Financial Markets and Institutions (2-downloads)

Year of

Prepayment

Effective Rate 

of Interest (%)

Year of

Prepayment

Effective Rate 

of Interest (%)

1

14.54

6

12.65

2

13.40

7

12.60

3

13.02

10

12.52

4

12.84

15

12.45

5

12.73

30

12.42

.

1

See Chapter 3 for a discussion on how loan payments are computed.

2

For example, to compute the effective rate if the loan is prepaid after two years, find the FV if

I = 11.5%, PV = 100,000, N = 360, and PMT = 990.29. Now set PV equal to 98,000 and compute I.

Divide this I by 12, add 1, and raise the result to the 12th power.

$100,000, you will receive only $98,000 ($100,000 – $2000). Your payment is computed

on the $100,000, but at the lower interest rate. Using a financial calculator, we find

that the monthly payment is $990.29 and your monthly rate is 0.9804%.

1

The effec-

tive annual rate after compounding is

As a result of paying the 2 discount points, the effective annual rate has dropped

from 12.68% to 12.42%. On the surface, it would seem like a good idea to pay the

points. The problem is that these calculations were made assuming the loan would

be held for the life of the loan, 30 years. What happens if you sell the house before

the loan matures?

If the loan is paid off early, the borrower will benefit from the lower interest

rate for a shorter length of time, and the discount points are spread over a shorter

period of time. The result of these two factors is that the effective interest rate rises

the shorter the time the loan is held before being paid. This relationship is demon-

strated in Table 14.2. If the 2-point loan is held for 15 years, the effective rate is

12.45%. At 10 years, the effective rate is up to 12.52%. Even at 6 years, when the

effective rate is 12.65%, paying the discount points has saved the borrower money.

However, if the loan is paid off at 5 years, the effective rate is 12.73%, which is higher

than the 12.68% effective rate if no points were paid.

2

Effective annual rate

⫽ 11.0098042

12

⫺ 1 ⫽ 0.1242 ⫽ 12.42%

Loan Terms

Mortgage loan contracts contain many legal and financial terms, most of which pro-

tect the lender from financial loss.

Collateral

One characteristic common to mortgage loans is the requirement that

collateral, usually the real estate being financed, be pledged as security. The lend-

ing institution will place a lien against the property, and this remains in effect until

the loan is paid off. A lien is a public record that attaches to the title of the property,

---

328

Part 5 Financial Markets

advising that the property is security for a loan, and it gives the lender the right to

sell the property if the underlying loan defaults.

No one can buy the property and obtain clear title to it without paying off this

lien. For example, if you purchased a piece of property with a loan secured by a

lien, the lender would file notice of this lien at the public recorder’s office. The lien

gives notice to the world that if there is a default on the loan, the lender has the

right to seize the property. If you try to sell the property without paying off the loan,

the lien would remain attached to the title or deed to the property. Since the lender

can take the property away from whoever owns it, no one would buy it unless you

paid off the loan. The existence of liens against real estate explains why a title search

is an important part of any mortgage loan transaction. During the title search, a lawyer

or title company searches the public record for any liens. Title insurance is then

sold that guarantees the buyer that the property is free of encumbrances, any ques-

tions about the state of the title to the property, including the existence of liens.

Down Payments

To obtain a mortgage loan, the lender also requires the borrower

to make a down payment on the property, that is, to pay a portion of the pur-

chase price. The balance of the purchase price is paid by the loan proceeds. Down

payments (like liens) are intended to make the borrower less likely to default on the

loan. A borrower who does not make a down payment could walk away from the

house and the loan and lose nothing. Furthermore, if real estate prices drop even

a small amount, the balance due on the loan will exceed the value of the collateral.

As we discussed in Chapters 2 and 8, the down payment reduces moral hazard

for the borrower. The amount of the down payment depends on the type of mort-

gage loan. Beginning in the mid 2000s the required down payment was often cir-

cumvented with piggy back loans where a second mortgage was added to the first

so that 100% financing was provided.

Private Mortgage Insurance

Another way that lenders protect themselves against

default is by requiring the borrower to purchase private mortgage insurance (PMI).

PMI is an insurance policy that guarantees to make up any discrepancy between the

value of the property and the loan amount, should a default occur. For example, if

the balance on your loan was $120,000 at the time of default and the property was worth

only $100,000, PMI would pay the lending institution $20,000. The default still appears

on the credit record of the borrower, but the lender avoids sustaining the loss. PMI is

usually required on loans that have less than a 20% down payment. If the loan-to-

value ratio falls because of payments being made or because the value of the prop-

erty increases, the borrower can request that the PMI requirement be dropped. PMI

usually costs between $20 and $30 per month for a $100,000 loan.

Ideally, PMI should have protected investors against losses on mortgage invest-

ments, and it did until recently. PMI is usually only required on the first mortgage. By

structuring loans so that the first mortgage loan was set at 80% loan to value with

a second mortgage covering the remaining 20%, PMI was avoided.

Borrower Qualification

Historically, before granting a mortgage loan, the lender would

determine whether the borrower qualified for it. Qualifying for a mortgage loan was

different from qualifying for a bank loan because most lenders sold their mortgage loans

to one of a few federal agencies in the secondary mortgage market. These agencies estab-

lished very precise guidelines that had to be followed before they would accept the loan.

If the lender gave a mortgage loan to a borrower who did not fit these guidelines, the

lender would not be able to resell the loan. That tied up the lender’s funds.

---

Chapter 14 The Mortgage Markets

329

The rules for qualifying a borrower were complex and constantly changing, but

a rule of thumb was that the loan payment, including taxes and insurance, should not

exceed 25% of gross monthly income. Furthermore, the sum of the monthly payments

on all loans to the borrower, including car loans and credit cards, should not exceed

33% of gross monthly income.

Lenders will also order a credit report from one of the major credit reporting

agencies. The credit score is based on a model that weights a number of variables

found to be valid predictors of credit worthiness. The most common score is called

the FICO, named after its creator, Fair Isaac Company. FICO scores may range from

a low of 300 to a maximum of 850. Scores above 720 are considered good while scores

below 660 were likely to cause problems obtaining a loan. The FICO score is deter-

mined by your past payment history, outstanding debt, length of credit history, num-

ber or recent credit applications, and types of credit and loans you have. It is

interesting to note that simply applying for and holding a number of credit cards

can significantly affect your FICO score.

When the competition to originate mortgage loans grew in the mid 2000s, a vari-

ety of mortgage loans were offered that circumvented traditional lending practices.

For example, borrowers were offered No Doc loans (sometimes called NINJA loans

for No Income, No Job, and No Assets) where income or assets were not required

on the loan application. These lending practices have been largely abandoned as

the search for quality borrowers has replaced the need for loan volume.

Mortgage Loan Amortization

Mortgage loan borrowers agree to pay a monthly amount of principal and interest that

will fully amortize the loan by its maturity. “Fully amortize” means that the payments

will pay off the outstanding indebtedness by the time the loan matures. During the

early years of the loan, the lender applies most of the payment to the interest on

the loan and a small amount to the outstanding principal balance. Many borrowers

are surprised to find that after years of making payments, their loan balance has

not dropped appreciably.

Table 14.3 shows the distribution of principal and interest for a 30-year, 

$130,000 loan at 8.5% interest. Only $78.75 of the first payment is applied to reduce

the loan balance. At the end of two years, the balance due is still $127,947, and at the

end of five years, the balance due is $124,137. Put another way, of $59,975.40 in

TA B L E   1 4 . 3

Amortization of a 30-Year, $130,000 Loan at 8.5%