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Unit 7 Real Estate Financing Programs
Terms in this set (68)
Interest (1 of 10)
Just as rent is paid and received for the use of an apartment, house, office, or store under the special conditions of a lease, real estate finance can be considered the process by which interest and principal are paid and received under the terms and conditions of a loan agreement. Money is borrowed (leased) at a certain interest rate (rent) for a specified time period during which the amount borrowed is repaid.
Most loans made on real estate are established at a simple rate of interest. Simple interest is rent that is paid only for the amount of principal still owed. When money is repaid to the lender, rent for that money stops.
The formula for computing simple interest is the following:
I = PRT where I = interest P = principal R = rate T = time
Using this formula, the interest on a $1,000 loan to be repaid in one year at 8 percent is $80.
I = PRT
I = $1,000 × 0.08 × 1
I = $80
Interest (2 of 10)
Interest Rate Factor
The interest rate factor represents the dollars required to pay off $1,000 of a loan for a set number of years on a fully amortized loan that will be paid off at the end of the loan term. Figure 7.1 illustrates how the factor changes according to the rate of interest and the term of the loan. Note that the interest rate and the factor are the same only at a rate of 6 percent for a 30-year loan.
To compute monthly principal and interest, multiply the number of thousands in the loan by the appropriate factor. Example $150,000 30year (Match this with Amortization scale which gives 6.66% at 7%) at 7%.
150 X 6.66 = $999
Interest (3 of 10)
Also known as a straight loan or bullet loan, a term loan requires payments of interest only with the entire principal being repaid at a specified time, called the stop date. The loan is then paid in full with a balloon payment of the principal plus any interest still owed.
Consider a term loan of $10,000 at 8 percent per annum, payable interest only monthly, to be paid in full in three years.
Pro Rata Months
Monthly Interest Payment
Final Principal Payment
When residential real estate prices reach new highs, qualifying borrowers for higher mortgage payments on larger loans becomes a serious problem. In order to reduce monthly payments, the use of interest-only loans emerges as an alternative type of loan.
When you examine the fixed-rate loan payment schedule in Figure 7.1, the regular monthly payment of $999.00 includes an amount for principal and interest and is designed to pay the debt of $150,000 at 7 percent in full over the 30-year time period.
To reduce this payment, the only portion that can logically be waived is the principal amount, reducing the payment to interest only. To reduce this payment any further would be paying less than interest only, which would result in the loan balance increasing each month by the difference, resulting in negative amortization.
A point is 1 percent of the total loan amount. For example, one point of a $200,000 loan is $2,000. Lenders charge discount points as up-front interest to lower the interest rate for the borrower while raising the yield for the lender. The number of points charged varies according to market conditions. A loan may be quoted as "5.5 percent with 3 points." One of the points is usually for the origination fee, which pays for the lender's processing expenses.
Interest (7 of 10)
Permanent/Temporary Buydown Plan
A buydown is money paid by someone (seller, builder, employer, buyer) to a lender in return for a lower interest rate and monthly payment. This buydown payment is essentially interest paid in advance and may lower the borrower's payments for the entire loan term (a permanent buydown) or for a lesser period of time, usually one year to three years (temporary buydown). Each percentage of buydown is quoted as a point. Buydowns are often used as a selling tool for new-home builders.
Assume a $100,000 loan for 30 years at 8 percent. To apply a TEMPORARY buydown of 2-1-0 would cost $2,432.04, or approximately two and one-half points.
Payment Rate Reg. P&I Effective Rate P&I Difference
1st year 8% $733.77 6% 599.56 134.21
2nd year 8% 733.77 7% 665.31 68.46
3rd year 8% 733.77 8% 733.77 0.00
Buydown Cost 1st year $134.21 × 12 = $1,610.52
Buydown Cost 2nd year $68.46 × 12 = 821.52
Total Buydown Costs $2,432.04
In most cases, it is not economically feasible for a borrower to pay for a buydown. Before making this decision, the buyer should calculate how long it would take to recover the additional cost at settlement.
Interest (8 of 10)
The most common payment format for a real estate loan is a system of regular payments made over a specified period. These payments include portions for both principal and interest. The process is called amortization. Amortization tables are available in text form and online.
Consider a loan of $90,000 at 7 percent for 30 years. The monthly payment of principal and interest is $599.40. The rate factor is 6.66.
Number of Thousands
Payment Factor (Figure 7.1)
Monthly Payment P & I
Note: There will be a slight difference between a payment calculated by calculator and one calculated from a factor table due to rounding.
Interest (9 of 10)
Distribution of Principal and Interest
Intrinsic in the amortization design is the distribution of the level payments into proportionate amounts of principal and interest.
Consider the $90,000 loan at 7 percent interest for 30 years with a monthly principal and interest payment of $599.40.
The schedule in the previous example can be extended for the full period of 360 months to show the complete distribution of principal and interest and the remaining balance of the loan at any time. These amortization schedules can be prepared on computer printouts and are often presented by lenders to borrowers so they can follow the progress of their payments. Amortization schedules are also available to the public online.
Interest (10 of 10)
Mortgage payments are normally paid in arrears. For example, a payment made on May 1 covers the principal due on that day plus the interest charged for the month of April. At closing, interest is usually charged to the borrower to cover the period from the closing date to the end of that month. The next full payment will not be due until the following month. For example, the closing is on June 15, interest is charged from June 15 to June 30, and the next payment is due on July 1.
