Chapter 14 Types of Financing

1
Chapter 14Types of Financing

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2
The Basic Mortgage Types

• Borrowers today have a variety of loan plans to
  choose from. The basic types of loans available
  from institutional lenders are
• Interest-only (or term) mortgages Payments
  during the life of the loan are interest only
  the entire loan amount is repaid at maturity
• Hybrid interest-only and amortized (also called
  interest-only for years) The loan is
  interest-only for a period of years, and then
  becomes amortized over the remaining life of the
  mortgage
• Fixed-rate constant payment mortgages (CPM), aka
  the standard fixed-rate mortgage Amortized
  mortgages with constant payments and a fixed
  interest rate. Can be issued for different
  maturities (standard plans are for 10, 15, 20,
  and 30 years.)
• Constant amortization mortgages Fixed-rate
  amortized mortgages that make a constant payment
  towards principal (constant amortization).
  Although the initial payment is higher that the
  fixed-rate CPM, the payment declines as the
  mortgage moves through time.

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The Basic Mortgage Types (Cont.)

• Adjustable rate mortgage (ARM) The loan
  interest rate, and thus the payments, are
  adjusted at periodic intervals with changes in
  interest rates. There are different ARM plans,
  each with different variable rate features
  including indexes, margins, adjustment periods,
  and caps,
• Hybrid fixed and adjustable The mortgage rate
  is fixed for a period of years, and then becomes
  adjustable at the end of the fixed period.
• Graduated payment mortgages Fixed-rate
  mortgages with payments that start below what the
  payment should be at the market interest rate and
  which then graduate (increase) in set increments
  each year for a number of years. Usually
  involves negative amortization.

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The Basic Mortgage Types (Cont.)

• Accelerated Payment Mortgages
• Growing equity mortgage (GEM) These are
  fixed-rate mortgages with payments that increase
  by a fixed percentage or fixed increments. The
  entire increase in payments over the initial
  amortized payment goes to reduce principal, and
  these extra payments toward principal decreases
  the loan term
• Biweekly mortgage The regular monthly payment
  is divided by 2 and paid every 2 weeks, with the
  result is that there is one additional monthly
  payment per year, all of which goes towards the
  reduction of principal, thereby decreasing the
  loan term.
• Shared equity loan arrangements the lender
  receives a share of the appreciation in property
  value and/or of the propertys cash flows. The
  borrower receives a below-market interest rate in
  exchange for giving the lender a share of the
  propertys equity.
• Reverse annuity mortgage (RAM) the lender makes
  monthly payments to the borrower over the loan
  term, and the lender is repaid from the sale or
  refinancing of the property.

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Standard Fixed-Rate Mortgage

• Prior to the 1930s, the purchase of homes was
  financed by interest-only mortgage loans for a
  5-7 year period, at the end of which they would
  either have to be repaid or refinanced.
• Obtaining a loan also required a large down
  payment, 40-50 of the house price.
• The Great Depression showed the strain which a
  finance system based on relatively short term
  interest-only mortgages placed on the housing
  finance system when these loans came due.
• The fixed-rate constant payment amortizing
  mortgage (known as the standard fixed rate
  mortgage, SFRM) was the mainstay of mortgage
  financing from the latter 1930's through most of
  the 1970's.
• However, the SFRM created serious problems for
  both lenders and borrowers during the period of
  high rates of inflation and the accompanying
  volatile increases in interest rates in the late
  1970s and early 1980s.

6
Standard Fixed Rate Mortgage

• The key problems of the SFRM under the conditions
  of high and uncertain inflation of the late
  1970's - early 1980's were
• Lenders had to bear the entire risk of volatile
  and unpredictable interest rate fluctuations.
• From the borrower's perspective, large increases
  in the inflation rate were accompanied by a steep
  rise in interest rates, which in turn meant a
  large increase in the size of the mortgage
  payments and a decrease in housing affordability.
  
• The decline in housing affordability occurred
  because the ratio of the required mortgage
  payment to household income increased sharply.

