Residential Mortgage

Overview
Duration: 42 Minutes

Russ Faulkner

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 Learning Objectives
At the end of this module, you should be able to:
• Explain why people use mortgages today.

• Identify the key mortgage types.

• Differentiate a mortgage from a traditional personal loan.

• Articulate basic characteristics of all U.S. residential mortgages.

• Detail the various major types of mortgages.

• Discuss the impact of changes in mortgage terms.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Basic Characteristics
Understanding mortgages
• A residential mortgage is a loan secured by real property.

• A mortgage note accompanies the mortgage and provides evidence of the

existence of the loan and the encumbrance of that real property.

• Home buyers or builders obtain a mortgage either to purchase, improve or

withdraw capital against the value of the property.

• Mortgages are available from financial institutions and lenders, such as a

bank or credit union, either directly or indirectly through intermediaries.

• Borrowers seek mortgages either because they do not have enough

savings or liquidity or they want to leverage their investment returns.

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 Common Terms: Parties
Term
Borrower / Owner /
Mortgagor
Lessor / Landlord
Lender / Mortgagee
Property
Guarantor
Lessee / Renter / Tenant
Credit rating or FICO Score
(formerly “Fair Issac”)
Residential Mortgage Overview
Simple Definition
The individual(s) or entity(ies) (e.g., a company) that will own the
property.
An owner that rents or leases the property to a tenant or lessee.
The party funding the mortgage loan
The physical land and /or building(s) that the owner will control (note:
some properties are located on land leases, so the “property” might
exclude the land itself as part of the assets acquired.
The individual(s) or entity(ies) that promise to pay back the load.
Virtually always the owner, but also often third parties with greater
credit-worthiness than the owner.
Occupant(s) who will use the property and pay the owner rent or
lease fees.
An assessment of the credit worthiness of individuals and
corporations based upon the history of borrowing and repayment as
well as the availability of assets and extent of liabilities.
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 Common Terms: Business Issues
Term Simple Definition
Property Price Purchase and sale amount between the owner and seller.
Appraised Value of Property Value of the property established by market conditions, including
comparable properties and appraisal. “What a person is willing to pay.”
Principal / Mortgage Amount Loan amount = property price LESS down payment
Down Payment Initial one (1) time payment paid toward purchase of property. Down
payment = property price LESS principal amount of mortgage.
Equity Amount of ownership that has been built up by the holder of the mortgage .
Equity = current property market value LESS mortgage balance.
Term Length of the mortgage in years and months.
Mortgage Type Establishes the borrower requirements and mortgage conditions (including,
e.g., floating vs. fixed rate)
Interest rate / Payment Frequency The cost of the loan in percentage terms and frequency (e.g., monthly) on
which cost (i.e., the interest rate) is calculated. Interest rate is also called the
reference rate (can be based on U.S. Treasuries, Prime Rate, LIBOR…)
Payment Amount The amount of interest and principal paid based on the principal, term,
interest rate, and payment frequency.
Fees Upfront amounts paid to secure mortgage from the lender and/or
intermediaries.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Common Terms: Legal and Other
Term Simple Definition
Terms and Legal agreements to the mortgage documents establishing the “rules of
Conditions the road” between borrower and lender, as well as their dealings with
third parties.
Covenants Promises made by the borrower, lender, guarantor and others to engage
in or refrain from specified actions.
Default Failure by the borrower (typically) to abide by the mortgage terms and
conditions (e.g., regarding payment). “Cure” refers to the right of the
parties to “fix” or correct a default.
Taxes and Insurance Monies due to governments and insurance entities related to the
property (typically, local property taxes, hazard insurance, mortgage
insurance, etc.)
Pre-payment and The right of (or restriction upon) the borrower to pay the mortgage
transferability principal before due, or to “sell” the obligation to pay the mortgage to
another party.

MANY other terms, conditions and clauses exist within the mortgage
documents. We will cover these in a subsequent module.
Residential Mortgage Overview © The Globecon Group, All Rights Reserved
 Why People Use Mortgages
• They do not have adequate savings or liquid funds to pay for the property
without a loan.

• The government encourages borrowing by allowing interest payments to

be tax deductible (e.g., $1,000 rent vs. $1,000 loan payment which may
cost $800 after tax savings) (mortgage interest is tax deductible).

• Borrowers gain the advantage of leverage, generating potentially higher

returns on capital.