Types Of Loans (1 of 20)
There are two general categories of real estate loans: conventional and governmental. Conventional loans can be conforming (conforming to guidelines set by Fannie Mae and Freddie Mac) or nonconforming (those that do not meet the Fannie/Freddie guidelines). Governmental loans are those insured by the Federal Housing Administration (FHA), guaranteed by the Veterans Administration (VA), provided by the U.S. Department of Agriculture (USDA), or provided by special programs created by individual states or local jurisdictions. Most originators of conventional loans do not keep them for their own portfolios but sell them in the secondary market.
Types Of Loans (2 of 20)
The most traditional loan product is the fixed-rate loan, in which the interest rate remains constant over the term of the loan. Fixed-rate loans may be amortized over a specific number of years in equal monthly payments, including principal and interest. The most popular fixed-rate loan is the 30-year mortgage, where the principal and interest portion of the payment remains the same with only slight annual changes in the portion set aside for escrow funds to pay property taxes and homeowners' insurance.
Types Of Loans (3 of 20)
Fixed-rate loans for 15 years are also popular with borrowers who wish to have their home paid for within a 15-year period. Lenders like them because of their relatively short amortization time, and they market these loans on the basis of the borrower being able to save significant amounts of interest, compared with the 30-year loan.
Types Of Loans (4 of 20)
Impound or Escrow Funds
In addition to the principal and interest the lender often collects monthly amounts needed to pay annual taxes and insurance. These amounts, referred to as IMPOUND FUNDS or escrow funds, in different parts of the country are determined by dividing the total amounts due each year by 12.
Types Of Loans (5 of 20)
every county assessor must maintain a current inventory of the fair market value of all privately owned real property within the county's boundaries. Thus, the term coined for this form of taxation is AD VALOREM (i.e., according to value).
Types Of Loans (6 of 20)
Hazard insurance premiums are based on risk—the higher the risk, the higher the insurance premium. The insurance rate for a wood-frame house located in a rural area far from any possible firefighting service would be higher than the rate for a brick home situated two blocks from a fire station. Also, if an area is vulnerable to hurricanes, tornadoes, excessive floods, or other natural disasters, insurance rates will reflect these risks.
includes both hazard and liability and is generally preferred by the lender. It also provides the best protection for the homeowner. Whatever method is used to determine the insurance rate, one-twelfth of the annual premium will be included in the monthly payment. A homeowners' insurance policy with a $360 annual premium will require that an additional $30 per month be included in the payment.
Types Of Loans (7 of 20)
Variable Payment Mortgages
Traditionally most loans are fairly standard in their payment schedules, requiring a certain sum to be paid at regular intervals over a prescribed time period. However, some real estate loans are designed to vary the required payments and interest to reflect more accurately the financial capabilities of a borrower, as well as the current state of the economy.
Types Of Loans (8 of 20)
Adjustable-Rate Mortgage (ARM)
The interest rate of an ADJUSTABLE RATE MORTGAGE (ARM) is adjusted in accordance with a prearranged index. The ARM usually includes an annual interest rate cap to protect the borrower from volatile interest rate fluctuations. In addition, there usually is an overall interest rate cap over the entire term of the loan.
Types Of Loans (9 of 20)
Components of an ARM that should considered when selecting an adjustable-rate mortgage include the following:
This indicates the frequency of interest rate adjustments with concomitant payments. For example, the interest on a one-year ARM can change every year, while the interest on a three-year ARM can only change every three years.
Sometimes called the teaser rate, it will always be below the market rate in order to attract borrowers to this type of loan.
The note rate or the calculated rate is the adjusted rate (index plus margin), imposed from time to time at the adjustment period.
Because ARM interest rates fluctuate from time to time, the rate at which to qualify a borrower often creates problems. If the initial loan rate is low but is expected to increase in the near future, the borrower may not be able to make the higher payments. Lenders may require a borrower making less than 20 percent down payment to qualify at the maximum second-year rate. However, all interest rate adjustments on the loan will be made from the initial loan rate.
The index is the starting point to adjust a borrower's applicable interest rate. Lenders must use an index that is readily available to the borrower but beyond the control of the lender. Some indexes are more volatile than others. Those most frequently used are the
• one-year constant-maturity Treasury (CMT) securities,
• Eleventh District Cost of Funds Index (COFI), and
• London Interbank (LIBOR) interest rates.
Each lender adds a margin percentage rate to the index at every adjustment period to derive the new note rate. Individual lenders set their own margins based on their estimated expenses and profit goals. The margin percentage rate may not change throughout the life of the loan. Typical margins range from 2 to 3 percent.
Interest Rate Caps
Most variable rate loans include an annual cap applied to the adjusted interest rate. This cap limits interest rate increases or decreases over a stated period of time and varies from lender to lender and ranges from one to two percentage points per year. Most lenders also include a life-of-the-loan interest cap ranging up to 6 percent. This combination of caps should provide the borrower protection against debilitating payment increases.
Types Of Loans (10 of 20)
Some lenders use annual payment caps instead of interest rate caps. The most common payment cap is 7.5 percent of the initial payment. This is equivalent to a 1 percent change in the interest rate. This means a payment of $750 per month, principal and interest, could not vary up or down more than $56.25 per month in one year's time. These payment caps are also combined with life-of-the-loan caps in some plans.
All ARM originations from federally insured lending institutions must comply with disclosure regulations. Under an amendment to Regulation Z, the borrower must receive:
•a descriptive ARM brochure;
•details of the specific loan program; and
•an illustrative example, based on a $10,000 loan, showing how the payments and loan balance have been affected by historical changes in the index.
Types Of Loans (11 of 20)
Graduated-Payment Mortgage (GPM)
A graduated-payment mortgage is designed with lower payments in the early years of a loan. These payments increase gradually until they are sufficient to amortize the loan fully. A GPM may specify less-than-interest-only early payments. This results in negative amortization and the principal amount owed increases over time by the amount of the deficiency.