7
Adjustable Rate Mortgage

• The adjustable rate mortgage (ARM) is the general
  term given to the type of mortgage that adjusts
  the interest rate of the loan periodically in
  accordance with changes in market interest rates.
• The key feature of all ARMs is that their
  payments are periodically adjusted in accordance
  with changes in interest rates.
• These mortgages have their interest rates tied to
  some public interest rate index.
• At periodic intervals of the loan, the interest
  rate of the loan is adjusted, in full or in part,
  in accordance with changes in the interest rate
  index.
• There are a wide variety of ARM plans that are
  distinguished from one another in a number of
  ways.
• A person shopping around for mortgage loans
  should be aware that ARMs can have five types of
  features that can affect the interest rate risk
  borne by the borrower and the cost of the loan.

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Adjustable Rate Mortgage (Cont.)

• Three of these features are common to all ARMs.
  These common features of ARMs are the following
• 1. An index of interest rates to which the ARM
  interest rate is tied this is the variable
  component of the interest rate it is what
  varies over the loan term.
• 2. The margin that is added to the value of the
  index by the lender this component of the
  interest rate is fixed (constant) over the loan
  term.
• 3. An adjustment period, which is the frequency
  with which the loan interest rate is adjusted to
  correspond to changes in the underlying index,
  with annual adjustments the most common.
• Without the presence of binding caps (discussed
  below), the interest rate for the next adjustment
  period equals the sum of the index value at the
  beginning of the adjustment period and the
  margin, i.e., i index margin.

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Adjustable Rate Mortgage (Cont.)

• Two other features of ARM loans are optional.
  That is to say, these features may or may not be
  found in a particular ARM loan.
• One optional feature is an interest rate "cap."
  A "cap" is a limitation on how much the interest
  rate can change. Caps are common in ARMs today.
• Generally speaking, there are two kinds of caps
• Adjustment period caps. These caps put a limit
  on how much the interest rate can change during
  any single adjustment period, and,
• Term caps. These caps put a limit on how much
  the interest rate can change over the loan term.

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Adjustable Rate Mortgage (Cont.)

• A second optional feature is negative
  amortization.
• Negative amortization refers to the situation
  where the interest charge for a period exceeds
  the mortgage payment for that period, and the
  unpaid portion of the interest charge is added to
  the loan balance.
• Thus, instead of the loan balance being reduced
  with each payment, it is increased as long as the
  interest charge exceeds the loan payment. Hence
  the name, negative amortization.
• A larger loan balance results in larger interest
  charges, and thus the loan balance increases with
  compound interest.

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Adjustable Rate Mortgage
Summary of What to Look For?

• Index
• Margin
• Adjustment period
• Interest rate caps
• Payment caps
• Negative amortization
• Disclosures Reg Z of the TILA requires detailed
  disclosures of the variable features of an ARM

ARM
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Graduated Payment Mortgages

• The GPM is a fixed interest rate mortgage with
  payments that start well below the standard
  fixed-rate mortgage payment and increase in
  predetermined increments over a period of time
  (e.g., 7.5 per year for five years).
• This mortgage plan is intended to enable young,
  often first-time, homebuyers to afford a home in
  a period of increasing inflation and rising
  interest rates by tailoring the payment pattern
  of the mortgage to their expected increases in
  income.

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Graduated Payment Mortgages (Cont.)

• There are a number of different GPM plans in
  existence. These plans differ with respect to
  the length of the graduation period (the length
  of time (in years) over which payments are
  increased), the amount of the initial (first
  year) payment, and the amount of increase in the
  payments in each year of the graduation period.
• An important feature of the GPM is negative
  amortization. As mentioned, negative
  amortization refers to the situation where the
  interest charge exceeds the mortgage payment and
  the unpaid portion of the interest charge is
  added to the loan balance.

