Other Types of Loans Flashcards
Let’s start by talking about interest-only loans.
An interest-only loan, also known as a straight loan or term loan, is a type of balloon-payment loan that calls for periodic payments of interest.
So, monthly payments go towards paying only the loan’s interest and not to both interest and the principal. Once the loan term is up, a balloon payment of the entire principal will come due.
Who Uses Straight Loans?
These loans are generally used for home improvement loans, second mortgages, and investor loans rather than for residential first mortgage loans.
But it’s not unheard of for a residential borrower to get an interest-only loan. One way an interest-only residential loan would make sense would be if the borrower expected strong appreciation of the property over the short term they planned to own it. That way, when they sell the property, the borrower will pay off the loan principal in full and get to keep the remaining funds from the sale.
This is a risky proposition, but it might make sense in a hot market. Just beware: If the property doesn’t appreciate in value over time, the borrower could end up with less in proceeds on the sale than what they need to pay off the loan.
A Fannie Mae-backed interest-only loan requires a 30% down payment, at least a 720 credit score, and a 24-month cash cushion.
Straight Loans (Interest-Only Loans)
A balloon-payment mortgage is not fully amortizing. It has a short term, usually five or seven years. But the payments are based on a longer term, as if the term were 30 years, for example. At the end of the loan’s term, the often-large remaining balance of the mortgage is due as a lump sum (a balloon payment). At this time, the borrower can refinance this amount (if they qualify).
Some balloon mortgages have a conversion option that allows the borrower to convert the remaining balance to a 25- or 23-year fixed-rate mortgage, based upon the term of the balloon mortgage. The conversion option usually provides for a rate slightly higher than that of fixed-rate mortgages.
While balloon payment mortgages are more common in commercial transactions, they can be used in residential sales. An example of a balloon payment mortgage is the seven-year Fannie Mae Balloon, which features monthly payments based on a thirty-year amortization, with the remaining principal due after seven years.
Advantages of a Balloon-Payment Mortgage
You may wonder why someone would want to take out a balloon mortgage. Well, I’ll give you three reasons why:
It typically has an interest rate that is 0.25% to 0.5% less than comparable fixed-rate mortgages.
Those who plan to sell their homes after five or seven years are in an excellent position to take advantage of this rate reduction. It could also work to a buyer’s advantage if they plan to refinance before the loan term is up.
The lower rate gives borrowers increased purchasing power because their housing expense is lower and they qualify for larger loans.
Balloon-Payment Mortgages
Graduated-payment mortgage (GPM) is a blanket term for a family of loans characterized by low initial payments that increase (or “graduate”) at set intervals and by set amounts during the term of the loan. Payment amounts usually increase anywhere between 7.5% and 12.5% annually until reaching a fixed amount that continues for the rest of the term.
GPMs were originally designed to entice first-time homebuyers into the mortgage market. In theory, a young borrower who expects their income to increase in the coming years may purchase a house with a GPM whose graduated payments they expect to be able to meet in the future as their income increases. In practice, however, GPMs have fallen out of favor with many lenders because the paperwork and underwriting considerations are more difficult, and because they carry a higher rate of default.
Nevertheless, some lenders continue to offer GPM plans to interested and qualified borrowers. GPMs are attractive to some lenders because they typically have market interest rates 0.5% to 0.75% higher than comparable fixed-rate loans. Borrowers who can’t qualify for a fixed-rate loan may qualify for a GPM on the basis of the lower initial payments. GPMs can make sense in rapidly appreciating areas, because the increased payments go along with an increase in the value of the property.
Negative Amortization
Some GPMs negatively amortize because the initial payments are not enough to cover all the interest due. This interest becomes compounded into the principal, causing even more interest to be due at the next payment period. However, not all GPMs have this feature. Some loans may have initial payments that cover only the interest, which in turn graduates to amortizing payments in the course of the loan term.
Graduated-Payment Mortgages
Bridge loans are short-term loans typically taken out for a period of two weeks to three years, while the borrower works to attain larger or longer-term financing.
That “bridge” can connect the borrower from their present construction loan to their eventual mortgage loan when the house is built. They are also used to bridge the mortgage loan on a borrower’s present home to the mortgage on the new home they wish to purchase.
The bridge loan may not require a payment for the first few months, giving the borrower time to sell their present home and avoid a property sale contingency on the offer they place on the new home.
