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Types of Mortgages
Types of Collateral:
Residential
1 to 4 family homes (up to 4 units)
Commercial
Larger apartments & non-residential
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 Normally max L/V=80%, unless private mortgage insurance (PMI) Majority of all loans
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Conventional
Terminology
Owner begins with "O", so: "...or" ===> Owner "Lessor" is Owner (Landlord), "Lessee" is Renter. "Mortgagor" is Owner (Borrower), "Mortgagee" is Lender.
Promissory Note: Contract establishing debt. Mortgage Deed: Secures debt with real property collateral (potentially conveys title). "Lien Theory" (most states): borrower holds title, lender gets lien. "Title Theory" (a few states): Lender holds title.
3) Hazard Insurance
Borrower must insure value of the property (at least up to mortgage amount) against fire, storm, etc.
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.
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etc., etc. . . . Anything the borrower and lender mutually agree on to include in the contract.
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More Terminology
Purchase Money Mortgage" vs Refinancing "Land Contract"
Title does not pass until contract paid off
"First Mortgage" (earlier recording) = "Senior Debt "2nd (etc) Mortgage" = "Junior Debt
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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.
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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?
$22 ,875 $1,000 $1,000 1 .10 12 1 .10 12 15 $10 ,000 1 .10 12 15
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(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
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How the Calculator "Mortgage Math" Keys Work. . . The five "mortgage math" keys on your calculator (N,I,PV,PMT,FV) solve:
0 PV PMT PMT PMT 2 1 r 1 r 1 r N
1 r N
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FV
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).
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Example:
10%, 20-yr fully-amortizing mortgage with payments of $1000/month. The calculator solves the following equation for PV:
0 PV 1000 1000 1000 1.00833 1.00833 2 1.00833 240
1.00833 240
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4) 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.)
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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.
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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).
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$60,000.0 0
$600.00
$617.17
$17.17
$59,982.8 3
$59,982.8 3
$599.83
$617.17
$17.34
$59,965.4 9
$59,965.4 9
$599.65
$617.17
$17.51
$59,947.9 8
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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.)
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If you can borrower 80% of house value, how much can you afford to purchase?
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can be anything,
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?
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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 30year partially-amortizing loan, with balloon of $20,325 due after 30 years.
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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.)
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1 r
FV
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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".
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1 r
PMT
N
1 r
FV
PMT FV
1 r
1 r N
CFN
Expressed in nominal per annum terms (i=mr, where m=P/YR), we can thus find the yield by computing the I/YR, provided the values in the N, PV, PMT, and FV registers equal the appropriate actual cash flow and holding period values.
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In 2ndary mkt, loans are priced so their yields equal the mkts required yield (like expected total return, E(r)=rf+RP, from before).
At the time when a loan is originated (primary market), the loan yield is usually approximately equal to its contract interest rate. (But not exactly)
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(c)The actual liquidating payment that pays off the loan at the end of the presumed holding period may not exactly equal the outstanding loan balance at that time (e.g., if there is a "prepayment penalty" for paying off the loan early, then the borrower must pay more than the loan balance, so FV is then different from OLB): CFN PMT+OLBN
So we must make sure that the amounts in the N, PV, and FV registers reflect the actual cash flows
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Example
$200,000 mortgage, 30-year maturity, monthly payments 10% annual interest The loan has 2 points
What is yield (effective interest rate) assuming holding period of 4 years (i.e., borrower will pay loan off after 48 months)? Break this problem into 3 steps:
(1)Compute the loan cash flows using the contract values of the parameters
(N=360, I=10%, PV=200000, FV=0, Compute PMT=$1755.14);
(2)Alter the amounts in the registers to reflect the actual cash flows; (3)Compute yield.
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Step 1)
360----> N
Step 2)
48----> N FV----> - 194804 X 1.03 = - 200,649 ----> FV 196000 ----> PV
Step 3)
I/YR----> 11.22%
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Expected yield (like E(r) or going-in IRR) is 11.22%, even though contractual interest rate on the loan is only 10%.
(When closing costs and prepayment penalties are quoted in "points", you do not need to know the amount of the loan to find its yield.)
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General rule to calculate yield: Change the amount in the PV Register last, (just prior to computing the yield).
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Equivalent solution to previous problem: Use CF keys instead of mortgage math keys 196000 ----> CFj key - 1755.14 ----> CFj key 47 ----> Nj key - 202404 ----> CFj key IRR ----> 11.22%
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Example
$100,000 mortgage, 30-year, 10%, 3 points prepayment penalty before 5 years. Expected time until borrower prepays loan = 4 years. How much is the loan worth today if the market yield is 11.00%?
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Step 1)
360--->N, 10--->I/YR, 100000--->PV, 0--->FV, Compute PMT---> -877.57.
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Step 2)
48--->N, FV---> -97,402 * 1.03 = -100,324 --->FV.
Step 3)
I/YR---->11.00%.
Step 4)
PV----> 98,697.
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If the borrower wants to pay the loan off after the fourth year (48 months), what will the prepayment penalty be?
