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Real estate financing usually involves five phases: (1) application, (2) analysis, (3) processing, (4) closing, and (5) servicing
The lending process begins by having the prospective borrower
complete a lender's loan application. A loan application form requests information about the borrower's financial status, such as level and consistency of income, personal assets, existing debts, and current expenses
the loan application form also asks for data concerning the
property, including its location, its age, the size of the lot, and any
existing improvements.
Once the application is completed, the lender reviews the form
and uses it as a screening device to determine whether the prospective
borrower and the subject property appear to meet the lender's
requirements.
If it becomes obvious that the borrower or the property
is unacceptable for a loan, the lender informs the applicant. If
it appears that the borrower and the property might be acceptable,
the analysis phase begins
Analysis involves an in-depth appraisal of the property and a
professionally compiled credit report on the prospective borrower.
After the appraisal and credit report are completed (and assuming
both are favorable), the lender presents the terms and cost of
financing to the borrower.
The borrower may accept, reject, or
attempt to negotiate the financing terms with the lender. Assuming
an agreement is reached, the processing phase begins.
Processing involves drawing up loan papers, preparing disclosure
forms regarding loan costs, and issuing instructions for the
escrow and title insurance company.
Each lender establishes its
own processing pattern in view of its special in-house needs.
Once the loan package has been processed, the closing phase
begins. Closing the loan involves signing all loan papers and then,
in conjunction with the other terms of the sale, transferring the
property.
In southern California, an independent escrow company,
the escrow department of a title company, or (in some cases) the
broker handles the entire escrow.
In much of northern California,
once the loan papers are signed, they are forwarded to the escrow
department of a title insurance company, which closes the sale.
After the title has been transferred and the escrow is closed, the
loan-servicing phase begins. Loan servicing refers to the recordkeeping
process once the loan has been placed
Many lenders do
their own servicing, while others pay independent mortgage companies
to handle the paperwork.
The goal of loan servicing is to see
that the lender makes the expected yield on the loan by promptly
collecting and processing the loan payments with minimum cost.
When money is borrowed to purchase real estate, the borrower agrees
to repay the loan by signing a promissory note, which outlines the
terms of repayment and sets the due date.
The promissory note is legal evidence that a debt is owed. The types of promissory notes in general
use are the straight note, installment note, and negative amortized note.
The straight note is frequently referred to as an interest-only note.
Under a straight note, the borrower agrees to pay the interest,
usually monthly, and to pay the entire principal in a lump sum on
the due date.
For example, if you borrow $100,000 for 30 years at
10 percent interest rate using a straight note, the monthly payments
would be $833.33 per month. The $833.33 payments cover just the
monthly interest.
Thus, 30 years hence, on the due date, you must
pay back the entire $100,000 principal. In other words, the payments
were only large enough to cover the monthly interest and did not
reduce the $100,000 principal.
Proof: $100,000 × 10% $10,000 ÷
12 months $833.33 per month. Ten percent is used for illustration
purposes only. Actual interest rates will vary.
The second and by far the most common type of real estate promissory
note is the installment note. An installment note requires payments
that include both principal and interest.
If you borrow
$100,000 for 30 years at 10 percent interest payable at $877.57
per month, including both principal and interest, you will find that
at the end of 30 years, the entire debt is liquidated.
Each monthly
payment of $877.57 includes the monthly interest due and reduces a
portion of the $100,000 principal. By the time the due date arrives
30 years hence, the entire principal has been paid back.
An installment
loan that includes principal and interest of equal installment
payments that liquidate the debt is called a fully amortized loan.
Under a fully amortized loan, no large balloon payment must be
paid on the due date of the loan, as the loan is completely paid off.
One variation of the installment note is to have monthly payments
that are large enough to pay the monthly interest and reduce
some of the principal, but the monthly principal portion is
not sufficient to entirely liquidate the debt by the due date.
Thus,
on the due date, the remaining unpaid principal must be paid in a
lump sum, often referred to as a balloon payment. Any payment
more than twice the lowest payment amount is called a balloon
payment.
One hundred thousand dollars for 30 years at 10 percent
interest payable at $850 per month would require a balloon
payment of $62,325.20 on the due date.