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Graduated Payment Mortgage, Example

• For purposes of illustration, assume the
  following simplified GPM
• LA 100,000, i 10, n 20 years, 1st
  yr. pmt 9,000, 2nd yr. pmt 10,000, pmt
  in yrs 3 -20 12,327, which is the payment to
  amortize the LB at EOY 2 over the remaining 18
  years of the loan term. The pmt on an equivalent
  SRFM is 11,746 per year.
• Year Beg. Bal. Payment Interest
  Principal End. Bal.
• 1 100,000 9,000 10,000
  -1,000 101,000
• 2 101,000 10,000 10,100
  - 100 101,100
• 3 101,100 12,327 10,110
  2,217 98,883
• This simplified example illustrates negative
  amortization. Negative amortization occurs when
  the loan payment is less than the interest
  charge. The unpaid portion of the interest is
  added to the loan amount. Thus the loan amount
  increases (is negatively amortized) as long as
  the payment remains below the interest charge.
  Neg. amort. may occur with other mortgage
  instruments, e.g., ARMS, hybrid mortgages, etc.

15
Growing Equity Mortgage (GEM)

• These mortgages are like graduated payment
  mortgages in that their payments increase at some
  predetermined rate for a period of time. The
  payments, however, start at the amount needed to
  fully amortize the loan principal over the loan
  term, and then they are increased above that
  amount.
• The payments may increase throughout the
  effective loan term until the loan is completely
  repaid, or they may increase only for limited
  period of time and then level off at the amount
  of the last payment increase.
• All of the annual increases in mortgage payments
  are applied to reduce the principal balance of
  the loan, with the result that the loan is repaid
  within a shorter period of time than the
  traditional fixed rate mortgage, resulting in the
  borrower saving in interest payments. For this
  reason, the GEM is referred to as an accelerated
  payment mortgage.

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Growing Equity Mortgage

• To illustrate, we have a GEM mortgage for
  80,000. The interest rate is 12. The mortgage
  term is 30 years. The payments increase at 5
  per year for six years following year 1 and then
  level off for the remainder of the loan term at
  the year 7 payment. The initial monthly payment
  is 822.89. The loan payments and interest and
  principal portions of the payments shown below
  are annualized for ease of display.
• Yr. Payment Interest Principal
  End. Bal.
• 1 9,874.68 9,584.38 290.30
  79,709.70
• (822.89/mo. x12)
• 2 10,368.41 9,519.48 848.94
  78,860.76
• (822.89/mo. x1.05x12)
• 3 10,886.84 9,382.33 1,504.51
  77,356.25
• 4 11,431.18 9,160.56 2,270.62
  75,085.63
• 5 12,002.74 8,840.08 3,162.66
  71,922.97
• 6 12,602.87 8,404.85 4,198.03
  67,724.94
• 7 13,233.02 7,836.59 5,396.43
  62,328.51
• 8 13,233.02 7,152.18 6,080.83
  56,247.68
• The maturity of this loan is shortened from 30 to
  about 14 years.

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Biweekly Mortgage

• This is another variety of an accelerated payment
  mortgage.
• With this mortgage, payments are calculated as if
  the mortgage was a regular monthly mortgage.
• This payment is then divided by two to determine
  the biweekly payment. But this amount is then
  paid every 2 weeks, not twice a month (it is a
  biweekly mortgage, not a semi-monthly mortgage).
• Since there are 52 weeks in the year, that means
  the borrower makes a total of 26 biweekly
  payments per year. This equates to the borrower
  making a total of 13 monthly payment per year,
  resulting in one extra monthly payment per year.
  
• This additional payment goes to the pay down of
  the loan principal, resulting in the loan being
  paid off sooner and the borrower saving in
  interest payments.

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Accelerated Payment Mortgages Closing Comments

• Given the fact that most residential mortgages
  have no penalty for early repayment, the borrower
  is free to make an additional payment on
  principal on his own at any time.
• Hence, accelerated payment mortgages are not
  necessary to achieve faster repayment if the
  borrower can exercise payment discipline.
• A mortgage that has a lower payment and a longer
  term gives the borrower flexibility by not
  obligating the borrower to make a large payment
  in a month in which he or she is pressed for
  cash.
• However, some borrowers regard these mortgage
  plans, as well as shorter term mortgages as
  forced savings plans.