Types Of Loans (12 of 20)
Low Documentation Loans
Some major lenders have offered a program for those with good credit and steady income who wished to avoid the hassle of providing documentation to be approved. Sometimes called a low-doc loan, this program was especially appealing to self-employed and commission-income borrowers. In most cases, a high credit score was required and the interest rate may have been slightly higher. As mortgage qualifying standards have become tighter since 2008, low-doc loans are rarely available.
Types Of Loans (13 of 20)
Home Equity and Home Equity Line of Credit (HELOC)
The exception to higher loan-to-value ratios is for home equity loans in the state of Texas. There are more restrictions and a rule that once a home equity loan is used, the mortgage is always considered a home equity loan. Click here to view information about the 12-day letter required for home equity lending in Texas.
A popular version of the home equity loan is the home equity line of credit (HELOC). The line of credit is set up in the same way as the home equity loan but rather than the borrower receiving the maximum amount as a lump sum payment at closing, the borrower can write an access check, make a withdrawal with a VISA access card, or transfer funds online for any amount up to the approved limit whenever funds are needed for almost any purpose.
Types Of Loans (14 of 20)
Home Ownership and Equity Protection Act of 1994
The Home Ownership and Equity Protection Act of 1994 (HOEPA) addresses certain deceptive and unfair practices in home equity lending. The law was strengthened by the Federal Reserve with an amendment to the Truth in Lending Act (TILA) in Section 32 of Regulation Z. Under this amendment, home loans are covered if the annual percentage rate exceeds the rate of Treasury securities of comparable maturity by more than eight percentage points (10 percent for second mortgages) or the fees and points paid by the borrower exceed $592 (2011 figure), including the cost of credit insurance and other debt protection products paid at closing. The amount is adjusted annually by the Federal Reserve Board, based on the Consumer Price Index.
Types Of Loans (15 of 20)
Reverse Annuity Mortgage (RAM)
This plan is based on a borrower's ability to capitalize on accumulated equity and is designed to enhance the income of the elderly. Many senior citizens own their homes free and clear but face the problem that their incomes are fixed and relatively low. Thus, the reverse annuity mortgage (RAM) allows them to utilize their equities, with the lender paying the borrower a fixed annuity.
The property is pledged as collateral to a lender, who may provide funds to the borrower in one of the following three ways:
•Funds may be provided with regular monthly checks to the borrower until a stipulated balance has been achieved with no cash payment of interest required. The increase in the loan balance each month represents the cash advanced, plus interest on the outstanding balance.
•An initial lump-sum payment may be provided.
•A line-of-credit on which checks may be drawn. When the maximum loan amount is reached, the borrower is obligated to start repayment. In some cases this requires the sale of the property.
Types Of Loans (16 of 20)
Conventional Conforming Loan Products
A conventional conforming loan is one that follows the Fannie Mae/Freddie Mac qualifying guidelines. Loans that do not meet the criteria set up by Fannie Mae and Freddie Mac are considered to be nonconforming loans and will not be purchased by Fannie Mae or Freddie Mac on the secondary market. The following four basic Fannie Mae and Freddie Mac guidelines are generally used to qualify borrowers for conventional loans. The actual percentage ratios shown for both housing (Rule 1) and debt (Rule 2) are not as significant today because most underwriting is done by computer.
•Rule 1. Principal, interest, taxes, property insurance, private mortgage insurance, and any applicable condominium or homeowner association fees shall not exceed 28 percent of borrower's gross monthly income.
•Rule 2. All of the previously listed plus monthly debts shall not exceed 36 percent of borrower's gross monthly income.
•Rule 3. Borrower must have good credit.
•Rule 4. Borrower must have stable employment.
Types Of Loans (19 of 20)
Fannie Mae/Freddie Mac Maximum Loan Limits
The conforming loan limit is now set by the Federal Housing Finance Agency (FHFA). The limit for 2011 and 2012 remained at $417,000 for most areas with a special provision for "high-cost" areas. These limits are set equal to 115 percent of local median house prices and cannot exceed 150 percent of the standard limit ($417,000 in 2012, or $625,500 for "high-cost" areas). According to provisions of the Housing and Economic Recovery Act of 2008 (HERA), the national loan limit is set based on changes in house prices over the previous year, but cannot decline from year to year. The limit for high-cost loans under the Economic Stability Act was actually higher in 2009 and 2010. New loan limits are generally published at the end of each calendar year for the coming year.
Types Of Loans (20 of 20)
Any loan exceeding the current Fannie Mae/Freddie Mac conforming loan limits is considered a jumbo loan. Lenders are free to set their own individual qualifying standards, although the Fannie Mae/Freddie Mac guidelines are often used. Jumbo loans may be up to whatever amount a lender is willing to risk.
Private Mortgage Insurance (1 of 5)
Private mortgage insurance (PMI) is required on conventional loans when the loan-to-value (LTV) ratio is in excess of 80 percent as stated in the Fannie Mae and Freddie Mac guidelines. The insurance covers the amount of the loan in excess of the 80 percent LTV ratio. Private mortgage insurance programs vary in the need for coverage and amount of coverage required. Rates can also vary depending on the private mortgage insurance carrier and on the credit standing of the borrower.
Mortgage insurance is issued to protect the lender in case the borrower defaults on the loan payments. If a property is foreclosed, the insurance company either pays the lender in full and acquires the property or pays the lender according to the terms of the insurance plan plus expenses, and the lender acquires the property.