Why? Because the $850
per month was enough to cover the monthly interest ($833.33), but it was not enough to cover the monthly interest and all of the
monthly principal, which would have taken $877.57 per month
Thus, the difference over the 30-year life of the loan comes to
$62,325.20, which must be paid on the due date in the form of a
balloon payment. Loan payments and balloon payments can be
calculated using financial tables or financial calculators.
Finally, some borrowers sign negative amortized promissory
notes. Negative amortized means that the loan payment does not
cover even the monthly interest.
Each month this shortage is added
to the principal owed, resulting in an increased loan balance, which,
in turn, incurs additional interest.
As mentioned above, a $100,000
loan at 10 percent payable interest would be a monthly payment of
only $833.33 = $100,000 × 10% ÷ 12 mo.
If a borrower paid only
$750 per month, the difference between the interest-only payment
of $833.33 and the $750 payment would be $83.33.
Each month
this additional $83.33 amount would be added to the $100,000
loan and begin to accrue interest.
If this continued for 30 years, the borrower would still owe a
balloon payment of $288,373.99 on top of paying $750 per month
for 30 years!
The total paid would be $750 × 360 payments = 30 years ×
12 = $270,000 $288,373.99 balloon payment, for a grand total of $558,373.99 to pay off a $100,000 negative amortized loan payable
for $750 permonth at 10 percent over 30 years!
Of course, in the
real world, most people do not stay in a home and pay for 30 years.
They usually sell or refinance long before 30 years, and the balance
owed on a negative amortized loan is far less than that illustrated
above.
But the lesson learned is that a negative amortized loan is
one where a loan balance grows each and every year prior to payoff.
Most real estate lenders qualify a borrower for either a fixed interest
rate or an adjustable rate loan.
The fixed interest rate is the
traditional real estate loan where the interest rate does not change
over the life of the loan.
Under the adjustable rate plan, the rate
may move up or down. Therefore, the monthly payment may decrease
or increase over the life of the loan.
Adjustable rate loans, usually called adjustable rate mortgages
or ARMs, have the following characteristics:
ARMS: 1. They are usually offered at a lower initial interest rate than traditional
fixed interest rate loans
ARMS : 2. Once the initial interest rate is established, the rate is tied to some
neutral index, which is beyond the control of the lender or the
borrower.
3. The index is usually a government index. Examples are the One Year
Treasury Spot Index, the Treasury 12-Month Average Index,or the
11th District Cost-of-Funds Index.
percent.
Other indexes used are tied to
certificate of deposit or CD rates, prime rates, or even a European
rate known as the London Inter bank Offered Rate or LIBOR .
The distance between the actual rate paid by the borrower and the index
is called the margin. A typical margin is 2 percent to 3 percent
4. Although not required,most lenders place a cap on how high the
rate can climb.Atypical cap is 5 percent or 6 percent; therefore, if
the initial interest rate is 6 percent, the maximum it can rise to is
11 percent or 12 percent.
5. The adjustment period can vary,with some lenders adjusting the
rate at six-month, one-year, or three-year intervals.
6. The maximum increase or decrease per period is established in
the lender's contract, with a maximum change of 1 percent per
six-month adjustment period being typical.
7. If the interest rate increases because of a change in the index, in
some cases, the borrower may have the option of (a) increasing
the monthly payment so the term of the loan remains the same or
(b) maintaining the same monthly payment and increasing the
term of the loan.
Usually, themaximumtermto which a 30-year
loan may be extended is forty years.Once a forty-year term is
reached, any increase in interest rate must increase the monthly
payment.
If the interest rate drops below the initial rate, the borrower
can continue the existing payments (which will shorten the
term) or decrease the monthly payments.However, in recent
years, fewer lenders are offering this feature.
8. The borrower must be given advanced notice prior to a change
in rate.
9. Some ARMs may be negative amortized loans. This means the
payments may not cover the annual interest. The unpaid interest
is added to the principal,making the loan larger. This can cause
some problems in later years.
10. Some lenders offer a convertible feature that allows the borrower
to convert an ARM loan to a fixed interest rate loan or a fixed rate
loan to an ARM.
The conversion is only offered during a certain
"window period," usually fromthe beginning of the second year
through the end of the fifth year.
The borrower may be required
to meet credit standards at the time of the conversion and is usually
required to pay extra fees.
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