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a. Mortgage Characteristics
Although mortgages can have unique terms, the demands of the secondary market increasingly
determine the guidelines for accepting or rejecting a mortgage application.
Collateral
All mortgage loans are backed by collateral that will have a lien placed against it. A lien is a
public record attached to the title of the property that gives the financial institution the right to
sell the property if the mortgage borrower defaults. A lien prevents sale of the property until the
mortgage is paid off and the lien removed.
1.1.1.1 Down Payment
In the absence of government insurance, a down payment is required to minimize default risk.
An 80% loan to value ratio is standard. If a borrower cannot pay the required 20% down
payment they may obtain FHA insurance. FHA insurance has a maximum borrowing amount
that varies according to regional housing costs. The borrower may instead apply for private
mortgage insurance (PMI). Most PMI requires a monthly payment that is added to the
principle and interest payment. Although it can vary from lender to lender, the typical monthly
mortgage insurance payment if the borrower pays only 10% down can be found by multiplying
the loan amount times a constant factor equal to 0.0051 and then dividing the result by 12. For
instance, on a $100,000 mortgage with 10% down, the monthly PMI premium would be
($100,000*0.0051)/12 = $42.50. If you finance 97% the constant is 0.0090 and the monthly PMI
payment would be $75.1
PMI does not usually provide complete insurance. PMI may pay between 12 and 35% of the
difference in the home value and the balance owed. As a homeowner pays the balance down they
can petition to have PMI removed to eliminate the payment. The home will have to be
reappraised and the homeowner must petition for the removal. Expect a lengthy process.
Teaching Tip: Once the homeowner reduces the principle amount to 80% or less of the house
value, either through payments and/or appreciation of the value of the home, the homeowner
may wish to have the house reappraised and apply for termination of the mortgage insurance.
The appraisal cost may be as low as $500-$600.
Insured vs Conventional Mortgages
Conventional mortgages are mortgages not insured by the Federal government. The term
insured mortgages refers to mortgages insured by the Federal government, not privately insured
mortgages.
Mortgage Maturities
1 Thanks to Chuck Schmautz, a mortgage broker at First Security Bank for providing this
information.
The two standard maturities are 15 year and 30 year, with 30 year mortgages predominating.
Some contracts call for balloon payments at the end of three to five years. These contracts may
require interest only payments during the interim period. Most borrowers will not be able to pay
off the balloon so the borrower is essentially agreeing to refinance the mortgage when the
balloon is due.
Teaching Tip: A balloon payment mortgage is riskier to the borrower because there is no
guarantee that refinancing will be granted. An injury or illness, a layoff, etc. can endanger an
individual’s primary asset, their home.
Interest Rates
Mortgage rates are a function of the fed funds rate, discount points paid, whether the loan is a
FHA or a conventional mortgage, maturity, whether the mortgage is fixed or adjustable rate,
regional demand for funds and the level of competition of suppliers of mortgage credit. Regional
credit availability is not an issue due to the national financing market.
1.1.1.2 Fixed versus Adjustable Rate Mortgages
Fixed rate mortgages (FRMs) remain the most popular mortgage type, although a significant
number of mortgages are adjustable rate. With the low rates of the early 2000s, adjustable rate
mortgages (ARMs) have not been as popular as in prior periods (at one point several years ago
50% of new originations were adjustable rate). The payment on ARMs can vary as the
applicable interest rate index changes. The index used cannot be the lender’s cost of funds and is
often an index of lenders’ fund costs (termed a COFI or cost of funds index). The rate change
per year and over the life of the mortgage is capped and prepayment penalties are not allowed
on ARMs. With a fixed rate mortgage the lender bears the interest rate risk, with an ARM the
borrower bears the interest rate risk.2 As we saw in 2007 and 2008 ARMs result in higher
default risk for lenders in periods of rising interest rates. When rates rise, borrowers have more
difficulty making the payments on their mortgage. The share of ARMs as a percentage of new
originations has fallen dramatically and is at about 5% in 2010 according to the MBA Mortgage
Finance Forecast.3
Teaching Tip: A home mortgage is usually the largest single monthly payout of the individual. It
may be prudent to know with certainty what this amount will be. If a borrower wishes to use an
ARM he or she should ensure they fully understand all the details, indeed, having a lawyer
review the loan contract is an excellent idea. An ARM borrower should determine the maximum
monthly payment and ensure that they can comfortably handle that amount. The two most
common types ARMs are fixed for 5 years, then floating and adjustable every year. The
borrower must take care when purchasing an ARM that is fixed for 5 years to ensure that they
can handle the maximum payments when the mortgage is recast and to be aware of any
possibility of negative amortization. ARMs offer teaser rates to entice borrowers to purchase
them. The size of the rate difference between an ARM and a FRM varies between rate
environments. Recently the fixed for 5 year ARM offered a 50-75 basis point advantage over 30
year FRM rates. The annual adjustment ARM usually offers a much larger advantage,
sometimes as high as 200 basis points over 30 year FRMs. These spreads vary as rate
2 The cap implies that even in an ARM the lender still bears some interest rate risk.
3 See the Mortgage Bankers Association website at www.mbaa.org.
expectations change however.