Private Mortgage Insurance (2 of 5)
There are also PMI payment plans in which the costs are financed. This is accomplished by adding the lump-sum premium amount to the loan balance to be repaid over the life of the loan. There is also a plan where the lender pays the PMI, but the borrower pays a higher interest rate on the PMI portion of the loan. One advantage to the borrower is that all the interest is deductible. The disadvantage is that the higher interest rate remains for the life of the loan.
Private Mortgage Insurance (3 of 5)
Factors that can be affected are the minimum credit score, the maximum loan amount, and the debt-to-income ratio. Mortgage insurance companies now use a standardized loan workout reporting template that was developed by the members of the Mortgage Insurance Companies of America (MICA). MICA is the trade association representing the private mortgage insurance industry and now has two separate Web sites: www.privatemi.com is geared to consumers, and www.micanews.com is aimed at policymakers and the media.
Private Mortgage Insurance (4 of 5)
Termination of PMI Payments
PMI premiums continue until the lender releases the coverage, which depends not only on the increased equity position of the borrower, but on the payment history as well. Once the LTV ratio reaches 80 percent, the insurance company is no longer liable for any losses due to default by the borrower, and the borrower may request that the insurance premium payments stop.
Private Mortgage Insurance (5 of 5)
Split or Piggy-Back Loan
One way for a borrower to avoid paying a PMI premium is called a split loan or a piggy-back loan, involving a first and second mortgage being executed simultaneously. The arrangement can be for an 80/10/10 split, an 80/15/5 split, or even an 80/20/0 split, although this would be rare today. In each case, the first mortgage remains at 80 percent LTV, which requires no PMI.
Refinancing Existing Conventional Loans (1 of 2)
Before making the decision, it is important to discuss a loan modification with the existing lender. It may offer a lower interest rate with minimal transaction fees eliminating the need for refinancing. In an effort to help homeowners avoid foreclosure several new refinancing programs were introduced in 2008 as part of the Making Home Affordable (MHA) initiative. The most recent plan for refinancing is the Home Affordable Refinancing Program (HARP).
The monies received from refinancing, even if they exceed the price paid for the property, are known as realized capital gains and are not taxable until they become recognized capital gains when the property is sold.
Refinancing Existing Conventional Loans (2 of 2)
Streamlined Modification Program (SMP)
In November 2008, the FHFA announced a Streamlined Modification Program (SMP) that Fannie Mae and Freddie Mac could offer to seriously delinquent borrowers in an effort to prevent foreclosure. The SMP allows a lender to modify an existing loan to provide the borrower with an affordable monthly payment at no more than 38 percent of gross monthly income. This can be done by reducing the interest rate, extending the term to 40 years, or forbearing part of the principal.
Home Affordable Modification Program (HAMP)
On March 4, 2009, the Home Affordable Modification Program (HAMP) was introduced as a part of the Making Home Affordable Program. The Treasury department will partner with financial institutions to reduce homeowners' monthly payments to a 31 percent front-end ratio.
In order to be eligible, the borrowers must
• be delinquent on the mortgage or at imminent risk of default,
• occupy the property as a principal residence, and
• have a mortgage that originated on or before Jan. 1, 2009, with an unpaid balance of less than $729,750.
The lender may take the following steps for an eligible borrower to achieve the 31 percent ratio:
• Reduce the interest rate to as low as 2 percent
• If necessary, extend the loan term to 40 years
• If necessary, defer a portion of the principal until the loan is paid off, waiving the interest on the deferred amount
• Elect to forgive principal in order to achieve the target monthly payment
Subprime And Predatory Lending (1 of 5)
In the financial world, mortgage loans are designated as A, B, C, or D paper. Ideally, all borrowers would be rated "A." There are cases, however, where the loan is considered "B" quality—showing definite credit problems; "C" quality—indicating borrowers with very marginal or poor credit; or even "D" quality—indicating a very high risk on the loan. A category of "A minus" may be used to describe those applicants who are very close to "A" but have minor credit or qualifying problems. Lenders who provide loans or even specialize in the B, C, or D paper are called subprime lenders.
Predatory lending is generally defined as the practice of charging interest rates and fees that are higher than justified by risk-based financing. Fees on a typical mortgage loan average around 1 percent; on a predatory loan, fees totaling 5 percent or more are common.
A subprime loan may range from 1 to 5 percent above the current market rate, depending on the extent of the potential borrower's credit problems. Borrowers should beware of predatory lending when the quoted interest rate is in excess of these percentages or the rate seems competitive but the APR (annual percentage rate) is much higher than the quoted rate.
Billions of dollars are lost by consumers every year due to predatory mortgages, payday loans, and other lending abuses, such as overdraft loans, excessive credit card debt, and tax refund loans. HUD, VA, Fannie Mae, Freddie Mac, the Mortgage Bankers Association, and the National Association of Mortgage Brokers have all worked very hard to combat the prevalence of predatory lending. Unfortunately, the predatory lender may be someone well-known and trusted by the potential borrower. It is suggested that a borrower check out any lender being considered with the local Chamber of Commerce, the Better Business Bureau, and either the Mortgage Bankers Association or the Association of Mortgage Brokers. The problem is especially difficult when the borrowers do not speak English and are literally being preyed upon by a lender of their particular ethnic-language group.