Scenario: Commercial Developer
A commercial developer needs to finance a project while their permit approval is sought. Because there is no guarantee the project will happen, the loan they take out might be at a high interest rate and from a specialized lending source that will accept the risk. This is their bridge loan.
Once the project is fully approved, it becomes eligible for more conventional loans with lower rates, longer terms, and greater amounts. A construction loan would then be obtained to take out the bridge loan and fund completion of the project.
Scenario: Consumer
A consumer is purchasing a new residence and plans to make a down payment with the proceeds from the sale of a currently owned home. The currently owned home will not close until after the close of the new residence.
A bridge loan allows the buyer to take equity out of the current home and use it as down payment on the new residence, with the expectation that the current home will close within a short time frame and the bridge loan will be repaid.
Bridge Loans
Blanket mortgages have more than one collateral property that acts as security for the loan. These mortgages typically are used by land developers and commercial investors, but anyone seeking to consolidate mortgage debts may receive such a loan. As they pay down the loan, they can get various properties released of their encumbrances.
Blanket mortgages create a blanket lien on the collateral properties. This means that in the event of default, the lender may foreclose on all of the properties thus encumbered. This can cause problems for those who buy a lot from a developer, because the house may still be encumbered by the developer’s blanket mortgage. If the developer defaults, the lender may foreclose on all of the collateral property, including lots that already have been sold.
Blanket Mortgages
One type of open-end mortgage is the construction mortgage.
In a construction mortgage, the lender pays funds to a borrower in installments, called draws, as the construction progresses. The sum total of these draws is typically 75% of the value of the property when it is completed. At the end of the building’s construction, the entire loan amount plus the interest accrued becomes due. This is usually paid for with a long-term mortgage that the borrower has arranged for in advance.
EXAMPLE
A borrower is constructing a single-family home whose value, when complete, will be $88,000. The construction loan amount, therefore, will be 75% of this, or 0.75 × $88,000 = $66,000. The mortgage contract calls for a series of six draws of $11,000 each over six months at a 10% annual interest rate.
The borrower will want to have a long-term mortgage loan of $67,951.98 at the end of the sixth month when the construction loan balance becomes due. (Notice that the borrower pays almost $2,000 in interest for one six-month period.)
Construction Mortgages
Put simply, subprime mortgages are mortgages with higher interest rates.
Subprime mortgages are normally made to borrowers with lower credit ratings. The lender offers a mortgage with a higher interest rate because the lender views the borrower as having a larger-than-average risk of defaulting on the loan.
Prime Lending
To understand what subprime lending is, we’ll also have to talk about what prime lending is. Prime lending is based on what’s called a prime rate. The prime rate is the interest rate that’s issued for mortgage borrowers with what lenders deem “good credit.”
This rate is usually three percentage points above the federal funds rate, which is set by the government. This federal funds rate is the interest rate that banks charge other banks for overnight loans, so adding 3% to that gives you the prime rate.
Subprime Lending
So, a subprime loan is a loan that has an interest rate greater than the prime rate. If the borrower has less-than-good credit, this is the option they’ll be given by the lender. Their assessment and qualification is based on a few factors, including, in this order:
Credit score
Size of down payment
Number of delinquencies on a borrower’s credit report
Types of delinquencies
If there is just one area in which the borrowers are below standard, such as credit score, the lender will be less willing to give them a prime loan, even if their income and assets are to the lender’s liking.
When a borrower doesn’t meet the lender’s qualifications, the lender might still deem them creditworthy enough to approve them for a mortgage. That mortgage might just be at a subprime rate.
Higher Rates and Fees
Because of the default risk associated with such borrowers, subprime mortgages have very high interest rates and much higher fees as compared to prime loans. This, combined with the fact that many subprime borrowers don’t have the same level of financial knowledge as a prime borrower, means a lot of predatory lending takes place in the subprime market.
That’s why it’s important for potential homeowners to shop around for mortgages, especially if their credit is less than stellar. This way, they can see what interest rates are being charged by different lenders and can pick one that has the best rates and features, hopefully avoiding predatory lenders.
Subprime Loans
I mentioned seller financing in the last level. Seller financing is a form of private lending (money lent by a private party, instead of a bank).
The loan given by a seller is referred to as a purchase-money mortgage.
A purchase-money mortgage is a note and deed of trust created at the time of purchase. The term is used in two ways: First, it may refer to any security instrument originated at the time of sale. But more often, it refers to the instrument given by the purchaser to a seller who “takes back” a note for part or all of the purchase price.
