PROP 1023 / CHAPTER 1 Flashcards
Many investors in income-producing properties, such as apartment buildings, find it financially advantageous to borrow a part of the required capital even though their own funds might be sufficient.
LIST 4 ADVANTAGES OF BORROWING?
First, to diversify investments and reduce the overall portfolio risk,
Second, it may be possible to borrow at an interest rate lower than the expected debt free return from the property.
Third, debt financing may allow the purchase of real estate as a hedge against inflation. The investor may anticipate an inflationary rise in the general price level and in the returns on real estate. If the payments on the loan are fixed for the term of the loan, the investor could expect to pay off the debt in “cheaper” (inflated) dollars
A fourth rationale for the use of debt financing is to save (or release) equity for other activities.For example, a merchandising or manufacturing concern may prefer to use available funds in the business (i.e., for inventory or expansion) rather than to invest it in land and buildings.
What are three disadvantages of mortgages as investments?
- heavy administrative burden
- lack of a secondary market
- illiquid investment
- requires large capital requirements
What is financial leverage?
Financial leverage refers to the use of debt to acquire additional assets.
Explain how real estate may be used as a hedge against inflation?
If the payments on the loan are fixed for the term of the loan, the investor may pay off the debt in “cheaper” (inflated) dollars.
During this period, mortgage financing involved long-term loans where interest was paid periodically (generally monthly) throughout the life of the loan. Partial payments of principal seldom occurred; rather the entire principal amount was repaid (or refinanced) at the end of the loan term.
ANSWER: 1900 to Late 1920s
During the economic collapse of the Depression (in the 1930s), many borrowers were forced to live off their savings rather than pay off a mortgage when due. Consequently, many lenders found they were owed the full amount of principal outstanding on a large number of loans by individuals without any funds, whose property was worthless as security. Lenders and borrowers suddenly became aware of the ________ risk associated with interest only loans.
ANSWER: PRINCIPAL RISK
How did the mortgage market respond to the great depression? Eg. what change resulted from the depression?
The market responded to the depression by turning to the use of repayment plans where periodic payment of both interest and principal occurred. The most common form of these repayment plans was the long-term, fully amortized mortgage, where each payment was constant in amount and was comprised of interest due, plus a partial repayment of principal.
A major innovation during this period was the use of mortgage default insurance.
ANSWER:
PostWorld-War II Period
NOTE ONLY
To increase the supply of mortgage money, the federal government tried to encourage financial institutions to increase their participation in mortgage lending by reducing the risk of loss in the event of default. The most successful method (which is still used) took the form of government insurance against default on residential mortgage loans granted under the terms of the National Housing Act.
NOTE ONLY
To increase the supply of mortgage money, the federal government tried to encourage financial institutions to increase their participation in mortgage lending by reducing the risk of loss in the event of default. The most successful method (which is still used) took the form of government insurance against default on residential mortgage loans granted under the terms of the National Housing Act.
NOTE ONLY
PARTIALLY AMORTIZED MORTGAGES
By the end of the 1960s, there was rapid inflation as well as rising consumer demands. The increase in consumer demand also increased competition between investment and consumption demands for the money supply.
Consequently, in order to ration funds, interest rates rose significantly and long-term lenders found themselves forced with a new type of risk—interest rate risk.
Mortgage lenders had no protection from being locked into long-term loans at rates below the current rate. Individual borrowers were protected, to some extent, from holding long-term debt at rates above the going rate because they were allowed to prepay the loan (paying an interest penalty) under Section 10 of the federal Interest Act.
From the lenders’ viewpoint, the opportunity cost of a heavy commitment to long-term fixed rate assets was first illustrated by the 31% (9% to 11.8%) increase in conventional mortgage interest rates in the three-year period commencing in January of 1972. Given the 72% increase that occurred between September 1979 and September 1981, from 12.5% to 21.46%, the 1972 increase does not seem significant, but, in its time, this first jump was of great concern to holders of fixed rate, long-term debt instruments.
In these circumstances, the mortgage agreement needed to be altered to give both borrowers and lenders increased protection against interest rate fluctuations.
The result of this need for protection was the emergence of the partially amortized mortgage, which has periodic payments based on a long-term fully amortized loan, but which matures on a short-term basis. At maturity, the full amount of the outstanding balance must be repaid or refinanced at the market interest rate.
This feature permits both lenders and borrowers to share the risk of possible fluctuations in the long-term lending rate.
