Chapter 10 Alternative Financing I Discount Points

Chapter 10 Alternative Financing

I. Discount Points

Discount Points n Before discussing specific alternative financing programs, it is important to explain discount points, often referred to simply as “points. ” n A POINT is one percentage point (one percent) of the loan amount. n For example, with a $100, 000 loan, one point would be $1000; six points would be $6, 000. n DISCOUNT POINTS are used to increase the lender’s yield from the loan without raising the interest rate. n n n NOMINAL RATE EFFECTIVE RATE Keep in mind that discounts are computed based on the loan amount, not the sales price. n Example: $222, 000 sales price $177, 600 loan amount 6% discount $177, 600 loan amount x. 06 $10, 656 discount

A. POINTS IN VA TRANSACTIONS n Payment of discount points has long been a part of most VA loans. n Lenders, then, have traditionally required the seller to pay enough points to increase the lender’s yield on VA loans to a rate that is competitive with conventional loans. n Under VA regulations, the buyer is prohibited from paying any discount points. n Any points required by the lender must be paid by the seller or a third party, such as a builder.

B. POINTS IN CONVENTIONAL LOANS n While the buyer is not prohibited from paying discount points on conventional or FHA loans, in most instances the seller is the one who pays the points as a way of reducing the interest rate to be paid by the buyer. n In effect, this makes the property more marketable. n When the seller (or a third party) pays points to reduce the buyer’s interest rate, it is called a BUY-DOWN. n It is far easier to sell property if the buyer’s interest rate is relatively low and affordable.

C. HOW MANY POINTS? n The number of points to be paid is often computed on the assumption that it takes six points to increase the lender’s yield on a 30 -year loan by 1%. n This is a “rule of thumb” approach to computing yields and should be confirmed with the lender before a final quote is made. n Example: $90, 000 proposed 30 -year loan 11% required yield 10% interest rate preferred by borrower $90, 000 x. 06 $5, 400 discount (usually paid by seller) $90, 000 - 5, 400 $84, 600 advanced by lender after discount $90, 000 note x. 10 nominal rate paid by borrower $9, 000 interest paid by borrower $9, 000 ÷ $84, 600 =. 11 yield to lender

II. Buydown Plans

Buy-Down Plans n One of the easiest and most agreeable ways to make expensive loans less expensive is the “buy-down. ” n The seller, builder, or any other person, including the buyer, makes a lump sum payment to the lender at the time the loan is made. n The money that has been paid to the lender is used to reduce the borrower’s monthly payments either early in or throughout the life of the loan. n The following examples will utilize high interest rates, as these are precisely the sort of market conditions under which buy-downs become popular. n Example: $65, 000 $3, 900 $822 - 770 $52 30 -year, 15% loan buy-down (6 points) quoted 15% loan payment buyer’s payment at 14% savings resulting from buy-down

A. TWO ADVANTAGES TO A BUY-DOWN n There are two fairly obvious advantages to a buy- down plan: 1. The buyer’s monthly payment is lower than normal. 2. The lender evaluates the buyer on the basis of the reduced payment, thereby making it easier to qualify for the loan.

B. PERMANENT BUY-DOWNS n A buy-down can be permanent or temporary. n If a portion of a buyer’s interest rate is permanently bought down (e. g. , for 30 years), the lender’s nominal rate (the rate stated in the promissory note) will be reduced by that amount. n Example: Lender quotes 15% for a 30 -year loan of $65, 000. Builder agrees to buy-down the note rate to 14%. Lender agrees to make the loan at this rate if Builder makes a lump sum payment to Lender of $3, 900 to buy down the interest rate by 1%.

1. How to Compute Permanent Buy-Downs n There are two ways to be completely accurate when determining a permanent interest rate buy-down. n One way is to obtain a discount/yield table booklet from a lender or title company and learn to use it; the other way is to call your lender for a quote.

C. TEMPORARY BUY-DOWNS n When interest rates are high, temporary buy-downs are very popular as a means of reducing a buyer’s payments—sometimes substantially—in the early months or years of the loan. n Many buyers feel they can grow into a larger payment but need time to get established. Temporary buy-down plans take two forms: level payment and graduated payment.

1. Level Payment Buy-Down Plan n A LEVEL PAYMENT BUY-DOWN PLAN calls for an interest reduction that is constant throughout the buy down period. n Example: Lender makes a 30 -year loan for $65, 000 at 15% interest. The seller agrees to buy-down the purchaser’s interest rate to 13% for three years.