In a purchase-money mortgage, the buyer can borrow from the seller in addition to the lender. This is sometimes done when a buyer cannot qualify for a bank loan for the full amount, so the seller “takes back” a portion of the purchase price as a second mortgage.
Sellers who wish to finance a mortgage and are not registered loan originators can still do so, provided that they meet one of the two following exemptions.
Exemption 1 (must meet all of the following):
The seller originates financing for only one property in a 12-month period.
The seller is a person, state, or trust.
The seller has not constructed or acted as a contractor for a residence on the property.
The financing does not result in negative amortization.
The financing is fixed rate, or does not adjust for the first five years.
Exemption 2 (must meet all of the following):
The seller originates financing for no more than three properties in a 12-month period.
The seller is a person or organization (partnership, corporation, association, cooperative, trust, estate, government unit, or proprietorship).
The seller has not constructed or acted as a contractor for a residence on the property.
The loan is fully amortizing.
The financing is fixed rate, or does not adjust for the first five years.
The seller has determined that the borrower has the ability to repay the loan according to its terms.
In addition, parties should fill out the Arizona Association of REALTORS® Seller Financing Addendum prior to the consummation of a seller-financed loan.
EXAMPLE
A buyer wants to purchase a property for $200,000. He has $40,000 for a down payment and agrees to assume the existing mortgage of $100,000. The owner agrees to take back a purchase-money second mortgage in the amount of $60,000.
At closing, the buyer will execute a note and deed of trust in favor of the owner and the seller will transfer the title.
The buyer will then owe the bank for the $100,000 mortgage and the seller for the $60,000 purchase money mortgage.
Purchase-Money Mortgages
A wraparound mortgage, also called the wrap, is a form of secondary financing. A wraparound mortgage enables a borrower to obtain additional financing from a second lender without paying off the first loan.
The lender of a wraparound mortgage is commonly the seller, but not always.
The second lender gives the borrower a new, increased loan at a higher interest rate and continues payment of the existing loan. The total amount of the new loan includes the existing loan as well as the additional funds needed by the borrower.
The borrower makes payments to the new lender on the larger loan, and the new lender makes payments on the original loan out of the borrower’s payments. The buyer should require a clause in the loan documents granting them the right to make payments directly to the original lender in the event of a potential default by the seller on the original loan.
Sounds a little confusing, I know. I’ll give you an example to help make it clearer.
Jim and Daisy shaking hands in front of a house (Jim and Daisy appear in the upcoming scenario).
Scenario: Jim and Daisy
Jim has a mortgage on his house with a current principal balance of $100,000. His interest rate is 5% and he has a monthly payment of $900. Jim is selling his house and he found a buyer he likes. Her name is Daisy.
Daisy, sadly, has very bad credit, and is having a hard time qualifying for a decent loan to buy Jim’s house. She knows she can afford to buy the house, but the bank is offering her subprime rates. After some negotiations, Jim and Daisy agree on a wraparound loan.
Daisy pays Jim a down payment of $20,000 and she agrees to a $60,000 wraparound note at 7%. When all is said and done, Daisy makes a monthly payment of $1,200 to Jim.
Jim continues to pay his lender his $900 monthly payment while he gets paid the $1,200 from Daisy. This gives Jim a monthly net income of $300 ($1,200 – $900).
Be Warned
Banks do not always appreciate wraparound mortgages. In a way, the buyer and seller are going around the bank’s back and handling all the finances on their own.
If the seller’s lender is in the dark about the arrangement and then they find out about it, there’s a decent chance that the lender will call the loan due. Most loans have an “acceleration clause,” which lets the lender call the loan due whenever ownership of the security changes.
Why Is It Called a Wraparound Mortgage?
This is called a wraparound mortgage because usually the seller has a mortgage on the property that they keep, paid off with the monthly payments received from the buyer. For this reason, the seller usually charges a higher interest rate than that of the mortgage they hold.
Nevertheless, this rate can be lower than the current market rate, making it appealing to buyers. Buyers also receive the advantages of no qualifying process and few closing costs. For example, there is no lender’s origination fee, appraisal fee, or credit report fee, but there may be legal fees and homeowner’s fees.
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Wraparound Mortgages
A package mortgage includes not only the real estate but also all personal property and appliances installed on the premises.