NOTE ONLY
PARTIALLY AMORTIZED MORTGAGES
By the end of the 1960s, there was rapid inflation as well as rising consumer demands. The increase in consumer demand also increased competition between investment and consumption demands for the money supply.
Consequently, in order to ration funds, interest rates rose significantly and long-term lenders found themselves forced with a new type of risk—interest rate risk.
Mortgage lenders had no protection from being locked into long-term loans at rates below the current rate. Individual borrowers were protected, to some extent, from holding long-term debt at rates above the going rate because they were allowed to prepay the loan (paying an interest penalty) under Section 10 of the federal Interest Act.
From the lenders’ viewpoint, the opportunity cost of a heavy commitment to long-term fixed rate assets was first illustrated by the 31% (9% to 11.8%) increase in conventional mortgage interest rates in the three-year period commencing in January of 1972. Given the 72% increase that occurred between September 1979 and September 1981, from 12.5% to 21.46%, the 1972 increase does not seem significant, but, in its time, this first jump was of great concern to holders of fixed rate, long-term debt instruments.
In these circumstances, the mortgage agreement needed to be altered to give both borrowers and lenders increased protection against interest rate fluctuations.
The result of this need for protection was the emergence of the partially amortized mortgage, which has periodic payments based on a long-term fully amortized loan, but which matures on a short-term basis. At maturity, the full amount of the outstanding balance must be repaid or refinanced at the market interest rate.
This feature permits both lenders and borrowers to share the risk of possible fluctuations in the long-term lending rate.
The ____________ permits individuals to make a tax-free withdrawal from their Registered Retirement Savings Plan (RRSP) to purchase or build a home, on the condition that the amount withdrawn is repaid in full within 15 years.
The Home Buyers’ Plan (HBP) permits individuals to make a tax-free withdrawal from their Registered Retirement Savings Plan (RRSP) to purchase or build a home, on the condition that the amount withdrawn is repaid in full within 15 years.
As an attempt to reduce INTEREST RATE RISKS FOR BORROWERS, the federal government introduced an _ _ _ _ _ _ _ _ program in 1984.
As an attempt to reduce INTEREST RATE RISKS FOR BORROWERS, the federal government introduced an interest rate insurance program in 1984.
In the 1980s the federal government also took steps to stabilize the flow of mortgage funds by attempting to attract more investors to the mortgage market. In 1986, Canada Mortgage and Housing Corporation (CMHC) created a new financial instrument called _ _ _ _ _ _ _ _ _ _ which are designed to help provide a steady flow of mortgage funds into housing in Canada.
The federal government also took steps to stabilize the flow of mortgage funds by attempt-ing to attract more investors to the mortgage market. In 1986, Canada Mortgage and Housing Corporation (CMHC) created a new financial instrument called NHA Mortgage-Backed Securities (MBS) which are designed to help provide a steady flow of mortgage funds into housing in Canada.
A significant change to mortgage financing in the 1990s was the introduction of _ _ _ _ _ _ _ _ _
A significant change to mortgage financing in the 1990s was the introduction of the 95% loan-to-value ratio.
Explain the Canadian Mortgage Bond (CMB) program?
Under the CMB program, the Canada Housing Trust (CHT), a special purpose trust created and managed by CMHC, issues CMBs to investors and uses the proceeds to purchase NHA mortgage-backed securities.
Under a CHT, investors purchase the bonds and receive fixed-interest payments every six months. These payments are guaranteed by the CMHC, as all the underlying mortgages are CMHC-insured. This reduces the risk associated with the bond, making them an attractive and conservative investment.
The proceeds received from the sale of the bonds are then used to purchase mortgage-backed securi-ties. The proceeds from the underlying mortgages of the mortgage-backed securities are used to pay the principal and interest payments to the bondholders.
The initial goals of the program were to promote competition in the residential mortgage market and to provide lower cost mortgage funding to financial institutions
What are Prime Mortgages?
Prime mortgages also known as “A” mortgages
Represent the majority of mortgage lending in Canada.
Mortgage that deal with borrowers who can qualify for mortgages based on their credit score and/or gross income.
Less risky for banks
In general, the longer the term of an investment, the higher the rate of interest that must be paid to lock in investment funds unless _ _ _ _ _ _ _ _.
In general, the longer the term of an investment, the higher the rate of interest that must be paid to lock in investment funds unless there is a general expectation of declines in interest rates in the future.