In communities across America, borrowers have lost their homes because of the actions of predatory lenders, appraisers, mortgage brokers, and home improvement contractors. Other predatory lending practices include:
• lending on properties for more than they are worth using inflated appraisals;
• encouraging borrowers to lie about their income, expenses, or cash available for down payment;
• knowingly lending more money than a borrower can afford to repay;
• charging high interest rates to borrowers based on their race or national origin;
• charging fees for unnecessary or nonexistent products and services;
• pressuring borrowers to accept higher-risk balloon or interest-only loans, or loans with steep prepayment penalties or possible negative amortization;
• stripping homeowners' equity from their homes by convincing them to refinance again and again when there is no benefit to the borrower;
• using high-pressure sales tactics to sell home improvements and single-premium mortgage insurance; and
• steering the borrower into a subprime mortgage when they could have qualified for a mainstream loan. Fannie Mae has estimated that up to one-half of borrowers with subprime mortgages could have qualified for loans with better terms.
Two types of loans that are not necessarily predatory but could be if the borrower does not understand the implications of the loan are the following:
• Balloon loan requiring full payment at the end of the initial term;
• Interest-only loan with balance of principal plus interest due at end of term.
State Legislation and Predatory Lending
Many states have initiated predatory lending legislation. The first of these was North Carolina in July of 1999.
Other states soon followed, and today almost every state, including the District of Columbia, has some type of antipredatory lending law. Unfortunately, these laws vary greatly from state to state, creating compliance difficulties for large national lenders.
Federal Legislation and Predatory Lending
Other than the traditional Real Estate Settlement Procedures Act (RESPA), Truth in Lending Act (TILA), and Homeowner and Equity Protection Act (HOEPA), there has been little federal legislation specifically prohibiting predatory lending. The new Consumer Financial Protection Board will be taking steps to address the problems of predatory lending in all areas of personal finance. HUD has taken action to combat one form of predatory lending in HUD 24 CFR Part 203 "Prohibition of Property Flipping" in HUD's Single Family Mortgage Insurance programs. This regulation was passed to prevent a home being purchased with an FHA-insured loan and then flipped within a short period of time for a considerable profit. In some cases, this was being done with collusion between the lender and an appraiser. In May 2010, in an effort to speed the sale of foreclosed homes, FHA dropped the 90-day requirement as long as the property is being sold by a lender after foreclosure.
Variations In Formats (1 of 17)
An open-end mortgage, allows a borrower to secure additional funds from a lender—funds that, in many instances, represent the principal already paid by the borrower.
Open-end mortgages are often utilized by farmers to raise funds to meet their seasonal operating expenses.
A basic legal problem associated with open-end financing is one of securing future advances under an already existing debt instrument and, at the same time, preserving its priority against any possible intervening liens.
Under the laws of those states that have adopted the Uniform Commercial Code, any personal property security agreements for the purchase of goods that become fixtures on the collateral property have a priority lien over future advances made under an original mortgage. Suppose a homeowner signs a financing contract to purchase and install a central air-conditioning system in June, and the agreement is recorded. In December the owners secure an advance on their open-end mortgage to build an addition to their home. Because the central air-conditioning system is now a fixture, the appliance company's lien will take priority over any future advances made by the original mortgagee.
A construction mortgage, also called an interim financing agreement, is a unique form of open-end mortgage. It is a loan to finance the costs of labor and materials as they are used during the course of constructing a new building. An interim mortgage usually covers the period from the commencement of a project until the loan is replaced by a more permanent form of financing at the completion of construction. This financial format is unique because the building pledged as part of the collateral for the loan is not in existence at the time that the mortgage is created. The value of the land is the only available collateral at the loan's inception, a condition that requires the lender to seek some form of extra protection.
The procedure for protecting the lender is both logical and practical. Although the full amount to be loaned is committed at the start of construction, the funds are distributed in installments as the building progresses, not as a lump sum in advance. The outstanding loan balance is matched to the value of the collateral as it grows.
Application and Requirements
To obtain a construction loan, the borrower submits plans and specifications for a building to be constructed on a specific site to a loan officer for analysis. Based on the total value of the land and the building to be constructed thereon, a lender will make a commitment for a construction loan, usually at the rate of 75 percent of the property's total value.
Construction loans are available for projects of all sizes, and the charges imposed vary according to the lender. Typically, there is at least a 1-point placement fee plus interest at 2 points above the prime rate charged to AAA-rated borrowers. Interest rates and placement fees fluctuate as a function of business cycles, borrowers' credit ratings, and individual situations.
Pattern of Disbursements
Disbursement of funds under a construction loan usually follows one of two basic patterns. A construction loan may be designed to include a schedule for disbursing funds in a series of draws as construction progresses. In a five-stage plan, an interim financier distributes 20 percent of the funds each time the building reaches another one-fifth of completion.
Another pattern of disbursement under a construction loan requires the borrower to submit all bills for subcontracted labor and materials to the lender, who then pays these bills and charges the loan account accordingly. This plan gives the lender greater control over the possibility of intervening construction liens.
Interest is charged on these monies only after they are disbursed following each inspection of the work's progress. The accumulated interest charges and the entire construction loan principal are paid in full within some relatively short period of time after completion of the project. Usually a construction loan is replaced by a permanent, long-term senior loan for which the builder has arranged in advance.
There are no insurance plans for guaranteeing the payments on construction loans. As additional protection, many construction financiers insist their borrowers/builders secure a completion bond from an insurance company, naming the lender as the primary beneficiary. The bond is drawn in the amount of the total construction cost and is exercised only if the builder is unable to complete the construction. Under this circumstance the lender can step in and use the bond proceeds to pursue the completion and subsequent sale of the property to recover the interim loan funds. Often small building companies cannot qualify for bonding and must pledge other assets as additional collateral for a construction loan.
Construction loans are drawn for relatively short time periods—six months to a year for a house and up to three years for larger projects.
