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  1. Lesson 6: Basic Features of a Residential Loan

  2. Introduction • In this lesson we will cover: • how a loan is amortized • length of repayment period • loan-to-value ratio • mortgage insurance and loan guaranty • secondary financing • fixed and adjustable interest rates

  3. Amortization • Loan amortization refers to how principal and interest are paid to lender during loan term.

  4. 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 and interest.

  5. Amortization Fully amortized loan • Payments of fully amortized loan are enough to pay off all principal and interest by end of loan term.

  6. Amortization Fully amortized loan • Payments of fully amortized loan are enough to pay off all principal and interest by end of loan term. • Payments include both principal and interest.

  7. Amortization Fully amortized loan • Payments of fully amortized loan are enough to pay off all principal and interest by end of loan term. • Payments include both principal and interest. • Every month the interest portion of the payment is smaller.

  8. Amortization Partially amortized loan • Partially amortized loan requires regular payments of principal and interest.

  9. Amortization Partially amortized loan • Partially amortized loan requires regular payments of principal and interest. • Payments insufficient to pay off debt by end of loan term.

  10. Amortization Partially amortized loan • Partially amortized loan requires regular payments of principal and interest. • But payments aren’t enough to pay off debt by end of loan term. • Balloon payment is required to pay remainder of principal.

  11. Amortization Interest-only loan • Interest-only loan calls for only interest payments during loan term. • At end of term, entire principal amount is due and must be paid off.

  12. Amortization Interest-only loan • Interest-only loan calls for only interest payments during loan term. • At end of term, entire principal amount is due and must be paid off. • No principal is paid off by monthly payments.

  13. Repayment Period • Repayment period is number of years borrower has to repay loan.

  14. Repayment Period • Repayment period is number of years borrower has to repay loan. • Until 1930s, typical repayment period was 5 years, with balloon payment of principal due at end.

  15. Repayment Period • Repayment period is number of years borrower has to repay loan. • Until 1930s, typical repayment period was 5 years, with balloon payment of principal due at end. • Now, loan terms are generally 30 years, although lenders offer 15-year and 20-year loans.

  16. Repayment Period • Length of repayment period affects: • amount of monthly payment, and • total amount of interest paid over life of loan.

  17. Repayment Period Monthly payment amount • Longer repayment period reduces amount of monthly payment. • 30-year loan thus more affordable than 15-year loan.

  18. Repayment Period Monthly payment amount • Shorter loan term: • higher payment amount • equity builds faster • more difficult to qualify for

  19. Repayment Period Total interest • Shorter repayment period substantially decreases total amount of interest paid on loan.

  20. Repayment Period Interest rate • Lenders generally charge lower interest rates for short-term loans.

  21. Advantages of 15-year loan: • lower interest rate • total interest much less • clear ownership in half the time

  22. 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 • tax deduction lost sooner

  23. Repayment Period 20-year loans • 20-year loan is compromise between 15-year and 30-year loan. • Monthly payments are higher than 30-year loan payments.

  24. Amortization and Repayment Period Fully amortized Partially amortized Balloon payment Interest-only loan Loan term Interest rate 15-year loan 30-year loan 20-year loan

  25. Loan-to-Value Ratio • Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased.

  26. Loan-to-Value Ratio • Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased. • The higher the LTV ratio, the smaller the downpayment.

  27. Loan-to-Value Ratio • Loan-to-value ratio (LTV) expresses relationship between loan amount and value of home being purchased. • The higher the LTV ratio, the smaller the downpayment. • Loan with lower LTV is generally less risky than one with high LTV.

  28. Loan-to-Value Ratio • Lenders use loan-to-value ratios to establish maximum loan amounts. • LTV is key factor in determining what borrower can afford to buy.

  29. Loan-to-Value Ratio • Lenders use loan-to-value ratios to establish maximum loan amounts. • LTV is key factor in determining what borrower can afford to buy. • Many lenders allow LTVs no higher than 80%.

