Chapter 5 - Consumer lending and mortgages

Question 1

What are the two main reasons to borrow money?

Answer 1

Two common reasons are to purchase goods or services they could not otherwise afford and to invest the borrowed funds to increase their standard of living.`

Question 2

What are the 5 advantages to consumer credit?

Answer 2

• It reduces the need to carry large amounts of cash.
• It simplifies payment for diverse purchases, and in some cases extends the manufacturer’s warranty.
• It can be used for cash flow planning by providing a monthly statement that allows expenses to be monitored.
• It allows the borrower to take advantage of bargains when cash is limited.
• It can provide a temporary fund for emergencies (e.g., drawing money from a personal line of credit).

Question 3

What are the 3 disadvantages of consumer credit?

Answer 3

• It increases the temptation to spend as soon as credit is available, rather than saving for or forgoing a purchase that one cannot immediately afford.
• It may lead to the impulsive purchase of items that are not needed.
• If credit is used to its maximum, its use as an emergency reserve is nullified.

Question 4

What are the 8 forms of consumer credit?

Answer 4

overdraft

credit card

charge account

PLOC

Personal loan

demand loan

residential mortgage

Home equity line of credit (HELOC)

Question 5

WHat is overdraft?

Answer 5

Is not normally thought of as a loan, but, nevertheless, it is a form of consumer credit. Specifically, it is an unsecured credit facility that allows a client to overdraw a chequing account up to a pre-determined limit. The purpose of an overdraft is to ensure that authorized transactions are not declined because of insufficient funds. Usually charges 21% or more + a fee per use.

Question 6

WHat is a credit card? What are the two main issuers of credit cards?

Answer 6

• A credit card is an open, revolving form of loan typically used by clients to make immediate purchases. Credit cards offer various options to meet the particular needs of different clients.

There are two common types of credit cards available: those issued by financial institutions (and some finance companies) and those issued by retailers.

Question 7

What is a charge account?

Answer 7

These accounts are a type of revolving credit, meaning that the borrower can re-borrow. However, the balance owing must be repaid in full within a specified time, typically 30 days. Some retailers allow instalment payments, with interest accruing on unpaid balances. Features and rates vary, including credit limits and minimum use requirements.

Question 8

WHat is a personal line of credit (PLOC)? What are the two types of PLOC?

Answer 8

• is an open, revolving loan that allows clients to re-borrow funds (up to an available limit) without having to re-apply for the loan. An LOC normally requires a minimum monthly repayment (often interest only) at the end of a 30-day period. The interest rate is applied to the amount drawn from the LOC. The rate is based on two factors: the bank’s prime rate (which fluctuates regularly) plus a certain number of basis points to account for borrower risk.
• An LOC can be either secured or unsecured

Question 9

What is a secured PLOC? what is an unsecured PLOC?

Answer 9

 Secured LOC. Is guaranteed by an underlying asset of unchanging value that can be liquidated to reimburse the outstanding debit of the borrower defaults on repayment. . A secured LOC receives a preferential interest rate compared to one that is unsecured.

 Unsecured LOC. Opposite of secured loc.

Interest starts on day loan is withdrawn.

Question 10

What os a personal loan?

Answer 10

• A personal loan is a type of instalment loan with a fixed term, which is the set time by which the funds borrowed must be repaid in full. Although the amounts borrowed can be large, the risk associated with this type of loan is often lower. Traditionally, a lien is taken over the asset purchased with the loan proceeds.

either fixed or variable rate

Usually offered for specific purchases, like a car. There is no assets attached. Thus, the higher interest rate.

Question 11

What is a demand loan?

Answer 11

• short-term loan granted with plenty of collateral. The interest rate is variable, and full repayment may be demanded by the lender at any time. Likewise, the borrower can repay the loan in full at any time, without penalty, upon written notice.

This type of loan is commonly used in real estate transactions to fund the down payment on a new property while the buyers wait for the sale of their existing property.
 When used this way, the loan is known as bridge financing. Such loans are offered by most banks subject to certain terms and conditions. They must be supported by a letter of undertaking and a copy of the firm sale agreement of the sold property.

Question 12

What is a residential mortgage?

Answer 12

• A residential mortgage is a contract between a lender (the mortgagee) and a borrower (the mortgagor), in which the lender extends credit to help the borrower pay for a property. The loan amount is based on the value of the property and the borrower’s ability to repay the loan. In return, the borrower grants the lender a claim (called a lien) on the property as security for the debt.

Question 13

What is a home equity line of credit (HELOC)?

Answer 13

• is a borrowing facility linked to the available equity of an existing property. A HELOC allows a borrower to borrow funds in the form of an LOC or mortgage, or a combination of both. Some financial institutions also allow for the inclusion of a credit card and overdraft. We explore this product in more detail later in this chapter.