Sources of Funds
The relatively short-term nature of construction loans closely matches the investment profile of commercial banks, which take an active role in this form of financing. However, some lenders that generally deal in long-term loans also participate in interim financing. For example, they will provide money for construction and then simply convert these interim mortgages to permanent mortgages for eligible borrowers. In other words, these lenders have created an in-house loan package, called a construction/permanent loan.
While construction loans are tailored to the investment needs of commercial banks, permanent long-term takeout loans match the investment designs of thrift institutions and life insurance companies. All types of investment groups can participate in the various stages of construction financing.
Depending on the terms of a specific transaction, a lender may require a borrower to pledge more than one parcel of property as collateral to back up a mortgage. The debt instrument used in this situation is called a blanket mortgage and can take any of the financing forms discussed previously. When the properties encumbered by a blanket mortgage are located in more than one county, the debt instrument must be reproduced and recorded at the courthouse in each county where a subject property is located.
When two or more properties are pledged as collateral for one loan, it is often necessary to provide some means for relinquishing an individual parcel as payments are made. Such a tool is called a release clause. In exchange for some action, such as a designated amount of repayment, a specific property or portion of a property can be freed from the lien of a blanket mortgage.
Most responsible land developers secure a special recognition clause from their underlying financiers that protects individual small parcel owners. This clause specifies that in the event of a default and a resultant foreclosure the underlying financier will recognize and protect the rights of each individual lot owner. Many states require not only full disclosure of the physical attributes of the land involved in such a development but also a description of all financing terms. These state disclosure laws closely parallel those of the federal government for interstate land sale promotions.
Tenants are able to pledge their leasehold interests as collateral for leasehold mortgages. Some of these mortgages are eligible for FHA and VA insurance and guarantees, and national banks have been authorized to make such loans provided that the lease term extends for a sufficient interval after the expiration of the leasehold mortgage.
As a consequence, if a loan default occurs that necessitates a foreclosure action, a lender will be protected by having the legal right to recover both the land and the building. Most leasehold mortgages are designed to include both land and buildings as collateral, requiring the landlord's subordination of the legal fee to the new lien.
When personal property is included with the sale of real estate it is possible to use a single financing instrument called a package mortgage. It includes as collateral not only the real estate but certain fixtures attached to the property and/or other items of personal property described in the mortgage document.
Most installations, such as heating units, plumbing fixtures, and central air systems, when attached to the real estate become real property and are automatically included under the lien. However, other fixtures not normally considered real property, such as ranges, ovens, refrigerators, freezers, dishwashers, carpets, and draperies, may be included in a home purchase financing agreement to attract buyers. This inclusion will enable homebuyers to stretch the payments for these items over the entire term of the mortgage, as opposed to the shorter term of a consumer installment loan.
An additional incentive to use the package loan is that the interest on a home loan is tax deductible whereas the interest on a consumer loan is not. Many commercial rental properties, including condominiums, apartment rentals, office buildings, and clinics are specifically designed to include package financing.
Manufactured Housing Mortgage
All manufactured housing (formerly known as mobile homes) must be built to HUD standards in a controlled atmosphere manufacturing plant. The structures are then transported in one or more sections on a permanent chassis to a building site. Are manufactured homes real or personal property? The lender is obviously concerned that there is sufficient collateral to justify financing the purchase of the home.
There is little doubt that a travel trailer attached by a hitch to an automobile or set onto the bed of a pickup truck or a van-type travel home is clearly identifiable as personal property. Many larger homes manufactured as factory-built housing units. Many are legally transportable only by professional movers. These units are permanently attached to lots in rental parks that cater to long-term tenancies or are installed on property purchased by the owner of the home. When long-term leases are involved or a home owner has title to the lot on which the unit is permanently affixed, real estate financing is possible. Most manufactured homes are eligible for FHA or VA financing.
The term purchase-money mortgage is usually used to refer to a seller's carrying back a portion or all of the sales price as a loan to a buyer. A purchase-money mortgage can be either a senior or junior lien on the property.
A bridge loan is an equity loan designed to serve a specific purpose, usually for a relatively short period of time. For example, owners of one property wishing to purchase another might seek a short-term bridge loan on their equity to be able to close the purchase. This loan would be satisfied when the old property was sold or at a specified time, whichever came first. The bridge loan is usually an interest-only term loan, requiring a balloon payment at its conclusion.
A wraparound loan is a special instrument created as a junior financing tool that encompasses an existing debt. Adopting any of the three basic financing forms, these encumbrances are used in circumstances where existing financing cannot be prepaid easily due to a lock-in clause or a high prepayment penalty. They are also used where the interest rate on the existing mortgage allows a lender to secure a higher yield by making a wrap loan.
The sale of a $100,000 property with a $10,000 cash down payment and an assumable first mortgage balance of $70,000 at 6 percent interest only can be financed by a seller who would carry back a new wraparound loan for $90,000 at 7 percent interest. This wraparound would require the purchaser/mortgagor to make payments on the $90,000 of $6300, while the seller/wraparound-mortgagee would retain responsibility for making the required payments on the undisturbed existing $70,000 first mortgage of $4200, leaving $2100 as a yield on the $20,000 wrap equity or 11 percent.
Option to Buy
An option to buy gives the buyer, also known as the optionee, the absolute right (but not the obligation) to acquire certain real estate during the option period, provided the option payments are kept current.
