978-0324784640 Chapter 6 Solution Manual

CHAPTER 6

Conventional Lending

OBJECTIVES OF CHAPTER

Upon successful completion of this chapter, students should be able to:

 Discuss how the standard fixed-rate mortgage developed and

why it was an important tool for reviving real estate and

mortgage lending after the Great Depression.

 Understand that a self-amortizing (direct reduction) mortgage

can save the mortgagor a meaningful amount of interest over a

term loan.

 Explain the dilemma mortgage lenders were in during the high

interest period of the early 1980s and what the consequences of

that dilemma were to profitability.

 Describe the components of an adjustable-rate

mortgage (ARM).

 Understand the various types of alternative mortgages and

which is more beneficial to the borrower and lender at various

times in the interest rate cycle.

 Discuss how the typical adjustable-rate mortgage is priced and

how that interest rate can change.

 Understand the differences between what a loan program is and

what a product is.

 Explain what a conforming loan is and what a conventional

mortgage is to a layperson.

SUGGESTED TRUE/FALSE

I. Introduction

II. Evolution of the Standard Fixed-Rate, Fully-

Amortized Mortgage

A. Direct Reduction Instrument

B. Mortgage Lenders Dilemma

C. Alternative Mortgage Instruments

D. 1990 to 2010: Return of the Standard Fixed-

rate Fully-amortizing Mortgage

III. 10-, 15-, 20-, OR 40-YEAR MORTGAGES

A. Sharing the Risk

B. Mortgage Program Nomenclature and

Definitions

C. Conventional vs. Government vs. Other

D. Conforming vs. Non-conforming

E. Non-traditional

F. Adjustable-Rate Mortgages (ARMs)

G. Structure of an ARM: Adjustment Period

H. Index

I. Margin

J. Interest Rate Caps

K. Fully-indexed accrual rate

L. Discounts

M. Spread

N. ARM Programs

O. Buydowns

P. Convertible Mortgages

Q. Two-Step, or Reset, Mortgages

R. Graduated Payment Mortgages (GPMs)

IV. Biweekly Mortgages

V. Conforming Mortgage Loans

A. Conforming Maximum Loan Amount

B. Fannie Mae and Freddie Mac Mortgage

Programs

C. Maximum Loan-to-Value Ratios for

Standard Purchases

D. Mortgage Insurance Requirements and

Credit Enhancement

VI. Non-Conforming Mortgage Programs

VII. Non-Prime (subprime) Mortgage Programs

What are the basic differences between conforming,

non- conforming and conventional loans?

Which is the least risky loan product and program a

borrower can obtain for a primary residence?

Give some examples of ARM mortgage products

and discuss which ones would be the best for which

situation.

How would you go about explaining the different

components of the ARM loan so that your client

could understand it?

With bi-weekly mortgages, the lender is sometimes

selling a service. What alternative methods would

you give your client to speed up the payoff their

mortgage?

Discuss how loan to value and FICO scores play a

part in loan risk.

Explain the difference between sub-prime and Alt-

A products and how did they evolve into such a

negative thing?

List five criteria for offering a client a sub-prime

loan. How would you analyze the risk factors

involved with the performance of that mortgage?

Teaching Tips

QUIZ

1. Fixed-rate mortgage loans are the norm around the world.

2. Self-amortizing loans started in England about 400 years ago.

3. Over the past thirty years variable-rate loans originations have

been as high as 60 percent.

4. Direct reduction mortgage costs more in interest than a year-end

payment loan.

5. The most popular index for an ARM loan is the one-year treasury

adjusted to a constant maturity.

6. The most common margin for an ARM loan is 325 basis points.

7. A problem with most ARM loans is there is no limit on how

much the interest rate may increase.

8. Discount ARM loan are illegal under most state laws.

9. A biweekly mortgage requires 24 payments are year.

10. Reverse Annuity Mortgages are only for people over 62.

MULTIPLE CHOICE QUESTIONS. More than one answer may be

correct – select all correct answers. (Correct answers are italicized.)

1. The maximum interest rate a mortgage lender may charge for an

ARM loan is called

a. margin

2. The primary reason mortgage lenders are interested in ARM loans is

to

a. limit mortgage choices for borrowers

3. Reverse Annuity Mortgages are designed for which borrower

a. first-time homebuyers

4. The biweekly mortgage loan requires how many payments in a normal

year?

a. 12

5. The 15-year loan is designed for the borrower who wants to

d. will only be in home for five years.

SUGGESTED SHORT ESSAY QUESTIONS

1. List and briefly describe the features of at least four alternative

mortgage instruments.

ANSWER:

Adjustable Rate Mortgage: Index + margin = initial interest rate.

Graduated Payment Mortgage: designed to provide borrowers with

Reverse Annuity Mortgage: designed to enable older retired

Shared Appreciation Mortgage: designed to give a borrower a

Price Level Adjusted Mortgage: designed to keep the real mortgage

Biweekly: designed to allow a borrower to match paydays with

ANSWERS TO ORAL DISCUSSION POINTS

The discussion points at the end of each chapter are intended for

oral discussion in class. Suggested answers/points to emphasize

for the questions are found below.

1. Discuss how the standard fixed-rate mortgage developed in the United States

and why it was an important tool for reviving real estate and mortgage

lending after the Great Depression.

ANSWER: Before the Great Depression, most mortgages were short-

term; interest only paid every six or twelve months. Because these

mortgages needed to be refinanced at the end of the term, many

2. Explain why a self-amortizing (direct reduction) mortgage can save a

mortgage borrower a substantial amount of interest over a term loan.

ANSWER: The standard fixed-rate mortgage is a monthly amortized, direct

reduction instrument. This means that equal monthly payments for the term

of the loan are used to directly reduce the amount owed by first paying

interest on the loan due since the last payment and then using the remainder

3. Discuss the differences between conventional and conforming mortgage

programs

ANSWER: A conforming loan is one that meets Fannie and Freddie

criteria. It can be a first or second mortgage or any other product, as long as

4. Identify and discuss the components of an adjustable-rate mortgage.

ANSWER: The student should explain that one of the various

Indexes is used which establishes an index rate to which is added the

5. What must a mortgage lender do to attract consumers to an adjustable-rate

mortgage when fixed-rate mortgages are attractively priced?

ANSWER: In order to make an ARM loan attractive to more consumers,

most lenders lower the initial interest rate (and thus the payment rate) from

6. What makes a mortgage loan “subprime” and what are some of the benefits and

challenges in this area of lending? How do they differ from “non–prime”

mortgages?

ANSWER: A “subprime” loan does not meet the basic criteria of standard

Freddie and Fannie guidelines. In other words, it is not a prime loan, due to

credit history, income source, asset source, underwriting documentation,

7. What is the difference between an eligibility issue and an underwriting

guideline?

ANSWER: If a borrower is not eligible for a mortgage product or program,

they simply do not meet the basic criteria such as loan amount, loan to value,

8. Explain the difference between mortgage instruments, programs, and

products

ANSWER: A mortgage programs can be conforming, non-conforming and

non-prime in nature. A mortgage product would be a type of ARM, fixed