Answer: Original loan in registers, then:
48=N, FV=97402, 99000=PV, 12=I/YR, FV=105883, so in this case: Penalty = 105883 97402 = $8,481.
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For bonds m=2; For mortgages m=12. Thus, BEY = ENAR with m=2.
"Mortgage Equivalent Yield" (MEY) = ENAR with m=12.
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Example:
What is MEY equivalent to 10% BEY?
2----> P/YR 10----> I/YR EFF%----> 10.25 12----> P/YR NOM%----> 9.80 (1 + .10/2)2 -1 = .1025 [(1 + .1025)1/12 - 1]12 = .0980
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Refinancing
This is essentially a comparison of two loans. NPV is the evaluation (decision) framework.
OCC (disc.rate, r) = Eff. int. rate in current loan market (mkt yield).
Basic principles (apples vs apples): 1) Compare over same time horizon; 2) Compare over the same debt amount.
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2.
3.
Compute NPV of incremental CFs of having New Loan instead of Old Loan (keeping in mind the apples vs apples principles). Subtract from this the transaction cost of obtaining the New Loan (e.g., title insurance, appraisal fees, etc). This gives the NPV of refinancing, except for: Subtract the value of the refinancing option in the Old Loan, which you are giving up when you refinance. (This is the prepayment option, the call option on a bond.)
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Steps (1) & (2) are all that is presented in typical R.E. finance textbooks. Unfortunately, the option value can often swamp the NPV result from the first two steps.
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(Note: With this procedure, you do not need to calculate how much you will borrow under the new loan in order to determine the NPV of refinancing.)
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Example of Step 1
Loan refinancing NPV calculation:
Old loan was $100,000 30-year mortgage taken out 5 years ago at 10%. Currently int rates on new 30-year loans are down to 8%, with 2 points. You expect to be in your house 7 years more (Exptd holding per.=y yrs). Old loan has 1 point prepayment penalty. New loan has no prepayment penalty. What is NPV of refinancing before considering transaction costs and option value?
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1st) Compute yield on new loan over expected holding period (current OCC):
360 = N, 8 = I/YR, 1 = PV, 0 = FV, Compute PMT = - .0073376. Now change to: 84 = N, and compute FV = .9247743. Now change to: .98 = PV, and compute I/YR = 8.3905% Write down this yield (or store in calc memory).
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2nd) Get remaining CFs of Old loan, and its current payoff amount:
360 = N, 10 = I/YR, 100000 = PV, 0 = FV, and compute PMT = - 877.57. Now change to: 60 = N, and compute FV = 96,574X 1.01 = 97,540 Write this number down (or store). It is what you have to pay to get rid of the old loan. Now change to: 144 = N, and compute FV = 87,771 X 1.01 = 88,649 FV Now change to: 84 = N.
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4th) From this "Benefit" of getting rid of the old loan, subtract the "Cost", that is, what you must pay to get rid of old loan:
104980 - 97540 = + $7,440 = "NPV of refinancing" (after Step 1 only) (After-tax NPV = +$5,668, =76% of BTNPV.)
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(after Step 2)
(This still lacks consideration of opportunity cost of giving up refinancing option value.)
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This can be seen in the previous calculations. We found that by exercising that option today, the borrower of the old loan could obtain a positive NPV of $5,940. Options always have positive value, because they give the holder a right without an obligation.
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The borrower does not have to refinance today (or ever) if she does not want to. A right without obligation enables the holder to take advantage of the upside of risk without being fully exposed to the downside of risk.
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When you pay off the old loan before its maturity, exercising the prepayment option, you then no longer have that option (in the old loan). Thus, part of the cost of refinancing is the value of the prepayment option in the old loan that is given up by its exercise.
How much is this option worth? . . .
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To rigorously value the refinancing option in a loan requires very advanced technical analysis. However, you can get a basic idea why (and how) this option value can make it worthwhile to wait and not refinance by considering the following simple numerical example.
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Note: Fundamentally, we are still applying the "NPV decision rule", which, if you recall, says that we should always maximize the NPV across all mutually exclusive alternatives. Clearly, refinancing the old mortgage today is mutually exclusive with refinancing it a year from now instead.
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Thus, if these are our only two alternatives (refinancing today versus possibly refinancing in one year if interest rates are still low enough then), then we must pick the one that has the highest NPV.
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Now recalculate Steps 1 & 2 NPV under each of these scenarios, one year from now (6 years gone by on the old loan, 6 more years to go in the holding horizon).
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Using the same procedures as indicated before, we get the following expected NPVs (after subtracting $1500 transaction costs) as of one year from now, under each interest rate scenario:
NPV1 = +$17,774, if interest rates are 6%; NPV1 = -$ 3,232, if interest rates are 10%.
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Thus, if the 10% interest rate scenario transpires, you would not refinance, but simply keep the old loan. In that case you would face a NPV=0 effect (from doing nothing). This reflects the fact that options are rights without obligation. As a result, as of today the expected NPV next year due to the refinancing option in the old loan is:
E0[refin1] = (50%)*(17774) + (50%)*(0) = +$8,887.