Lease with Option to Buy
A variation of the option to buy is a lease option to buy. In this case, the buyer agrees to purchase the property at a price negotiated within the lease. Often, a portion of the rent is applied to the purchase price as an incentive for closing the transaction. Contemporary lease-options include a right of first refusal clause instead of an outright option. Here, the price is not fixed at the outset; market conditions dictate the final value to be accepted by both parties. A variation that is regaining popularity since it has become more difficult to obtain mortgage financing is the lease purchase. Unlike the lease-option, there is an actual sales contract that includes the sales price, provisions for the amount of rent to be paid, any credit to be given back to the purchaser at time of settlement, and a projected settlement date. Financing is usually arranged 30 to 60 days prior to the projected settlement date.
There are three types of mortgage participation. One is a partnership among several mortgagees, a second includes the teaming of several mortgagors, and a third establishes a partnership between a mortgagee and a mortgagor.
Partnership of Mortgagees
In the first type, a mortgage participation involves more than one mortgagee as the owner of the instrument designed to finance a real estate project. It is used in large project financing. Several mortgagees join together, each advancing a proportionate share of the monies required and receiving a commensurate share of the mortgage payments.
Mortgage-backed securities are in reality a form of mortgage participation. Individual investors may purchase shares in a designated group, or pool, of mortgages (e.g., Ginnie Mae guarantees mortgage-backed securities or other real estate mortgage investments conduits [REMICs]).
In addition to the private partnerships among several mortgagees on a single loan and the Ginnie Mae mortgage-backed securities program, real estate mortgage trusts (REMTs) also offer opportunities for mortgage partnerships. Trusts are formed where investors purchase beneficial shares under special terms. Using the pool of monies acquired by the sale of these beneficial interests, mortgage trust managers invest in real estate mortgages and distribute the profits according to a prearranged formula. The private ownership quality of REMTs allows them to invest in high-risk loans such as junior loans or construction financing. Sometimes, as a result of adverse financial conditions, REMTs are inadvertently converted to REITs (real estate investment trusts) when they foreclose on their delinquent mortgagors and end up owning the properties they financed.
Partnership of Mortgagors
The second type of mortgage participation involves several mortgagors sharing responsibility for a single mortgage on a multifamily property, called a cooperative.
A cooperative vests ownership in a corporation that issues stock to all purchasers, giving them the right to lease a unit from the corporation. This proprietary lease is drawn subject to the rules and restrictions established by the corporation, and management is in the hands of a board of directors elected by the stockholders. The major weakness of the cooperative form of mortgage participation is that each cooperative participant is dependent on the other owners to prevent a default of the mortgage. A financially irresponsible tenant or units that remain unsold for long periods create a financial strain on the remaining tenants who are still liable for making the total mortgage payments.
Partnership of Mortgagees and Mortgagors
The third type of participation, called a participation mortgage, is engendered when a mortgagee becomes a partner in the ownership of a project on which a loan will be placed. When a developer requests a commitment for a participation mortgage on a substantial commercial real estate project, a lender may accept a higher loan-to-value ratio, lower the interest rate, or make other concessions in return for a percentage of the project's ownership as a condition for issuing the loan commitment. These mortgagee ownerships range from 5 to 50 percent or more and simultaneously make the lender a partner in the development as well as its financier.
Shared Appreciation Mortgage
Lenders sometimes can expand their earning possibilities by participating in a real estate transaction as both owners and financiers. In addition to the Shared Appreciation Mortgage (SAM), where the lender reduces the initial interest rate in exchange for a share of the property's future increased value, there are other variations of this type of participation financing.
The most complete form of equity participation is a joint venture, in which the lender puts 100 percent of the funds needed for a development up front in exchange for the expertise and time of the developer. The lender then becomes an investor in full partnership with the developer.
Some joint venture partnerships are expanded to include the landowner, the construction company, the financier, and the developer, who supervises the entire project from its inception until it is completely rented and sometimes even beyond as a permanent manager. Passive investors in joint venture partnerships cannot use a loss from passive investment to protect their active income.
The sale-leaseback approach to real estate finance is generally applied to commercial properties, because rents paid by businesses and professional persons are deductible expenses in the year in which they are incurred. Using this approach, a seller/lessee enjoys many benefits, including the following:
• The seller/lessee retains possession of the property while obtaining the full sales price, in some cases keeping the right to repurchase the property at the end of the lease, in effect freeing capital frozen in equity.
• The seller/lessee maintains an appreciable interest in realty that can be capitalized by subleasing or by mortgaging the leasehold.
• The seller/lessee gets a tax deduction for the full amount of the rent, equivalent to being able to take depreciation deductions for both the building and the land.
When the lease includes an option for the tenant to repurchase the property at the end of the lease term, it is called a sale-leaseback-buyback. However, care must be taken to establish the buyback price at the fair market value at the time of sale. Otherwise the arrangement is considered a long-term installment mortgage, and any income tax benefits that might have been enjoyed during the term of the lease will be disallowed by the Internal Revenue Service. Also, a fair market purchase option can only be included if the property is a new acquisition and the lessee has never been in the title chain.
A more common form of lender participation than the sale-buyback form is split-fee financing. In this plan, the lender purchases the land and leases it to the developer while financing the improvements to be constructed on the leasehold as well.
The land lease payments can be established at an agreed-upon base rate plus a percentage of the tenant's income above a specified point. Under this arrangement, the lender/investor benefits by receiving a fixed return on the investment plus possible overages, while maintaining residual property rights through ownership of the fee. The developer has the advantage of high leverage and a fully depreciable asset, because she owns the leasehold improvements but not the land.
Tax Impacts In Mortgage Lending (1 of 4)
A special financing tool designed to postpone capital gains income taxes on properties that do not qualify for special exemptions available under the income tax laws is called an installment sale plan.