2. Graduated Payment Buy. Down Plan n A GRADUATED BUY-DOWN PLAN calls for the largest subsidies in the first year or two of the loan, with progressively smaller subsidies in each of the remaining years of the buy-down period. n Example: Lender makes a 30 -year loan for $70, 000 at 14. 75% interest. Builder agrees to buy-down purchaser’s interest rate by 3% the first year, 2% the second year, and 1% the third year.

3. How to Compute Temporary Buy-Downs n To be 100% accurate, use the yield/discount tables previously mentioned or obtain a quote from your lender. Example: Level Payment Buy-Down $76, 000 loan amount 16. 25% coupon (note) rate 14. 25% subsidized rate (five years) 1. Determine monthly principal and interest without subsidy. $76, 000 x. 0136494 16. 25%, 30 -year interest factor $1, 037. 35 monthly payment without subsidy 2. Determine payment with subsidy. $76, 000 x. 0120469 14. 25%, 30 -year interest factor $915. 56 monthly payment with subsidy

Calculation (cont. ) 3. Subtract subsidy payment from actual payment and multiply by 12 (months). $1, 037. 35 actual payment - 915. 56 subsidized payment $121. 79 monthly subsidy x 12 $1, 461. 48 annual subsidy 4. With a level payment plan, the annual subsidy is constant for the entire buy-down period (in the case of this example, 5 years). So the final step is to multiply the annual subsidy by the number of years in the buy- down plan. $1, 461. 48 annual subsidy x 5 years in buy-down plan $7, 307. 40 total buy-down (subsidy)

III. FNMA/FHLMC Limits on Buydowns

Fannie Mae/FHLMC Limits on Buy-Downs n Fannie Mae and FHLMC guidelines impose limits on discounts, buy-downs, and other forms of contributions by sellers, or other interested parties n Contributions are limited to a percentage of the sales price or appraised value, whichever is less. n If the contributions exceed Fannie Mae and FHLMC guidelines, the contribution amount must be deducted from the value or sales price before determining the maximum loan amount (with the exception of contributions by an employer or immediate family member), which are not subject to these limits. n Example: $100, 000 sales price (principal residence) 105, 000 appraised value 90, 000 90% loan 6, 000 maximum contribution n n

IV. Adjustable-Rate Mortgages

Adjustable Rate Mortgages n Perhaps the most popular and widely accepted form of alternate financing is the adjustable rate mortgage, universally referred to as an ARM. n Because the ARM shifts the risk of interest rate fluctuations to the borrower, lenders normally charge a lower rate for an ARM than for a fixed rate loan. n Although the majority of borrowers prefer the security of a fixed rate, ARMs have maintained a place in the market despite comparatively low mortgage rates. n Generally, as interest rates rise and fall, so does the popularity of adjustable rate mortgages.

A. WHAT IS AN ADJUSTABLE RATE MORTGAGE? n An ADJUSTABLE RATE MORTGAGE (ARM) is a mortgage that permits the lender to periodically adjust the interest rate so it will accurately reflect fluctuations in the cost of money. n ARMs are made primarily by banks and mortgage companies. n The ARM passes the risk of fluctuating interest levels on to borrowers, where many lenders feel it belongs. n With an ARM, it is the borrower who is affected by interest movements. n If rates climb, the borrower’s payments go up; if they decline, the payments go down.

B. HOW DOES AN ARM WORK? n The borrower’s interest rate is determined initially by the cost of money at the time the loan is made. n Once the rate has been set, it is tied to one of several widely recognized and published indexes, and future interest adjustments are based on the upward and downward movements of the index. n An INDEX is a statistical report that is a generally reliable indicator of the approximate change in the cost of money. n At the time a loan is made, the index preferred by the lender is selected, and thereafter the loan interest rate will rise and fall with the rates reported by the index.

Figure 10 -4

C. ELEMENTS OF AN ARM LOAN n There are several elements that give form to an adjustable rate mortgage. They include: 1. 2. 3. 4. 5. 6. 7. 8. the index; the margin; the rate adjustment period; the interest rate cap (if any); the mortgage payment adjustment period; the mortgage payment cap (if any); the negative amortization cap (if any); and a conversion option (if any).

1. The Index n Most lenders try to use an index that is very responsive to economic fluctuations. n Thus, most ARMs have either a Treasury rate (usually one-year) or the cost of funds as an index. n The COST OF FUNDS INDEX (COF) is an average of the interest rates savings and loan associations pay for deposits and other borrowings with a certain range of maturities.