In recent years, this kind of loan has been used extensively to finance furnished condominium units. Package loans usually include personal property, such as furniture, drapes, and kitchen appliances, as part of the sales price of the home. A package deed of trust may serve as a security agreement on the personal property and fixtures to be placed in or attached to the real property.
Package Mortgage
Reverse mortgages, also called reverse annuity mortgages (RAMs), are loans designed for people over the age of 62. They can be a life saver when used to supplement income that is needed for essentials like medicine, food, payments, etc. Reverse mortgages can sometimes allow the borrower to take cash out.
So what about the Bad and the Ugly? Nothing is bad, unless it’s misunderstood. And if it’s misunderstood, it can be really ugly. Let’s look at the facts.
There are a few things you should know about reverse mortgages:
The borrower does not have to qualify for the loan. This is because the lender’s protection is in the property.
The borrower still owns the home. The lender has a lien on the property just like they would with other mortgage loans.
There are no monthly payments. This sounds good, but since there are no payments, interest is being added to the amount borrowed every month (negative amortization). So the balance is constantly going up. The longer the borrower has the loan, the higher the balance will get. It is very possible that if the borrower lives a nice, long life, the balance could exceed the value of the property. That’s not a problem for the borrower, but what about the heirs left with the bill?
When the borrower passes away, the title to the property passes to the heir(s) with the borrower’s estate. If there is any equity (the difference between what the property will sell for and the mortgage on the property) left in the property, it belongs to the heirs.
One of the best things about reverse mortgages is that they are no-recourse loans. There is no personal liability. If the borrower lived a long life and the balance on the loan now exceeds what the property will sell for, the lender cannot force anyone to pay for the loss.
If the heirs choose to let the lender have the property rather than pay the debt, the lender will foreclose on the property, sell it for what they can, and assume any loss that results.
The upfront fees can be high. The fees are sometimes added to the loan balance at the beginning, eating up equity right away. The best time to get a reverse mortgage is while the borrower feels like they still have many years left to live in the home.
Reverse Mortgages: The Good, the Bad, and the Ugly
With a reverse mortgage, the borrower must continue living in the property. If they plan to move or sell in the future, this loan is not for them. Most loans allow borrowers to be gone temporarily as long as the intent is for them to return to the home. When the last homeowner passes away (if it’s owned by a married couple, for example) or leaves the home permanently, the loan has to be paid in full.
If the rules in the loan document are violated, the lender has the power of foreclosure.
As long as the borrower is fully aware of the facts about the reverse mortgage, there really is no bad or ugly side to it. And lenders go to great extremes to be sure the borrower understands what they’re agreeing to. The borrower must know the facts.
Scenario: Sherry’s Social Security
Sherry is 75 years old. She paid off her home awhile ago. She is finding that her social security checks don’t quite support her quality of life. She decides to take out a reverse mortgage.
She gets her home valued at $225,000 and agrees to reverse mortgage $50,000 worth of equity. The terms of her loan give her a monthly payment of $415, which is enough for Sherry to keep up her chic-grandma lifestyle. The loan does include interest payments, which will be taken out of the equity. So, whenever Sherry’s home is eventually sold, Sherry or her heirs will have even less equity in the home.
Remember: The balance on the $50,000 mortgage will be increasing, which may eat into her equity if the value is not increasing at the same rate.
Sherry sits on a couch, knitting, in front of a roaring fire in her fireplace.
Long-Term Plans
A home equity loan is a loan in which funds are borrowed using the homeowner’s equity for collateral. It’s notable that these funds can be used for any purpose, such as remodeling the kitchen or paying for college tuition.
Equity loans are often limited to 80% of the value of the property. For example, if a home is worth $215,000, the maximum amount the owner can take out in loans is $172,000. If there is already a mortgage on the house that will take $50,000 to pay off, the owner will be able to get no more than $122,000 in a cash-out equity loan.
People that are in a large amount of debt might be tempted to take out a home equity loan to pay it off. Their credit card interest rate might be above 20%, while a home equity loan’s could be in the single digits. This could be useful to a borrower if utilized correctly. For example, a borrower would save money if they were able to get a substantially lower interest rate and pay off the credit card. Better to be paying 5, 6, or even 10% in interest than the 20% or more that credit cards can charge.
In taking out the loan, the borrower would also be consolidating their debt to one payment. This is known as debt consolidation.
Risks of a Home Equity Loan
A home equity loan is a loan in which funds are borrowed, using the homeowner’s equity for collateral. So, if the borrower finds themselves unable to repay the loan, they could lose their home. Therefore, borrowers should carefully consider their options before taking out a home equity loan.