A gain on an installment sale is computed in the same manner as is the net capital gain on a cash sale: gross sales price minus costs of sale minus adjusted book basis equals net capital gain. However, under an installment sale the seller can elect either to pay the total tax due in the year of the sale or to spread the tax obligation over the length of the installment contract. The installment plan allows a seller to pay tax in amounts proportionate to the gain collected each year. A seller whose tax bracket decreases over the term of an installment contract will pay less tax than if he had elected to pay the full tax in the year of the sale. This arrangement is particularly advantageous to a seller nearing retirement age who will enter a lower tax bracket during the term of the installment contract.
Another method often employed to postpone tax on capital gains is the property exchange technique. Internal Revenue Code Section 1031 provides for the recognition of gain to be postponed under the following conditions:
• Properties to be exchanged must be held for productive use in a trade or business or for investment.
• Properties to be exchanged must be of like kind to each other; that is, their nature or character must be similar. Like kind is only limited to another income-producing property. A rental condo could be exchanged for a delicatessen; a rental town house could be exchanged for a gas station or marina. One property may be exchanged for several properties; it is not limited to one.
• Properties must actually be exchanged.
Property held for productive use in a trade or business may include machinery, automobiles, factories, and rental apartments. Property held for investment may include vacant land and antiques. Like kind includes a machine for a machine or real estate for real estate. Improvements on the land are considered to be differences in the quality of the real estate, not in the type. Thus, a vacant lot can be exchanged for a store property. Often unlike property, called boot, is included in an exchange and must be accounted for separately.
There are at least six basic mathematical computations involved in the exchange process:
1.Balancing the equities
2.Deriving realized gains
3.Deriving recognized gains
4.Determining tax impacts
5.Reestablishing book basis
6.Allocation of new basis
Generally, the investor who is trading up benefits by not being required to pay taxes, while the downside exchanger is taxed on gains. A prudent investment program provides for trading up during an investor's acquisition years and trading down after retirement, when tax brackets are lower.
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Journalize the following transactions completed during May of the current year. Use page 1 of the journal given in the Working Papers. Source documents are abbreviated as follows: check stub, C; memorandum, M; receipt, R; sales invoice, S; calculator tape, T. May 1. Received cash from owner as an investment, $15,000.00. R1. 1. Paid cash for rent,$1,800.00. C1. 2. Paid cash for electric bill, $105.00. C2. 4. Paid cash for supplies,$450.00. C3. 4. Paid cash for insurance, $1,200.00. C4. 7. Bought supplies on account from Dunn Supplies,$900.00. M1. 11. Paid cash to establish a petty cash fund, $250.00. C5. 12. Received cash from sales,$475.00. T12. 13. Paid cash for repairs, $250.00. C6. 13. Paid cash for miscellaneous expense,$40.00. C7. 13. Received cash from sales, $235.00. T13. 13. Sold services on account to Midwest College,$225.00. S1. 14. Paid cash for advertising, $300.00. C8. 15. Paid cash to owner for personal use,$200.00. C9. 15. Paid cash on account to Dunn Supplies, $500.00. C10. 15. Received cash from sales,$305.00. T15. 15. Sold services on account to Matterhorn University, $425.00. S2. 18. Paid cash for miscellaneous expense,$95.00. C11. 18. Received cash on account from Midwest College, $125.00. R2. 19. Received cash from sales,$480.00. T19. 20. Paid cash for repairs, $160.00. C12. 20. Bought supplies on account from Greenway Supplies,$120.00. M2.
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In early January, Burger Mania acquired 100% of the common stock of the Crispy Taco restaurant chain. The purchase price allocation included the following items: $4 million, patent;$5 million, trademark considered to have an indefinite useful life; and $6 million, goodwill. Burger Mania's policy is to amortize intangible assets with finite useful lives using the straight-line method, no residual value, and a five-year service life. What is the total amount of amortization expense that would appear in Burger Mania's income statement for the first year ended December 31 related to these items?
The following data refer to Clear Panes, a division of Global Corporation. Clear Panes makes and sells residential windows that sell for $150 each. Clear Panes expects sales of 150,000 units in 2017. Clear Panes’ annual fixed costs are$2,750,000 and their variable cost is $90 per window. Global evaluates Clear Panes based on residual income. The total investment attributed to Clear Panes is$12 million and the required rate of return on investment is 16%. Ignore taxes and depreciation expense. Answer each of the following parts independently, unless otherwise stated. 1. What is the expected residual income in 2017? 2. Clear Panes receives an external special order for 10.000 units at $120 each. If the order is accepted, Clear Panes will have to incur incremental fixed costs of$250.000 and invest an additional $450.000 in various assets. What is the effect on Clear Panes's residual income of accepting the order? 3. The window latch Clear Panes manufactures for its windows has a variable cost of$20. An outside vendor has offered to supply the 150.000 units required at a cost of $21 per unit. If the component is purchases outside, fixed costs will decline by$100.000 and assets with a book value of $150.000 will be sold at book value. Will Clear Panes decide to make or buy the component? Explain your answer. 4. One of Clear Panes's regular customers asks for a special window with stained glass inserts. The customer requires 2.500 of these windows. Clear Panes estimates its variable cost for these special units at$105 each. Clear Panes will also have to undertake new investment of $300.000 to produce these windows. What is the minimum selling price that will make the deal acceptable to Clear Panes? 5. Assume the same facts as in requirement 4. Also suppose that the customer has offered$130 for each stained glass window. In addition, the customer has indicated that its purchases of the existing product will drop by 1.500 units. a. What is the net change in Clear Panes's residual income from taking the offer, relative to its planned 2017 situation? b. At what drop in unit sales of the regular window would Clear Panes be indifferent to the offer?
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