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Equity Sharing Loan Arrangements

• An equity sharing loan arrangement gives the
  lender a share of the equity cash flows, in
  addition to the interest payments on the loan.
  These arrangements are designed to provide the
  lender with an inflation hedge and also to
  enhance the lenders return.
• As with other mortgage designs, equity sharing
  loan arrangements come in a variety of forms.
• Equity sharing loans may give the lender a claim
  to some portion of the equity built up in the
  property at the end of the loan term or at the
  time of sale, and/or a share, or participation,
  in the annual or monthly residual cash flows from
  property operations.
• As an example of the latter, the lender may get
  20 of the equity cash flow after the mortgage
  payment.
• The amount of such participation is normally
  expected to rise at or near the inflation rate,
  thus giving the lender an inflation hedge.
• These arrangements are frequently associated with
  favorable lending terms, which give the
  investor/borrower a reduced interest rate, hence,
  lower loan payments, in return for a share of the
  equity.

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Equity Sharing Loan Arrangements (Cont.)

• The following are examples of different mortgage
  designs that give the lender a share of the
  property value at the sale of the property or at
  the end of the loan term.
• The shared appreciation mortgage (SAM) gives the
  lender a portion of the appreciation in property
  value at the end of the loan term or the time of
  sale, whichever comes sooner.
• The shared equity mortgage (SEM) gives the lender
  a portion of the equity at the end of the loan
  term or at the time of sale. A share of the
  equity consists of both a share of any
  appreciation and a share of the original equity
  in the property.
• A convertible mortgage gives the lender a claim
  to a specified portion of the equity in the
  property through the exercise of an option to
  convert the loan amount into a specified share of
  the property equity (e.g., 35, 50, or some
  other share).
• By having a claim to an equity interest at the
  end of the loan term or at designated future
  date, the lender can benefit directly from any
  inflation-induced appreciation in the value of
  the property.

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Reverse Annuity Mortgage (RAM)

• The reverse annuity mortgage (or RAM) is designed
  to provide a source of income to elderly
  homeowners whose home is owned free and clear or
  where the mortgage has been substantially paid
  off. It provides a way by which elderly people
  with substantial equity in their home can improve
  their cash flow situation by borrowing on the
  equity stored in the house.
• The RAM is a loan with which the cash flow
  pattern (the pattern of cash disbursement and
  repayment) is the opposite of that of a standard
  mortgage loan. Rather than a single disbursement
  and a long series of loan repayments, the
  borrower receives a long series of cash flow
  disbursements (in the form of cash advances).
• The loan is repaid at the end of the loan term or
  when the borrowers move or die. The house is
  typically sold for the repaid of the debt.

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Wraparound Mortgage (A Wrap)

• Wraparound loans are used to obtain additional
  financing while keeping an existing loan in place
  (commonly an assumed loan with a favorable
  interest rate).
• The existing loan remains in effect and the new
  mortgage wraps around it.
• The wrap loan is a second mortgage loan that is
  junior to the existing mortgage that it wraps
  around.
• A wrap combines payments on an existing senior
  mortgage with payments on a new loan.
• The borrower, however, makes only one payment to
  the "wrap" lender, the payment for the wrap
  loan.
• Moreover, the borrower does not assume the
  existing loan the wrap lender is liable for that.

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Wraparound Mortgage (Cont.)

• The wrap lender makes the payment on the
  exisiting mortgage (which stays in force) and
  keeps the remainder of the wrap payment.
• Wrap loans are only attractive to the lender if
  the interest rate on the old loan is sufficiently
  below the rate on the wrap loan to provide
  profitable leverage.
• The wrap lender may be the original borrower, who
  would remain liable for making the payments on
  the original loan, or a third party, possibly an
  institutional lender, that assumes responsibility
  for the original mortgage.
• The homebuyer with a wrap loan must take
  precautions in case the wrap lender (e.g., the
  seller) does not make payments on the existing
  loan, even though the borrower has made its
  payments on the wrap loan. Think about the
  difficulties which this could cause the homeowner
  with the wrap loan.