The FHFA publishes the National Average Contract Mortgage Rate for the Purchase of
Previously Occupied Homes by Combined Lenders. Some lenders use this rate for setting
interest rates on ARMs. Federally chartered savings associations must use this rate. It can be
found at www.fhfa.gov and as of May 2014 the rate was 4.53%.
Teaching Tip: A buyer should ascertain the type of home that is easily saleable in their area.
They should not be in a hurry when purchasing a home. “Shop till you drop” is good advice in a
major, often illiquid investment. Typically, a home buyer should not buy a home where the total
monthly payment will be more than 25%-35% of their current take home pay. One won’t enjoy a
home that one can never afford to leave, and financial frictions are a major source of stress on
relationships.
Teaching Tip: The borrower can often obtain a conversion option which allows the borrower to
convert the ARM to a fixed rate mortgage. This option is usually granted within a narrow time
window, say from year 3 to year 5. It is usually not a good deal because the conversion will
typically occur at a markup over fixed rates at the time of the conversion, not at today’s fixed
rates.
Teaching Tip: Because of the annual caps ARMs can be good deals if you believe you will either
move or refinance in 3 to 5 years as long as the borrower is aware that there is a possibility of not
being able to refinance due to changes in the borrower’s condition or changes in the housing and
mortgage markets.
1.1.1.3 Discount Points
A borrower can buy a lower interest rate by paying points up front. A discount point is 1% of
the loan amount. Lenders periodically establish point schedules that show what interest rate they
are willing to offer if the borrower pays a certain amount of points. A simple breakeven analysis
can be used to determine whether the borrower should pay the points. The dollar value of the
points / monthly payment savings = number of months required to recoup the points. If the
borrower expects to live in the house for the breakeven number of months or longer, it is
worthwhile to pay the points. This example ignores taxes.
When should you pay points? You are thinking of purchasing a $100,000 home and making a
20% down payment. The 30 year mortgage rate is 8 1/4% at par, but you can get an 8% rate by
paying 5/8s of a point. What should you do if you are not going to prepay the mortgage?
(Ignore taxes)
If you don’t pay the points (r = 8 1/4% / 12 = 0.6875%):
$80,000 = $PMT * [1 - 1.006875-360] / 0.006875
$PMT = $601.01
If you pay the points (r = 8% / 12 = .6667%)
$80,000 = $PMT * [1 - 1.006667-360] / 0.006667
$PMT = $587.01
Payment Savings = $601.01 - $587.01 = $14 / month
Cost: 5/8s of a point = 0.625% * $80,000 = $500
Would you pay $500 today to save $14 a month?
What is the breakeven?
W/ Payments
$500 = $14 * [1 - 1.006667–N ] / 0.006667]
Reinvested4Solve for N (r = 8%/12)
N = 40.93 months or 3.4 years
W/O Payments Easy way: $500 / $14 = 35.71 months or 2.98 years
Reinvested
Pay the points if you believe you will keep the mortgage for at least as long as the breakeven
time period.
The refinancing decision is similar, instead of the points cost the refinancing (refi) cost will be
the present value and the payment savings will be payment. One can also calculate the net
present value of paying the points or of the refi decision.
Teaching Tip: You might wish to advise your students that if the breakeven is 5 years or longer,
it is probably not worth paying the points because most people’s life circumstances are likely to
have changed by 5 years, and one cannot tell whether one will still wish to remain in the same
house after that time.
The above analysis assumes the homeowner does not prepay the mortgage. Paying the points
results in a lower interest rate and thus more of each payment goes to principal with the lower
rate. This will yield a slightly lower required payout in the event the mortgage is prepaid. The
present value of this amount will be small if the mortgage holder remains in the home for a long
time. The text provides an example of finding the approximate breakeven time to prepay for the
decision of when to pay points. The text breakeven example ignores taxes and is an
approximation only because it appears to ignore the difference in the balance from the two loans
over time.
Other Fees
A homebuyer will normally face a host of fees (payable at closing or before) including:
Application fee
Title search fee
Title insurance fee
Appraisal fee
Loan origination fee (usually 1% of the loan amount)
Closing agent/review fee
Costs to obtain mortgage insurance (FHA, VA or private) if needed
Teaching Tip: Closing costs average from 3%-5% of the mortgage amount (excluding points),
with 3% the most common.
