LO 3.3.5: Analyze a situation to develop appropriate financing stategies.

Question 1

What is the most significant cost of a mortgage

Answer 1

The interest payable on the outstanding principal, which is based upon a stated interest rate

• Home mortgage interest rates are influenced by the prevailing level of long-term interest rates in the economy
• • Reflect inflationary expectations
• • Amortized: beginning payments go toward interest (banks get their interest first); latter payments go toward principal.
• • Rates by lender vary, borrower should shop

Question 2

What are the additional costs (other than interest) on a mortgage

Answer 2

Additional mortgage costs include:

• 1). loan origination fees,
• 2). appraisal fees,
• 3). credit reporting costs,
• 4). title search costs,
• 5). and points.

Question 3

What is a point

Answer 3

A point equals 1% of the amount borrowed [1% of the loan balance] and is essentially a fee charged by the lender in exchange for a lower interest rate. (121)

Question 4

What are the tax implications of home ownership

Answer 4

Points paid are generally income tax deductible for the buyer of a home, up to a certain level of mortgage debt

• Interest on mortgages used for home purchase or substantial improvements can be considered an itemized tax deduction, up to specific limits
• Capital gains on the sale of a home are taxed under only certain circumstances.

Question 5

Home mortgage

Answer 5

Most widely used long-term installment loan

Question 6

Mortgage

Answer 6

The borrower (mortgagor) gives the lender (mortgagee) a lien on property as security for the repayment of the mortgage

Question 7

Lien

Answer 7

Legal right to repossess the property, which serves as collateral if borrower defaults
* When borrower/mortgagor repays loan, mortgagee removes the lien.

Question 8

Loan-to-value (LTV) ratio

Answer 8

• A key characteristic of a mortgage loan
• The percentage of the value of the collateral real estate that is loaned to the borrower.
• • The lower the LTV, the higher the borrower’s equity- for a lender, loans w/lower LTV are less risky bc the borrower has more to lose in the event of default (so less likely to default)
• • Lenders also favor high property values when compared to the loan amount; this means the lender is more likely to recover the amount if borrower defaults (prompting the lender to repossess and sell the property)
• • Consider conversely— the higher the LTV, the lower the borrower’s equity.

Question 9

Prime loans

Answer 9

Mortgages made to good credit borrowers with high LTV (lower borrower equity) in the U.S.

Question 10

Subprime loans

Answer 10

Mortgages made to lower credit quality borrowers with a high LTV (lower borrower equity/lower-priority claim to the collateral in event of default) in the U.S. (121)
* Also related to jumbo loans (above dollar limit of Fannie Mae and Freddie Mac with damaged credit) (122)

Question 11

Key characteristics of mortgage loans include

Answer 11

• 1. maturity,
• 2. the determination of interest charges,
• 3. how the loan principal is amortized,
• 4. the terms under which prepayments of loan principal are allowed, and
• 5. the rights of the lender in the event of default by the borrower. (121)

Question 12

Federal Housing Administration (FHA) Loans

Answer 12

Federal government guaranteed through various FHA programs
* Appeal to buyers who may not meet financial underwriting requirements for a conventional home loan (i.e., 15- or 30-year fixed mortgage or adjustable-rate mortgage)

Question 13

Key features of FHA loans

Answer 13

Key features of Federal Housing Administration Loans:

• • very low initial down payment,
• • lower interest rate (sometimes, bc fed’t gov guarantee)
• ** Guarantee = if borrower defaults, the FHA will buy the loan from the lender.

Question 14

Mortgage insurance

Answer 14

A policy that protects lenders against losses that result from defaults on home mortgages
* FHA requirements include mortgage insurance, primarily for borrowers making a down payment of less than 20% (down payment of <20% = majority loan/minority equity = low equity = high LTV)

Question 15

Veterans Administration (VA) Loans

Answer 15

• AKA. VA mortgages
• Federal guarantee of repayment for service members and veterans of U.S. armed services, their spouses, and other eligible beneficiaries.

Question 16

Key features of VA loans

Answer 16

• No initial down payment required
• The entire purchase can be borrowed (high Loan-To-Value)
• No mortgage insurance is required (the VA does not require the borrower to put >20% down).

Question 17

Conventional mortgage

Answer 17

Issued by commercial lenders in the private sector

• AKA. conforming loans
• • Because they conform to Fannie Mae and Freddie Mac dollar limit requirements
• • Example: 2019, a single-family home in Alaska had a conforming loan limit of $484K

Question 18

Jumbo loans

Answer 18

Loans above the conforming loan limits ($484K dollar limit) by Fannie Mae and Freddie Mac.

• AKA. nonconforming loans
• AKA. subprime loans — higher down payment and/or higher interest rate requirements
  
  • Loans for those with damaged credit.

Question 19

Fixed-Rate Mortgages

Answer 19

have a level interest rate for the term of the loan and a fixed payment amortization schedule

Question 20

What is an amortization schedule

Answer 20

Details the portion of each payment allocated to interest and principal.

Question 21

What kind of mortgage should a client with stable cash flow and wants a predictable mortgage payment each month choose

Answer 21

“A client

• who has a stable cash flow (and anticipates one in the future) and
• who wants to have a predictable mortgage payment each month
• should choose a conventional fixed 15- or 30-year mortgage,
• for which the principal is completely paid off at the end of the term.” (122)

Question 22

30-year vs. 15-year mortgage

Answer 22

• 30-year mortgage will have a lower payment

* 15-year mortgage usually has a lower interest rate/less interest paid over life of loan

Question 23

Adjustable-rate mortgages (ARMs)

Answer 23

interest rate and payment may change every month, quarter, year, three years, or five years

• changes are usually tied to a specific index e.g., LIBOR
• many have a cap that limits how much the interest rate, and the monthly payment can change
• ARMs can allow for negative amortization to occur

Question 24

Negative amortization

Answer 24

When the agreed-upon monthly payment is less than the accruing interest charges and unpaid interest is added to the mortgage balance, increasing the debt
** When the monthly payment is less than the growth in interest, the unpaid interest is added to the principal balance.