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What is the present value of this expected value one year from now? Option values are risky, so they should be discounted at a high discount rate reflecting a large risk premium in the opportunity cost of capital. Suppose we require a 25% per annum return on holding the option. Then the PV today of the refinancing option in the old loan is:
PV[refin1] = 8887 / 1.25 = +$7,110.
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Thus, under the above assumptions, the refinancing option in the old loan is worth $7,110. This value would be given up if we refinance today. In return, we would obtain the +$5,940 NPV from the exercise of the refinancing option today. Thus, step 3 of our refinancing calculation reveals that it does not make sense to refinance today:
NPV[refin0] = NPV0 - PV[refin1] = 5940 - 7110 = -$1,170
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In other words, given the refinancing option, the old loan would not really be worth $104,980 in the market today. Only a fool would pay that much to buy the old loan, given that there is a good chance the borrower will pay it off early with a liquidating payment of only $97,540. Indeed, the market value of the old loan today is probably only a little more than $97,540.
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Suppose the MV of the Old Loan today is $98,000. This means that the market value based NPV of the refinancing transaction today would be:
98000 - 97540 - 1500 = -$1,040 (similar to the NPV we got by our explicit option valuation exercise above).
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However, if you are quite sure that interest rates are at their low point and will only be heading up, then you might refinance with less than a 2 point spread. (If you could really be sure interest rates would never be lower than today, then you can ignore step 3 and make your decision just on the basis of steps 1 & 2. But of course, nobody has a "crystal ball" for seeing future interest rates.)
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Additional Points
What about the prepayment option value in the new loan?
The prepayment option value is actually already included in the NPV evaluation we did in Step 3, at least in an approximate way. Recall that the NPV in Step 3 is based on the NPV without the option calculated in Step 1 (the +$7,440). Now recall that we used the new loan yield as the opportunity cost of capital applied to discount the old loan cash flows to arrive at that Step 1 NPV. In fact, in the mortgage market the new loan interest rate is set high enough to fully price the new loan prepayment option which the lender is giving the borrower in the new mortgage, so as to make the new loan a NPV=0 transaction from the lenders perspective at the time of refinancing. That is, if the new loan did not have a prepayment option, it would have a lower interest rate. By applying this callable bond yield rate in Step 1, we arrive at a lower present value for the remaining old loan cash flows, and hence a lower NPV from refinancing in Step 1, than we otherwise would if we were using a non-callable bond yield rate as the opportunity cost of capital. This difference (very closely) incorporates the value of the new loan prepayment option, that is, gives us a Step 1 NPV which is already net of the new loan prepayment option value.
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How will it ever be optimal to refinance, considering the lost option value?
If you are familiar with basic option theory, it may help to understand that the prepayment option is a call option on a bond. The underlying asset is the old mortgage (excluding its prepayment option, otherwise we would be going around in circles). The exercise price is what one must pay to be released from the old mortgage. (Note that this exercise price changes over time as the remaining balance on the loan changes.) The prepayment option is normally an American option, in the sense that it may be exercised at any time. Basic option value theory tells us that it is optimal to exercise an American call option prior to the maturity (expiration date) of the option provided that: (1) the option is sufficiently in the money (underlying asset value sufficiently higher than the exercise price), and (2) that the underlying asset pays cash dividends that are large enough to provide a sufficient opportunity cost to holding the option (considering that the option holder does not receive dividends from the underlying asset until the option is exercised). In the case of the mortgage prepayment option the dividends are the monthly mortgage payments that the borrower must pay each month, which will be saved by exercising the option. Thus, by analogy to American call options, it is clear that there will be some level of current market interest rates below which the value of the underlying asset (the old mortgage without its prepayment option) will be high enough to place the prepayment option sufficiently in-the-money to make its immediate exercise optimal, in order to obtain the dividends of the loan payment savings. In principle, this option exercise decision is independent of how the borrower will be obtaining the capital to pay off the old loan, that is, whether the borrower is refinancing in the sense of using new debt capital, or recapitalizing by replacing debt with new equity capital.
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Definition: Process by which lenders (loan originators) determine which loans should be made (to whom), and the terms and conditions of those loans.
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Purpose:
1)
2) To minimize losses in foreclosure 3) More generally: To make sure expected return to lender is sufficient, including consideration of default risk (so lender avoids a neg.-NPV transaction).
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2) Time Value of Money (Riskless S.T.Interest Rate) 3) Interest Rate Risk (yield curve) 4) Prepayment Risk (related to interest rate risk) 5) Default Risk ("Credit Risk")
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6) Illiquidity Premium
Note: These considerations apply to loan underwriting in general, not just residential mortgages, and underlie the market yields that come out of the secondary mortgage market (RMBS, CMBS), the primary source of capital.
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Borrower Criteria:
1) 2) 3)
4)
Level of Household Income Stability, Growth of Income Financial Condition (Net Worth, Liquidity) Other considerations (credit hist, svgs hist, dependents, etc., but age, gender, race etc. not legal considerations, according to "Regulation B" of FRB)
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2)
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