  30. Loan-to-Value Ratio • Lenders use loan-to-value ratios to establish maximum loan amounts. • LTV is key factor in determining what borrower can afford to buy. • Many lenders allow LTVs no higher than 80%. • High LTVs help people who don’t have money for large downpayments.

  31. Mortgage Insurance/Loan Guaranty • Purpose of mortgage insurance or guaranty is to protect lender from foreclosure loss.

  32. Mortgage Insurance/Loan Guaranty • Purpose of mortgage insurance or guaranty is to protect lender from foreclosure loss. • Also provides incentive for lenders to make loans that would otherwise be too risky.

  33. Mortgage Insurance/Loan Guaranty Mortgage insurance • Mortgage insurance works like other types of insurance: • policyholder pays premiums, and • insurer provides coverage for certain types of losses.

  34. Mortgage Insurance/Loan Guaranty Mortgage insurance • Policy protects the lender against losses from borrower default and foreclosure. • Insurer agrees to indemnifylender. • Insurer will make up any deficiency after foreclosure.

  35. Mortgage Insurance/Loan Guaranty Mortgage insurance • Policy protects the lender against losses from borrower default and foreclosure. • Insurer agrees to indemnifylender. • Insurer will make up any deficiency after foreclosure. • Insurer also underwrites loan.

  36. Mortgage Insurance/Loan Guaranty Loan guaranty • In loan guaranty, a third party (guarantor) agrees to take on secondary legal responsibility for borrower’s obligation to lender. • Guarantor reimburses lender for losses from borrower default.

  37. Mortgage Insurance/Loan Guaranty Loan guaranty • Guarantor might be: • private party,

  38. Mortgage Insurance/Loan Guaranty Loan guaranty • Guarantor might be: • private party, • nonprofit organization,

  39. Mortgage Insurance/Loan Guaranty Loan guaranty • Guarantor might be: • private party, • nonprofit organization, or • governmental agency.

  40. Mortgage Insurance/Loan Guaranty Loan guaranty • Guarantor might be: • private party, • nonprofit organization, or • governmental agency. • Guarantor may also underwrite the loan.

  41. Secondary Financing • Secondary financing • Second loan obtained to pay part of downpayment or closing costs for a home.

  42. Secondary Financing • Lender making primary loan usually restricts type of secondary financing a borrower can use. • Buyer must qualify for combined payments on both loans.

  43. Secondary Financing • Lender making primary loan usually restricts type of secondary financing a borrower can use. • Buyer must qualify for combined payments on both loans. • Restrictions intended to minimize risk of default on second loan.

  44. LTV, Insurance or Loan Guaranty Loan-to-value ratio Mortgage insurance Indemnify Loan guaranty Secondary financing

  45. Fixed or Adjustable Interest Rate Fixed-rate loan • Fixed-rate mortgage • Interest rate charged on loan remains constant through loan term. • Considered industry standard.

  46. Fixed or Adjustable Interest Rate Fixed-rate loan • Fixed-rate mortgage • Interest rate charged on loan remains constant through loan term. • Considered industry standard. • When market rates rise or fall, loan rate stays the same.

  47. Fixed or Adjustable Interest Rate Adjustable-rate loan • Adjustable-rate mortgage • ARM allows lender to adjust loan’s interest rate to reflect changes in cost of money.

  48. Fixed or Adjustable Interest Rate Adjustable-rate loan • Adjustable-rate mortgage • ARM allows lender to adjust loan’s interest rate to reflect changes in cost of money. • Transfers risk of rate fluctuations to borrower.

  49. Fixed or Adjustable Interest Rate Adjustable-rate loan • Adjustable-rate mortgage • ARM allows lender to adjust loan’s interest rate to reflect changes in cost of money. • Transfers risk of rate fluctuations to borrower. • Generally lower interest rate than fixed-rate loans.

  50. Fixed or Adjustable Interest Rate How ARMs work • Borrower’s interest rate first determined by market interest rates at time loan is made.