2. Margin n The MARGIN is the difference between the index value and the interest charged to the borrower. n It remains constant throughout the loan term. Example: 9. 25% current index value 2. 00% margin 11. 25% mortgage interest rate (note rate)

3. Rate Adjustment Period n The RATE ADJUSTMENT PERIOD refers to the intervals at which a borrower’s interest rate is adjusted, e. g. , six months, one year, or three years. n After referring to the rate movement in the selected index, the lender will notify the borrower in writing of any rate increase or decrease. n Annual rate adjustments are most common.

4. Interest Rate Cap n Lenders use two different mechanisms to limit the magnitude of payment changes that occur with interest rate adjustments: interest rate caps and payment caps. n If a limit is placed on the number of percentage points an interest rate can be increased during the term of a loan, it is said to be CAPPED. n Today, most ARMs have caps of some kind. n PAYMENT SHOCK results from increases in a borrower’s monthly payments which, depending upon the amount and frequency of payment increases, as well as the borrower’s income, may eliminate the borrower’s ability to continue making mortgage payments.

5. Teaser Rates n To compete, lenders lower the first-year interest rates on the loans they offer and introduce borrowers to discounts and buy-downs. n The low initial rates have subsequently been dubbed TEASER RATES.

6. Fannie Mae and FHLMC Caps n Both Fannie Mae and FHLMC have guidelines relating to ARM interest rate caps. n Most ARMs purchased by Fannie Mae and FHLMC are limited to rate increases of no more than 2% per year and 5% over the life of the loan.

7. Mortgage Payment Adjustment Period n The MORTGAGE PAYMENT ADJUSTMENT PERIOD defines the intervals at which a borrower’s actual principal and interest payments are changed. n It is possible they will not coincide with the interest rate adjustments. n If a borrower’s principal and interest payment remains constant over a three-year period but the loan’s interest rate has steadily increased or decreased during that time, then too little or too much interest will have been paid in the interim. n NEGATIVE AMORTIZATION

Figure 10 -6

8. Mortgage Payment Cap n When there are no limits on the amount mortgage payments can be increased, borrowers are vulnerable to extreme changes in the cost of money. n Inevitably, unrestricted increases would create hardships for many borrowers.

9. Negative Amortization n There has been a dramatic movement away from plans that can result in negative amortization. n This is probably because mortgage plans that provide for, or at least have a possibility of, negative amortization are not as attractive to borrowers as plans that do not permit negative amortization. n In general, today’s borrowers are better informed with respect to adjustable rate loans.

10. Negative Amortization Cap n Negative amortization has to be watched carefully or it could become an unmanageable problem for both the homeowner and the lender. n The current industry practice is to set a limit between 110%-125% of the initial loan balance as a cap. n Bear in mind that negative amortization ceilings can be reached ONLY IF the interest rate increases several percentage points a year, for a number of years, without relief.

11. Periodic Reamortization n As mentioned just above, many ARM loans with a possibility of negative amortization have a maximum cap for the amount of negative amortization. n If the cap is reached, the loan payments are periodically re-amortized to a level sufficient to pay off the loan over the remaining term, without regard to any payment cap that might otherwise apply.

D. CONVERTIBLE ARMs n One of the most popular innovations in ARM loans is the conversion option. n A convertible ARM is one in which the borrower has the right to convert from an adjustable rate loan to a fixed rate loan. n ARMs with a conversion option normally include the following: 1. Higher interest rate (often both the initial rate and the converted rate are higher); 2. Limited time to convert (e. g. , between the first and fifth year); and 3. Conversion fee (typically about 1%).

E. ARM LOAN-TO-VALUE (LTV) RATIOS n ARMs with loan-to-value ratios of 80%, 90%, and 95% are available. n However, higher LTV loans are often subject to some restrictions. n For example, many lenders refuse to make 90% or 95% ARM loans if there is a possibility of negative amortization. n In most cases, borrowers seeking 90% or 95% ARMs will be required to occupy the property being purchased.

F. FHLMC AND FANNIE MAE LTV GUIDELINES FOR ARMs n Loan-to-value ratios may not exceed 90% for ARMs. n The lower loan-to-value requirements are due to the potential risk involved from payment increases when the interest rate is adjusted.

G. DISCOUNTS AND SUBSIDY BUY-DOWNS ON ARMs n Some ARMs have initial interest rate discounts or subsidy buy-downs. n A discounted rate, in this context, means the borrower pays less than the NOTE RATE (index rate plus margin) prior to the first interest rate adjustment. n The discounted rate is frequently referred to as a teaser rate. n Loans with a subsidy buy-down reduce the borrower’s initial rate by payment of funds in advance. n The subsidy buy-down is usually paid by the seller. n The probability that payment shock will occur is increased, because a payment increase after the first adjustment period is almost inevitable, even if there has been no increase in the value of the index in the interim.