Question 25

What type of client may want to consider an ARM

Answer 25

A client who wants lower initial monthly payments and does not anticipate remaining a home for a long time.

Question 26

Interest-only mortgage

Answer 26

• short-term homeowner tries to keep the mortgage payment at a minimum
• Hoping the FMV of the home will increase, so the principal amt will be paid off by the sale proceeds
• If the value of the home declines from its original purchase price, homeowner may be in a cash-deficit position after resale
• TF, interest-only mortgages should be executed only by risk-aggressive homeowners
• • The homeowner plans to only pay interest, and then sell the property to cover the principal; but if the home value is less after the homeowner resells, they could end up in a cash deficit.

Question 27

Balloon Mortgages

Answer 27

Borrower makes fixed payments, based on established interest rate of long-term mortgage

• Pmts only made for short duration- 5 or 7 years, borrower must then pay off remainder as lump sum
• Payments may be limited to interest only

Question 28

Key features of a balloon mortgage

Answer 28

• Favorable rate to 30-year mortgage- shorter time frame
• • shorter time frame for repayment
• • smaller risk to the lender of a variance in the prevailing rates
• Although the balloon payment may force refinance at higher interest rates
• • a balloon mortgage may be appropriate for borrowers who play to sell their homes before the fixed payment period is over
• This is a calculated risk that could have severe consequences.

Question 29

What type of client may want to consider a balloon mortgage

Answer 29

• A balloon mortgage works well
• • for clients purchasing homes during high interest rate periods
• ** and want to refinance when rates drop
• • for those with enough invested assets buy/finance house without borrowing
• • those who have access to family loans when the period ends and rates have not dropped (so they have to pay off the balloon payment with family loans, instead of refinancing at a higher rate)

Question 30

Graduated Payment Mortgage

Answer 30

• Payable over long time period e.g. 30 years
• Fixed-rate
• Payments are lower in first few years (sometimes increase annually)
• Then, they adjust to a higher payment that continues for the remainder of the loan

Question 31

Who is a graduated payment mortgage appropriate for

Answer 31

• People who anticipate increase in income with some certainty
• Enabling them to afford a higher pmt in the future
• Upside is this may qualify some for a mortgage that they could not have qualified
• Downside is negative/reverse amortization possibility (owing more money upon sale)

Question 32

Disadvantages of a graduated payment mortgage

Answer 32

• higher pmts during second period (vs. standard fixed rate)
• higher interest costs, and
• negative equity accumulation in the early years of the loan
• • reverse amortization/negative amortization
• • pmts are not enough to pay interest due

Question 33

Reverse mortgages

Answer 33

• The house is paid off and used as an income source/loan for a retiree; the loan is paid off by selling the home.
• Gives senior citizens with limited income ability to stay in their homes
• Payment stream is reversed—lender pays homeowner secured by equity in the home
• The lender makes payments based on age of borrower at the time the loan is made
• Retirement planning; available to age 62 or older with a residence free from indebtedness (required percentage owned based on the homeowner’s age)
• Once the homeowner no longer occupies the property (e.g. death or nursing home), the debt must be repaid to the lender, usually by selling the home.
• Less risk bc reverse mortgages are a nonrecourse loan — the homeowner, or homeowner’s heirs, never have to pay back more than the value of the home.
• If a borrower goes into a nursing home and sells the house to repay the reverse mortgage, any extra cash proceeds may cause a loss of medicaid eligibility.

Question 34

Refinancing a home

Answer 34

Common reason: take advantage of declining rates

• Lower monthly payments, decrease repayment period, or both, reducing interest costs
• Gives owners ability to free up some equity in their homes
• Original mortgage paid off by funds from new loan
• A new appraisal may be necessary

Question 35

What should the client consider when deciding whether to refinance

Answer 35

When evaluating whether to refinance:

• Consider additional costs and compare with benefits of refinancing
• Length of time client expects to own the home—costs for refinancing are less if client plans to own home for a long time and can offset costs w/lower payment

Question 36

How do you determine the payback period for refinancing

Answer 36

To determine payback period for refinancing = Total Closing Costs / Monthly Savings

Question 37

What is the most common refinancing pitfall

Answer 37

Common refinancing pitfall: continually refinancing to a 30-year term

• Extends time frame of mortgage by continually refinancing
• Refinance to a term similar to the original payoff date.

Question 38

What value can planners add to client’s mortgage loan process

Answer 38

• Discuss all aspects of refinancing with them so they are able to make a well-informed decision
• The decision should consider:
• • interest rate,
• • loan term,
• • additional fees and costs,
• • and the option for clients to take cash out of the loan to determine if refinancing is in their best interest

Question 39

Home Equity Loans and Lines of Credit

Answer 39

Essentially second mortgages that use current equity to provide money for home improvements or other purposes

Question 40

Home equity loan

Answer 40

• 10-year installment loan; receives a lump sum in the amt of the loan
• Borrowers repay with equal monthly payments over fixed term

Question 41

Home equity line of credit (HELOC)

Answer 41

• Provides a set of amount of credit from which funds may be withdrawn as needed
• Borrowers make payments only on amount they borrow, not full amount available (2-3% of amount borrowed)