4 This method assumes the $14 per month savings is invested at the monthly rate of .6667% per
month. If the money is not reinvested, the ‘without payments reinvested’ method is correct.
Mortgage Refinancing
Due to low interest rates in the 2000s, mortgage refinancing business boomed. In the early
2000s refinancings comprised 70% of all originations, but more recently have comprised
between 40% and 60%. Refinancings are expected to fall in 2014 as interest rates are projected
to increase. A typical rule of thumb is that the new mortgage rate should be 200 basis points
below the old rate, but with ARMs and reduced refinancing costs refinancings can be worthwhile
at smaller rate reductions. A breakeven similar to that mentioned above can be used to determine
if refinancing is worthwhile.
Teaching Tip: According to Corelogic home prices increased 11.2% in Q3 2013 from the same
quarter in 2012 and are predicted to increase 3.1% per year for next 5 years.
b. Mortgage Amortization
The typical mortgage is fully amortized at the original maturity so that the principle is reduced
with each payment and no balloon remains at maturity. Amortizing payments are calculated
using the present value of annuity formula. An amortization schedule depicts the amount of
each payment that goes to principle and to interest.
Example 1:
A borrower agrees to a $200,000, thirty year fixed rate mortgage with a 5.75% (or 0.4792% per
month) quoted interest rate. What is the payment amount and how much of each payment goes
to principle and interest?
Payment = $200,000 / (1-1.004792-360)/0.004792 = $1,167.15. The amortization schedule below
provides the breakdown of each payment into principle and interest on a dollar and a percentage
basis. The first 24 and the last 25 months of payments are shown.
Notice that the total interest paid on the mortgage ($220,172.46) is greater than the original
balance.
….………………
…
Example 2: Recent sample of rates on a $244,000 Mortgage (current quotes are available at
BankRate or at http://mortgage-x.com/x/rates.asp and are searchable by state)5
15 yr FRM 3.125% Par
30 yr FRM 4.25% Par; 4.125% 1.00 pt
P&I Payment on the 30 year (Par): ($244,000 mortg.) $1,200.33
P&I Payment on the 15 year (Par): ($244,000 mortg.) $1,699.73
Payment Difference – $ 499.39
Total Interest paid on the 30 yr FRM: $ 188,120
Total Interest paid on the 15 yr FRM: $ 61,951
Interest Difference $ 126,169
Teaching Tip: Be sure that students understand that their total monthly payment will normally be
about $100-$200 higher than the principle and interest payment due to insurance and taxes.
c. Other Types of Mortgages
Jumbo Mortgages
Jumbo mortgages are mortgages for loan amounts that exceed the maximum ‘conforming’ limits
allowed by the mortgage agencies Fannie Mae and Freddie Mac. Congress actually can specify
these maximums. In 2014 the maximum amount was $417,000, although there have been
exceptions due to the crisis.6 Jumbo mortgage interest rates have a 25 to 50 basis point spread
over conforming mortgages and may require a higher down payment.
Subprime Mortgages
Subprime mortgages are mortgages where the borrowers do not qualify for a ‘prime’ credit rating
because of a low credit score arising from prior credit problems such as delinquencies and
defaults. Or they may simply lack sufficient credit history or have insufficient income.
Subprime originations were about 9% of the total between 1996 and 2004 but increased to 21%
in the 2004 to 2006 time period. Originators weakened their credit standards and quickly sold
the mortgages. Congress encouraged this, particularly after the Democratic takeover of
Congress. ARMs and Interest Only mortgages were also used to make initial payments low to
encourage more home buyers. Both of these mortgages are likely to force homeowners to make
higher payments if interest rates rise over the life of the loan. When credit problems emerged in
this sector it led to a correction of housing prices in the broader market in part because of
securitization of mortgages which included the subprimes. Sharp declines in subprime backed
mortgage securities quickly led to the financial crisis.
Alt-A Mortgages
Alt-A is short for Alternative A- Paper. This term is used for mortgages that are riskier than
prime but not as risky as subprime. They may represent borrowers who have incomplete
documentation, poorer credit scores, higher loan to value ratios, etc. than prime mortgages.
Interest rates on Alt-A loans are usually between prime and subprime rates. Alt-A loans do not
conform to Fannie Mae and Freddie Mac standards.