H. HOUSING EXPENSE-TOINCOME RATIOS ON ARMs n ARMs with no rate or payment caps have the potential for large increases in the ratios. n Likewise, loans with rate discounts or subsidy buy-downs that exceed 2% add to the chances of significant payment shock. n When ARMs are made with these features, secondary market investors, and many private mortgage insurance companies, are insisting that the traditional housing expense-to-gross income and total monthly debt payment-to-income ratios of 28% and 36% be disregarded in favor of lower, more conservative ratios.

I. APPRAISALS ON PROPERTIES SECURED BY ARMs n Because ARMs introduce additional elements of risk to mortgage lending, many lenders adhere more strictly to their underwriting guidelines when evaluating an application for an ARM. n A lender is particularly likely to review the appraisal for an ARM with special care. n When underwriting an ARM, the underwriter will review the appraisal report very closely to determine if the appraiser has performed this analysis satisfactorily.

J. ARM STANDARDIZATION n The widespread acceptance of ARMs represents a major evolutionary phase in the housing industry. n Uniform ARM underwriting standards have since been adopted and the secondary market agencies are now purchasing ARMs on a large-scale basis. n Originally, lenders were underwriting ARMs on the basis of their own standards and were largely keeping them in portfolio. n With standardization, lenders follow secondary market guidelines and resell ARMs just as they do fixed rate loans.

K. ARM DISCLOSURE n Lenders offering adjustable rate mortgages must comply with the Federal Reserve’s guidelines under Regulation Z of the Truth in Lending Act requiring certain disclosures to be made to ARM borrowers. n Disclosures must be provided to the borrower when the loan application is made or before payment of any nonrefundable fee, whichever occurs first.

The following disclosures must be made, if appropriate, to the individual loan program applied for: 1. The index used to determine the interest rate. 2. Where the borrower may find the index. 3. An explanation of how the interest rate and payment will be determined. 4. A suggestion that the borrower ask the lender about the current margin and interest rate. 5. If the initial rate is discounted, a disclosure of that fact and a suggestion that the borrower inquire as to the amount of the discount. 6. The interest and payment adjustment periods. 7. Any rules regarding changes in the index, interest rate, payment amount, or loan balance (including an explanation of any caps, a conversion option, or the possibility of negative amortization). 8. An explanation of how to calculate the payments for the loan. 9. A statement that the loan has a demand feature (that is, a “call” provision or acceleration clause). 10. A description of the information that will be included in the adjustment notices and when those notices will be provided. 11. A statement that disclosure forms are available for the lender’s other ARM programs.

L. WHAT YOU NEED TO KNOW ABOUT ARMs n As an agent, you must always be prepared to answer buyers’ and sellers’ questions. n When it comes to ARM financing, it would be reasonable to expect the following questions: 1. What Will My Interest Rate be? 2. How Often Will My Interest Rate Change? 3. How Often Will My Payment Change? 4. Is There Any Limit to How Much My Interest Rate can be Increased? 5. Is There Any Limit to How Much My Payment can be Increased at Any One time? 6. What is the Probability of Runaway Negative Amortization? 7. Can My ARM be Converted to a Fixed Rate Loan?

V. The Growth Equity Mortgage

The Growth Equity Mortgage (GEM) n Sometimes called a building equity mortgage (BEM) or rapidly amortizing mortgage (RAM), the GEM solves many of the problems that have limited the appeal of ARMs. n Still, today it enjoys only limited public acceptance. n Though there are numerous variations of the growth equity mortgage, all of them share the following characteristics: 1. The interest rate is fixed over the life of the loan. 2. First year payments of principal and interest are based on a 30 -year term. 3. The borrower’s payments are increased at specified intervals (usually annually) for all, or a portion of, the life of the loan. 4. Because the interest rate is fixed, 100% of the annual payment increases are used to reduce the principal balance.

A. DETERMINING ANNUAL PAYMENT ADJUSTMENTS n There any number of annual payment adjustment plans, but by far the most popular method is to increase the payments by a fixed percentage—typically 3% or 5%. n Example: $86, 000 loan at 10. 25% (fixed rate) based on a 30 -year term. Payments to be increased 3% annually. $86, 000 x. 0089610 10. 25%, 30 -year factor $770. 65 initial monthly payment n In the example above, the borrower’s payments are increased by 3% each year, and the entire increase is always applied to the loan balance.