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Wraparound Mortgage (Cont.)
Assume the following scenario A home is sold
for 100,000. An existing 1st mortgage of
20,000 at 7 interest is kept in place, for
which the home seller remains liable. The buyer
pays 40,000 down. As part of the purchase
price, the seller extends a new wrap loan to
the buyer for 60,000, which includes the amount
of the existing loan plus the remaining 40,000
of the home price. The wrap loan has an interest
rate of 10.
Seller, or wrap lender
1st Lender
Buyer
Continues to receive pmts from the seller on the
20,000 1st mortgage at 7
Makes pmts on the 60,0002nd Mortgage at 10
Makes a 60,000 2nd mtg that includes a 40,000
new loan and the existing 20,000 1st mtg, but
remains liable for the 1st
(Includes pmt for the wrapped 20,000 1st )
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Other Types of Loans

• Blended-Rate Mortgages The lender refinances an
  old loan and provides additional money to the
  borrower by issuing a new loan with a rate on the
  new loan that blends the rate on the old with
  the current market rate on a new loan. The lender
  combines the amount owed on the old loan with the
  new money into a new loan that replaces the old
  one. Thus unlike the wraparound, the old loan is
  extinguished.
• Package Mortgage This type of mortgage covers
  personal property, such as equipment and
  appliances, along with the real estate. What are
  the advantages of such an arrangement to the
  purchaser? These include lower interest rates,
  longer term, convenience of having only one
  payment, and deductibility of interest, which is
  no longer available with consumer loans. It is
  also used in commercial property financing where
  furnishings and other personal property are
  included in the mortgage. For example, this is
  very common with hotel financing.

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Other Types of Loans (Cont.)

• Blanket Mortgage A mortgage that secures
  (blankets over) what becomes two or more separate
  properties. The mortgage typically contains a
  partial release clause that sets forth the
  conditions by which a portion of the property
  under the mortgage can be released from the
  mortgage.
• It is used extensively in land development where
  one mortgage is used to secure a loan for the
  purchase and/or development of a large land
  parcel. Then as individual lots are developed
  and eventually sold, they are individually
  released from the mortgage so that the buyer can
  obtain the lot free and clear of the mortgage.
  
• Such loans typically require that some specified
  portion of the sales proceeds be paid to the
  lender to reduce the balance of the loan.

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Other Types of Loans (Cont.)

• Rich Uncle financing This refers to a
  relative, friend, or investor who provides money
  for all or most of the down payment (the equity),
  in return for which they receive some interest in
  the property. The interest can be a share of
  appreciation and/or rental payments, the right to
  claim tax depreciation, or some other interest in
  the property.
• Equity Mortgage A second mortgage on the equity
  in a property. Equity home loans are frequently
  used as lines of credit. They have advantages
  over consumer loans in that the interest rate on
  mortgages (even 2nd mortgages) are generally
  lower and the interest paid is usually tax
  deductible.

28
Seller Financing

• Seller financing refers to cases where the seller
  of property provides the financing for the
  transaction by agreeing to accept part of the
  purchase price in the form of a loan. The seller
  becomes the lender in the transaction.
• Seller financing is widely used for land sales,
  but it can be used in other types of
  transactions.
• Two commonly used types of seller financing are a
  land contract (aka installment contract and
  contract for deed) and a purchase money mortgage

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Seller Financing(Cont.)

• Land Contract With this type of financing, the
  seller loans a specified amount of the purchase
  price to the buyer, in return for which the buyer
  makes regular installment payments to the seller.
  The payments are similar to the payments on a
  mortgage. Unlike a mortgage, legal title remains
  with the seller, at least until a specified
  number of payments have been made, at which point
  the land contract effectively becomes a mortgage.
  The buyer is recognized to have equitable title
  until legal title is conveyed.
• Purchase Money Mortgage (PPM) The name given to
  the mortgage when the buyer gives the mortgage to
  the seller of property. The seller of the
  property becomes the mortgagee rather than a
  financial institution.
• However, PPM also refers to any mortgage used to
  finance the purchase of real property.