Question 14

Decisions to grant credit, whether for personal loans, credit cards, or home mortgages, are generally all made on the basis of what two factors?

Answer 14

affordability and credit history

Question 15

granting credit.

affordability. What factors go into this? What test do they have to pass?

Answer 15

When determining mortgage affordability, financial institutions consider borrowers’ present and future ability to handle their financial obligations.

They calculate two debt service ratios that determine the amount of debt that borrowers can afford to carry.

In addition, the borrowers must pass a stress test, which calculates their ability to pay debt if interest rates climb higher than the current average.

Question 16

granting credit.

Credit history. WHat is the primary method used for assessment?

Answer 16

• Clients’ success in obtaining credit depends on their financial situation and the way they present their situation to the lending institution.

the five C’s.

Question 17

What are the 5 C’s? WHat are they defined as?

Answer 17

character

capacity

credit

collateral

capital

Question 18

the 5 C’s.

collateral

Answer 18

• refers to property that can be used to secure a loan. Lenders may require collateral as security if the loan is substantial relative to the client’s net worth. If the loan is in default, the assets pledged as collateral are liquidated to provide for repayment of the loan.

Question 19

the 5 C’s.

Character

Answer 19

• refers to the client’s honesty, reliability, repayment history, and intention to repay the credit. Character is assessed based on the client’s existing level of assets and debt, employment record, residence stability, and purpose for the loan. Accurate assessment relies on full disclosure by the client.

Question 20

the 5 C’s.

capacity

Answer 20

• refers to the client’s ability to repay the loan. Capacity is assessed based on the client’s current income, job stability, assets, and future considerations.

Question 21

the 5 C’s.

credit

Answer 21

• refers to the client’s past credit history, which the lender considers an indicator of how debt may be handled in the future. Credit assessment is determined by the client’s current use and availability of existing credit, payment history, delinquencies, and any records of outstanding judgments.

Question 22

the 5 C’s.

capital

Answer 22

• refers to net worth and is based on the client’s total assets and general financial situation. Capital is viewed as an extension of the client’s character, an indicator of their financial management skills, and a source of collateral. A high score in this category can indicate that the client has a secondary source of funds for repayment in case their regular income is disrupted.

Question 23

What are the four pieces of information found on a credit report? WHat do they entail?

Answer 23

1. Personal information
   – Name, current address, previous address, current employer, employment history, and other personal information
2. Account history
   – A list of all current and previous creditors and a score related to payment history
3. Inquiries
   – A record of anyone who has requested the credit report in the past few years, either for credit or employment purposes
4. Public record information
   – Information regarding legal judgments, civil actions, liens, or bankruptcies

Question 24

What is a credit score? What is the highest and lowest? What is an average score? WHat is needed to get a mortgage?

Answer 24

Credit-reporting agencies provide a credit score, also known as a beacon score, that is a numerical value based on a statistical analysis of the borrower’s information.

All the information contained in a credit report is translated into the credit score, which is a three-digit number ranging between 300 and 900 (or zero, if the client has no credit history). An average credit score is around 650.

A score between 620 and 680 is generally required to qualify for a mortgage from major financial institutions

Question 25

WHat are the two divisions of the mortgage marketplace?

Answer 25

the primary market for mortgage funds, and the secondary market where debt instruments are bought and sold

Question 26

primary mortgage market.

What are the three main mortgage lenders?

Answer 26

chartered banks, credit unions, and financial cooperatives.

Question 27

primary mortgage market.

Chartered banks

Answer 27

Concentrate on loans for single-family housing. Because of their vast pool of funds and extensive branch system, they have a large portion of the market share.

Question 28

primary mortgage market.

Credit unions and financial cooperatives

Answer 28

share a spot in the market second only to chartered banks. They have traditionally served small groups such as the employees of a single workplace. They are viewed as competitors to the chartered banks.

Question 29

primary mortgage market.

The 5 others.

Answer 29

1. Trust companies.
2. Life insurance companies
3. pension funds
4. mortgage investment corporation (MIC)
5. Canada mortgage and housing corporation (CMHC)

5.1 CMHC-Insured mortgages

Question 30

The bank act.

Who monitors the banks?

Answer 30

Banks are regulated under the Bank Act and related legislation. Compliance is monitored by the Office of the Superintendent of Financial Institutions (OSFI).

Question 31

the bank act.

What is the LTV?

Answer 31

The Bank Act restricts mortgage loans to an 80% loan-to-value (LTV) ratio, which means that the loan can consist of no more than 80% of the property’s value. A higher LTV may be permitted if the loan proceeds above 80% are NHA insured.

Question 32

the secondary mortgage market.

What occurs on the secondary mortgage market?