5 Rates are higher on ‘jumbo’ mortgages.
6 https://www.fanniemae.com/singlefamily/loan-limits
Option ARMs
Option ARMS may also be called ‘pick-n-pay’ mortgages. These loans allow the borrower to
choose between various payment options. The four main types are
a) Minimum payment
This version provides the lowest initial payment, usually at a1% rate. The initial payment
is set for 12 months and after that it varies. A payment cap limits how much the payment
can vary. The text quotes a 7.5% cap. Continuing to make minimum payments will
result in capitalization of unpaid interest which will add to the loan amount, resulting in
negative amortization. A borrower is allowed to pay the minimum until the loan balance
reaches 110% to 115% of the original loan balance. After this maximum is reached the
borrower loses this option and must go with one of the other three. This alternative is
very risk for the borrower and should be discouraged.
b) Interest only payment (IO)
An IO mortgage allows the borrower to pay interest only (at an adjustable rate) initially.
The IO option is eliminated at some point in the mortgage, usually 5 to 10 years from the
start. At that point the payment will increase, usually substantially as the principal must
now be amortized over the remaining life of the mortgage. Payments can thus increase
due to higher interest rates and due to the switch to amortization. Before the crisis, these
options were sold to naïve borrowers, but they are obviously very risky. The borrowers
were apparently told they were not risky, or the risk was downplayed because the
homebuyers were told they could refinance when the payments increased. The financial
crisis eliminated this option however. At the end of the IO period the borrower must
choose between the remaining two options below.
c) A 15 year fully amortizing payment
At this point the payment is the same as a 15 year ARM with monthly payment
fluctuations, although the payments are likely to be higher than if a 15 year ARM had
been originally if the minimum payment or IO options were used.
d) A 30 year fully amortizing payment
At this point the payment is the same as a 30 year ARM with monthly payment
fluctuations, although the payments are likely to be higher than if a 15 year ARM had
been originally if the minimum payment or IO options were used.
Second Mortgages
Second mortgages are subordinated claims to senior mortgages. About 15% of primary mortgage
holders have a second mortgage. Seconds totaled about $1.09 trillion in 2007. Home equity
loans allow customers to borrow on a line of credit secured with a second mortgage. Interest on
home equity loans is normally tax deductible whereas credit card interest is not.
Teaching Tip: Be careful advising individuals to use a home equity loan to pay off credit card
debt. Theoretically, an expensive vacation or even a shopping spree could endanger your home
ownership if the buyer cannot manage credit properly. Under today’s bankruptcy laws, unpaid
credit card debts will not normally result in the loss of home ownership, whereas default on a
home equity loan will cause the loss of the home.
Teaching Tip: Citigroup and Household International came under fire in 2002 for their aggressive
marketing tactics used in selling mortgages to subprime borrowers.
Reverse Annuity Mortgages (RAMs)
RAMs are for homeowners with a substantial amount of equity in their home who wish to
supplement their income, usually retirees. Note that RAMs are sometimes called REMs
(Reverse Equity Mortgages). With a RAM the FI makes a monthly payment to the homeowner.
The FI is in effect buying out the homeowner’s equity over time. At maturity the house is sold
and the proceeds are used to pay off the FI. RAM maturities are usually set up so that the
homeowner will die before maturity. As the population ages and health care costs increase
RAMs are likely to grow in popularity. In the short term the housing market continues to soften
and home prices fall, RAMS may not be attractive to lenders.
The OTS provides an information packet on RAM with the following information:
•The homeowner can choose from various payout methods. The payout can be 1) lump
sum, 2) monthly payment for tenure (as long as the homeowner lives in the house), or a
fixed term and 3) credit line or combo of 2) and 3).
•REM Costs are higher than for standard mortgages:
Higher origination fees, closing costs and servicing fees
Most (90%) are FHA insured and so have 2% mort. insurance premium plus ongoing fee
for a rising loan amount
Origination fees are based on the home value, not loan amount, and home value is greater
than loan amount
Closing costs run between $7,000 and $15,000. If the owner moves or dies quickly, they
may not recover those costs.
•Financial counseling is required because these are complex instruments.
Teaching Tip: Don’t want to leave anything to the kids? They never visit anyway? Use a RAM
and enjoy your retirement!
Teaching Tip: New Types of Mortgages (from Smart Money Column: Mortgages Get More
Exotic, by Stacey Bradford, Wall Street Journal Online, July 25, 2004)
40 year mortgages
Negative Amortization Mortgage
Flex-ARM mortgage
Piggyback Mortgage or Combo loan
103s and 107s
Details are available from the article. Most of these alternative mortgage types are riskier for
home buyers and many are no longer available after the financial crisis; most are generally
methods to buy more house than you could otherwise afford.
The following website has spreadsheets depicting how negative amortization of ARMs can affect
payments. The results are surprising.
http://www.decisionaide.com/mpcalculators/NegativeARMS/NegativeARM.asp
