Rate Mortgage The “classical” mortgage is both FRM & CPM: PMT = P/(PVIFAr,N) = P / [(1 – 1/(1+r)N )/r]
MONTH BEG. BAL. INTEREST PMT PRIN END BAL. 1 $60,000.00 $600.00 $617.17 $17.17 $59,982.83 2 $59,982.83 $599.83 $617.17 $17.34 $59,965.49 3 $59,965.49 $599.65 $617.17 $17.51 $59,947.98 $60,000, 12%, 30-year CPM...
You should know what formulas you would place in each cell of a spreadsheet (e.g., Excel) to produce such a table. (See “schedpmt.xls”, downloadable from course web site.)
Using Your Calculator • Calculate Loan Payments: Example: $100,000 30-year 10% mortgage with monthly payments: • ----> N 10----> I/YR 100000 ----> PV 0 ----> FV PMT----> - 877.57
2) Calculate Loan Amount (Affordability): Example: You can afford $500/month payments on 30-year, 10% mortgage: 360----> N 10----> I/YR 500----> PMT 0----> FV PV----> - 56,975.41 = Amt you can borrow.
If you can borrower 80% of house value, how much can you afford to purchase? • Purchase Price = $56,975 / 0.80 • Purchase Price = $71,218
3) Calculate Outstanding Loan Balance: Example: What is the remaining balance on $100,000, 10%, 30-year, monthly-payment loan after 5 years (after 60 payments have been made)? First get loan terms in the registers: • ----> N 10----> I/YR 100000----> PV 0----> FV PMT----> - 877.57 Then calculate remaining balance either way below: N ----> 60 N----> 300 FV ----> - 96,574.32 PV----> 96,574.32
4) Calculate payments & balloon on partially amortizing loan: Same as (3) above. 5) Calculate the payments on an interest-only loan: Example: A $100,000 interest-only 10% loan with monthly payments: N can be anything, • ---> I/YR, 100000 ---> PV, -100000---> FV, PMT ---> -833.33
6) Meet affordability constraint by trading off payment amount with amortization rate: Example: Go back to example #2 on the previous page. The affordability constraint was a $500/mo payment limit. Suppose the $56,975 which can be borrowed at 10% with a 30-year amortization schedule falls short of what the borrower needs. How much slower amortization rate would enable the borrower to obtain $58,000?
Enter: I/YR = 10, PV = -58000, PMT = 500, FV = 0, Compute: N = 410. Thus, the amortization rate would have to be 410 months, or 34 years. Note: This does not mean loan would have to have a 34-year maturity, it could still be a 30-year partially-amortizing loan, with balloon of $20,325 due after 30 years.
7) Determining principal & interest components of payments: Example: For the $100,000, 30-year, 10% mortgage in problem #1 on the previous page, break out the components of the 12 payments numbering 50 through 61. In the HP-10B, after entering the loan as in problem #1, enter: 50, INPUT, 61, AMORT, = $9,696.06 int, = $834.80 prin, =$96,501 OLB61. To get the corresponding values for the subsequent calendar year, press AMORT again, to get: = $9,608.65 int, = $922.21 prin, =$95,579 OLB73. (Other business calculators can do this too.)
Loan Yields and Mortgage Valuation Loan Yield = Effective Interest Rate Yield = IRR of loan Recall: IRR based on cash flows.
Let: PV= CF0 PMT= CFt , t=1,2,...,N-1 PMT + FV = CFN N= Holding Period where: CFj represents actual cash flow at end of period "j".