Answer 32

The secondary mortgage market is where existing mortgages and blocks of mortgages held by lenders are bought and sold. The original holders of the mortgages, such as banks or trusts, sell these investments to pension funds, private investors, or other institutions. Lenders sell mortgage holdings as part of the process of managing their capital investments and cash flows, as well as to maintain profitability and corporate liquidity. Mortgage loans allow institutions to earn a profit on the spread between deposit rates and mortgage rates.

Question 33

The secondary mortgage market.

What kind of returns do the secondary mortgage market provide? What would an investor in this market be looking for?

Answer 33

The purchasers of blocks of mortgages seek secure income streams and profitable long-term investments. NHA insured mortgages trade near the level of government bond interest rates because the market considers them to be low-risk obligations of the federal government. In many cases, those who sell the mortgages continue to manage the loans for a fee, and the mortgagors are unaware that the ownership of the mortgage has passed into other hands.

Unlike bonds or stocks, mortgages are not a homogenous product. The underlying security on mortgages is real property, which is inherently illiquid. And, because financial institutions offer negotiable prepayment terms, the repayment stream is unpredictable. However, the growth in financial products has resulted in a corresponding growth in asset and liability matching tools for lenders. One such tool is the mortgage-backed security (MBS). Mortgage-backed securities are fixed-rate investments that represent an ownership interest in pools of mortgages that have been securitized – that is, grouped together and resold to institutional and private investors. One type of MBS is a pool of residential mortgages secured by CMHC.

Question 34

When deciding how much one can afford to spend when buying a home, what are the 6 key financial factors that must be considered?

Answer 34

• LTV ratio (loan-to-value)
• Debt service ratios
• Mortgage stress test
• Term and amortization
• Interest rate
• Fees incurred in buying the property

Question 35

1. LTV – Loan-to-value ratio

What is it?

Answer 35

Represents the relationship between the amount of the mortgage loan made by the financial institution and the value of the property purchased. It is calculated by dividing the amount of the loan by the value of the property purchased and is expressed as a percentage (e.g., 80%).

Question 36

1. LTV – Loan-to-value ratio

What are the two structures that the Bank Act requires the funds borrowed for mortgages.

Answer 36

With a conventional mortgage, the borrower provides a down payment of 20% or more of the property’s value. Mortgage loan insurance is not normally required.

With a high-ratio mortgage (or insured mortgage), the borrower usually provides a down payment of less than 20% of the purchase price. This type of mortgage requires the borrower to obtain mortgage loan insurance to reduce the risk of the debt to the lending institution. The borrower must pay fees for the mortgage loan insurance.

Question 37

1. LTV – Loan-to-value ratio

The example and the purchase price to downpayment

Answer 37

• Purchase price = 500K –> Min down-payment = 5%
• Purchase price = 501k-999k –> min. down-payment = 10% ABOVE 500k
• Purchase price = 1M –> min. Down-payment = 20% of the purchase price
• Ex. A property’s purchase price is $650,000. The minimum down payment is $40,000, which is calculated as follows: * The minimum required down payment on the first $500,000 is 5%, or ($500,000 × 0.05) = $25,000 * The minimum required down payment on $150,000, the remaining amount over $500,000, is 10%, or ($150,000 × 0.10) = $15,000 So, in this example, the minimum down payment required is 6.15% ($40,000/$650,000).

Question 38

2. Debt service ratios

What is the debt service ratio and what are the two ratios used?

Answer 38

o The maximum mortgage that a lending institution will allow a borrower to carry is based on two ratios: the gross debt service ratio (GDS ratio or GDSR) and the total debt service ratio (TDS ratio or TDSR).

Question 39

2. Debt service ratios

a. gross debt service ratio

Answer 39

a. Gross debt service ratio
 The GDS ratio is a standard measure of creditworthiness. It considers only the expenses (including debt payments) directly associated with the property being purchased. This ratio is calculated on a monthly or annual basis.
 To calculate the GDS ratio, the following shelter related costs are added together and divided by the gross family income: * Mortgage payments * Property taxes * Heating costs * 50% of any condominium fees Ideally, the GDS ratio should not be above 32%.

Question 40

2. debt service ratios

b. total debt service ratio

Answer 40

b. Total debt service ratio
 The TDS ratio is closely linked to the capacity principle from the Five Cs of credit. Whereas the GDS ratio considers only the expenses and debt directly associated with the property being purchased, the TDS ratio considers all debts. It is calculated on a monthly or annual basis as a sum of the following elements, where applicable, divided by the gross family income:
* Mortgage or rent payments
* Property taxes
* Home heating costs
* Condominium fees (50%)
* Minimum required debt payments
 In brief, the TDS ratio includes shelter costs and the client’s total debt repayment load. The maximum TDS ratio is generally 40%.

Question 41

3. the mortgage stress test