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Construction Loan

• Construction loans are used to finance
  construction projects. They are also called
  interim loans because they are relatively
  short-term loans not intended to provide
  long-term or permanent financing for the project.
  They are more risky to the lender than loans on
  improved property.
• The amount of the loan is agreed on beforehand,
  but the money is advanced in stages as
  construction progresses.
• The interest rate on the loan is typically tied
  to a highly variable short-term rate. For
  example, the loan interest rate may be quoted as
  prime (or LIBOR) plus 2 (this means whatever the
  prime rate is add 2 to it).
• The loans are either interest-only or require no
  payment until completion, at which time the
  entire amount, principal plus accrued interest,
  is paid.
• Permanent, or long-term, financing is commonly
  arranged to pay off the construction loan.

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Options

• An option is contract that is purchased which
  gives the holder (the optionee) the right, but
  not the obligation, to buy property (or some
  other asset) at an agreed-upon price within a
  specified time period. The seller has the
  obligation to sell if the buyer exercises the
  option (i.e., decides to buy).
• Options are commonly used in real estate to
  obtain control of a property while the
  prospective purchaser examines such things as its
  marketability, its zoning and other land use
  restrictions, and the availability of appropriate
  financing before deciding to actually purchase
  it. If things do not work out satisfactorily,
  the optionee loses only the price of the option
  rather than a much larger amount of money.
• Leasing with the option to purchase is one
  variety of option agreement.

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Affordable Housing Loans

• Financing arrangements designed to make housing
  more affordable for low and moderate income
  households.
• Low income households generally do not have the
  same credit history as more affluent households,
  such as checking accounts and consumer loans.
  Thus, underwriting standards are modified to
  recognize different forms of good credit, such as
  timely payment of rent and utility bills.
• Low down payment loans, such as the 97
  conventional loan.
• Such loans commonly require the borrower to take
  a pre-purchase home buyer education course.

33
Leasing as a Method of Financing

• Which property to acquire for use is a real
  estate decision. How to acquire a desired
  property for use is a financial decision.
• The two main ways in which property can be
  acquired for use are,
• 1. By purchasing and owning the property and,
• 2. By leasing the property.
• Often a user has a choice as to whether to own or
  lease a property. Each form of tenure (way of
  holding property) provides the right to use and
  the right to occupy the property, but each also
  involves a different set of property rights and
  different types of risks.
• The decision to buy or lease is appropriately
  made though a set of capital budgeting
  techniques, called lease vs. buy analysis, that
  are taught in finance courses.

34
Leasing as a Method of Financing (Cont.)

• With leasing, use of real estate is obtained by a
  contractual agreement through which the property
  owner gives over the right of use and occupancy
  to the tenant for a period of time (for the
  length of the lease contract, sometimes with
  options to renew).
• A long-term lease provides most of the benefits
  of ownership, except for the sale of the
  property.
• Leasing allows a user to have a property for use
  for a specified period of time without having to
  invest large amounts of capital or acquire a
  large debt burden, and without having to bear the
  risks of property ownership.
• Leasing also provides flexibility to the tenant
  if the location does not work out.

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Some Special Types of Leasing Arrangements

• Sale and leaseback A transaction in which a
  person or firm that owns property sells it,
  receives a cash payment from the sale, and then
  leases the property back. It is a financing tool
  commonly used by firms to free up capital from
  their real estate. Firms continue to have use of
  the property for their business, but they obtain
  a capital infusion from the sale.
• Land leases the land is leased for a long term,
  generally at least 50 years. Buildings and other
  improvements are constructed on the land and
  owned by either the user of the building or
  someone else. Ownership of the improvements goes
  to the land owner at the end of the lease.