B. EQUITY BUILDS UP QUICKLY n Because payment increases are used to reduce the mortgage debt, a borrower will pay off a GEM much sooner than a 30 -year fixed rate mortgage. n If payments are increased 3% per year on a 15% loan, the entire debt will be retired in 13 years and 7 months; with 5% annual increases, the same loan will pay off in just 11 years and 4 months. n A GEM’s repayment term is dependent on the interest rate and the magnitude of the annual payment increases.

Figure 10 -7

C. PAYMENTS ARE PREDICTABLE n The borrower’s payments will increase annually, but unlike adjustable rate mortgages that are tied to an index, the amount of the annual increase is known at the outset of the loan.

D. NO NEGATIVE AMORTIZATION n To the contrary, with a GEM, there is accelerated positive amortization.

E. REDUCED INTEREST COSTS n A GEM borrower will pay less than half the interest he or she would pay with a traditional 30 -year, fixed rate mortgage.

F. SIMPLICITY OF LOAN n In contrast to ARMs, the GEM is easy to understand explain. There is little doubt buyers are reluctant to commit to a major debt, like a home loan, if they do not understand how it works.

G. LOWER-THAN-MARKET INTEREST RATE n Very often lenders are willing to make GEM loans at lower-than- market rates because they will recapture the principal so quickly. n Recaptured principal can be reinvested at competitive market rates. n The lower-than-market rate makes it easier to qualify for the loan.

VI. Reduction Option Mortgage

Reduction Option Mortgage n A REDUCTION OPTION MORTGAGE is a fixed rate loan that gives the borrower a limited opportunity to reduce the interest rate without paying refinancing costs. n For example, on a 30 -year reduction option mortgage, the borrower might be given the option of reducing the interest rate once, at any time during the second through fifth years of the loan term. n There might be some additional limitations; for example, the borrower might not be allowed to exercise the option unless market interest rates had declined at least 2%. n If the borrower chose to exercise the option, the lender would charge a processing fee, usually in the neighborhood of a few hundred dollars. n Interest rates for reduction option mortgages tend to be slightly higher than for fixed rate loans without the reduction option.

VII. Biweekly Loans

Bi-Weekly Loans n A BI-WEEKLY LOAN is a fixed rate mortgage set up in a fashion similar to a standard 30 -year conventional loan. n Both interest rate and payments are fixed. n However, payments are made every two weeks instead of every month. n Bi-weekly loans offer significant savings over the life of a loan. n For example, if a $70, 000 loan at an interest rate of 10. 5% is paid on a bi-weekly schedule, instead of a monthly payment plan, the borrower would save approximately $60, 000 in interest. n Because payments are made every two weeks (not twice a month), 26 payments are made each year (i. e. , the equivalent of an extra monthly payment is made each year). n Bi-weekly loans are generally paid off in approximately 20 to 21 years, instead of 30 years.

VIII. Home Equity Conversion Mortgages

Reverse Mortgages n Reverse mortgages are designed to help elderly homeowners achieve financial security by converting their home equity into cash. n A reverse mortgage borrower generally must be over age 62 and own a home with little or no outstanding mortgage balance. n The most basic reverse mortgage is the TERM LOAN, which provides monthly advances for a fixed period of time (generally three to 12 years). n At the end of the period, all principal advances, plus interest, are due. n n n SPLIT TERM LOAN TENURE LOAN LINE OF CREDIT LOAN

IX. Shared Appreciation Mortgages

Shared Appreciation Mortgages n With a Shared Appreciation Mortgage (SAM), the lender gives you a reduced interest rate in return for sharing the appreciation of equity in your home with you. n The rate reduction in the past has been as much as 2% and the lender wants anywhere from 25 -50% of the equity in your home. n These loans often have prepayment penalties that do not allow the borrower to get out from under an adverse turn in the market. n This loan could be a good deal for a borrower if interest rates are increasing and the home is held through a period of declining home values. n This type of mortgage could have been a very bad choice for a borrower in the past few years in California.

X. CHAPTER SUMMARY n Alternative financing programs were originally developed in the 1980 s to meet the dual challenges of higher home prices and higher interest rates. n In order to make it easier for borrowers, many of these alternate financial plans involve the payment of discount points, temporary buy-downs, or permanent buy-downs to reduce the borrower’s interest or lower the payments. n Borrowers contemplating applying for an ARM should be made aware of the following important elements: the lender’s index for adjusting the interest rate, the lender’s margin above the index rate, rate and payment adjustment periods, the possibility of negative amortization, whethere is an option to convert to a fixed rate loan, and whethere any periodic or lifetime caps on the interest rate.