Home equity loans are not predatory by nature. In fact, it could be the right financial decision for someone. But keep in mind: predators like collateral.
Borrowers should examine the terms of a loan very carefully before taking out a home equity loan. A predator might hit the borrower with a large balloon payment at the end, or a variable rate might put the borrower in a worse position than when they started.
Debt consolidation through a home equity loan can be a risky move, and borrowers should be made aware of those risks. In addition, borrowers can find debt consolidation loans that don’t use home equity as collateral.
Home Equity Loan
Now that you’ve learned quite a bit about the mortgage lending activities that precede the purchase of a residence, let’s move on to commercial financing. The majority of commercial real estate financing is conventional loans done with banks and private lenders. Commercial loans usually have shorter terms than residential loans (5-10 years is typical) and are reserved for business properties such as subdivisions, retail centers, apartment complexes, office buildings, and other income-driven developments.
Bank lenders will assess the real estate investor’s credit history and income from their businesses, employment, or investments. Good credit history and solid income will usually enable the investor to have access to good financing. The bank will want to examine the investor’s personal and business balance sheets for the past three to five years.
Lenders may require that a personal guarantee is included in the terms of a commercial loan. With a personal guarantee, one or more members of the business promise to repay the loan if the business ceases to operate or is otherwise unable to pay it. A commercial loan without personal guarantees is known as “non-recourse” financing.
Financial History
Lenders are especially interested in the investor’s past financial history. A reasonable expectation of future income is also important. A debt coverage ratio is also vital when seeking a commercial loan. This ratio will reflect the cash flow that is available from the borrower to cover the cost of the loan plus fees. The higher the number, the more willing the lender will be to issue the loan. Typically, lenders will want to see a business’s net operating income (NOI) cover the debt service with 115% to 150% of the amount of the debt service leftover once the loan is repaid.
Most commercial property lenders want to see a higher down payment than is typical for residential down payments. The down payment can vary based on the size and class of the asset, plus investor qualifications such as an up-to-date business plan, assets, and a good credit history.
Basis Points
Unlike with residential loans, commercial lenders utilize basis points in order to calculate and discuss interest rates and fees. A basis point is equal to 1/100th of a percentage point, and therefore 100 basis points equal 1% of the loan amount. That may not seem like a lot, but keep in mind that since commercial loans tend to involve a large amount of money, just a few points can make a huge difference!
Prepayment Penalties
What happens if a borrower wants to pay off a commercial loan early? A yield-maintenance prepayment penalty is a lender’s way of recouping the loss of interest fees if a borrower repays the loan before it matures. A yield-maintenance premium allows the lender to make as much – or nearly as much – as it would’ve made had the borrower seen the loan through to maturity. Without a yield-maintenance prepayment penalty in place, lenders could lose out on thousands of dollars in interest fees.
Know the Requirements
Investors should ask a bank lender for information about the typical terms and required documentation for a commercial loan before applying since it can be a time-consuming process. Some loans require the investor to meet certain requirements regarding their debt-to-cash ratios, cash flow, etc. If the borrower cannot meet these requirements, it could result in a higher interest rate. Also, note that the asset is equally important to the lender. They will spend just as much time underwriting the property as the mortgagee.
Commercial Real Estate Financing
The majority of commercial loans are conventional loans. However, there are still a few alternative options that can be utilized. Let’s take a look at two of the most common: seller financing and Small Business Administration Loans.
Seller Financing
Seller financing is attractive to sellers in commercial transactions for a couple of reasons. Not only can the income that is generated help provide the funds needed for another business venture, but it can also help to reduce debt in their overall business portfolio. Seller financing is flexible just like it is in residential financing, and can be used for the full sales price, or just a portion that may not be covered by traditional financing.
Small Business Administration Loans
While government-sponsored loans such as VA and FHA loans are not available for commercial loans, there is another government entity that can help out small business owners – the U.S. Small Business Administration (SBA). SBA 504 loans are available to almost any type of small business, including service, retail, manufacturing, and wholesale businesses. Those businesses with a net worth of less than $7 million and after-tax net profits of less than $2.5 million are eligible.
504 loans can be used not only for commercial real estate, land, improvements, and modernization, but also towards assets such as machinery and equipment. The funds can also be used towards business expenses such as interest, professional fees, utilities, parking, landscaping, upkeep, and more.
Commercial Financing Alternatives