• You can tap the value of

real property as the value
of the property increases,
through a home equity loan.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Personal Loan vs Mortgage
Loan
Description: A loan is a type of debt.
"Delivery of a sum of money to another
under a contract to return at some future
time an equivalent amount with or without
Law Definition:
an additional sum agreed upon for its use;
and if such be the intent of the parties the
transaction will be deemed a loan“.
The borrower initially receives an amount of
credit from the lender, which they pay back,
Use:
usually but not always in regular
installments, to the lender.
Types: Secured loans & Unsecured loans.
Residential Mortgage Overview
Mortgage
A mortgage is a method of using property
(real or personal) as security for the
payment of a debt.
A legal document by which the owner
(buyer) transfers to the lender an interest in
real estate to secure the repayment of a
debt, evidenced by a mortgage note.
Mortgage is seen as the standard method
by which individuals and businesses can
purchase residential and commercial real
estate without the need to pay the full
value immediately.
Mortgage by demise, Mortgage by legal
charge & Equitable Mortgage.
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 Basic Overall Types
Types of Mortgages Detail Prevalence

Mortgage by demise In a mortgage by demise, the mortgagee (the lender) Mortgages by demise
becomes the owner of the mortgaged property until the were the original form of
loan is repaid or other mortgage obligation fulfilled in full, mortgage, and continue
a process known as "redemption". This kind of mortgage to be used in many
takes the form of a conveyance of the property to the jurisdictions, and in a
creditor, with a condition that the property will be small minority of states in
returned on redemption. the United States.
Mortgage by legal The debtor (borrower) remains the legal owner of the This most common type
charge property, but the creditor (lender) gains sufficient rights of mortgage in the U.S.
over it to enable them to enforce their security, such as a
right to take possession of the property or sell it. To protect
the lender, a mortgage by legal charge is usually recorded
in a public register.
Equitable mortgage The lender is secured by taking possession of all the Not common in the U.S.
original title documents of the property and by borrower's
signing a Memorandum of Deposit of Title Deed (MODTD).
This document is an undertaking by the borrower that
he/she has deposited the title documents with the bank
with his own wish and will, in order to secure the financing
obtained from the bank.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Mortgages
The basics of a mortgage
Mortgage loans are structured as long-term loans customized to the
needs and financial abilities of the borrower.

Amount to Borrow Mortgage Type Term/Tenor Interest Rate & Fees

Amount is set based on The type describes The loan length or time The level of interest and
the value of property, whether it is an to maturity is set based amount of fees
anticipated use of funds, amortizing or non- on personal, business determines to cost of the
borrower’s financial amortizing loan, fixed or and planning needs of loan to the borrower
means / credit adjustable rate, borrower, including and the return to the
worthiness, amount of government guaranteed projected length of lender. Set largely based
down-payment or not. ownership of property, on the anticipated risk of
available, property cash flow needs. the borrower.
location.

Terms and Conditions

Guarantors, right of prepayment, security interests and numerous other terms and conditions control the
mortgage loan, note, security documents and associated other instruments.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Amount Borrowed
Mortgage underwriting standards determine the amount borrowed based on:

Borrower Property Lender Market Conditions

Income Location Available capital State of property markets
Debt Type & quality Portfolio State of capital markets
Credit history Loan-to-value Investment Strategy
Savings Marketability Risk/return needs
Guarantee
Use of funds
Ratio analysis

Based on a “good credit rating,” the typical home buyer

borrows 80% of the purchase price. Typically, the mortgage
cost (principal and interest) should represent <= 35% of the
buyers take-home pay.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Mortgage Types
Fixed-Rate Mortgage
Interest is fixed for an amount of
time; e.g., 10, 15, 20, 30, or even
40 or 50 years, at which point
the amortized principal is paid in
full.
Jumbo Loans
Above Freddie Mac and Fannie
Mae conforming guidelines,
therefore the big secondary
lenders will not secure jumbo
loans. 2006 maximum amount
for a conforming loan: $417,000.
Residential Mortgage Overview
Adjustable-Rate Mortgage
The interest rate fluctuates with
an indexed rate plus a set
margin; adjustment intervals are
predetermined. Minimum and
maximum rate caps limit the size
of the adjustment.
Second Mortgages / Junior in Claim
Second Mortgage – Home
Equity Loan
A home equity loan is when a
lender gives you a lump sum of
money and you pay it back over
a fixed payment schedule - just
like your primary mortgage.
Typically these loans have fixed
interest rates.
Balloon Mortgage
The rate is fixed for a period of
time, but the principal is not
completely amortized during the
period. The entire balance of the
principal is due as a balloon
payment at the end of that
period.
Second Mortgage – Home
Equity Line of Credit
(HELOC)
A HELOC allows you to borrow
up to a certain amount of money
from a lender until you've
reached your limit (e.g., a line of
$30,000). The "line" is a credit
line guaranteed by your house.
HELOCs have adjustable interest
rates.
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 Mortgage Types (continued)
Interest-only ARM
For a period of time, you pay
only interest, and do not pay
down the principal.
Balloon Conforming
Mortgage
Interest rate is fixed for a period
of time, but the principal is not
completely amortized. For the
remainder of the term, it adjusts
to a new fixed rate determined
by the Fannie Mae net yield
index plus the margin. 30-yr.
term.
Residential Mortgage Overview
1-yr. Treasury ARM
The rate is fixed for one year,
then becomes adjustable every
year. The new rate is determined
by the treasury average index
plus the loan margin (usually
2.25-2.5%). 30-yr. term.
Flexible Payment Option
ARM
The borrower chooses from an
assortment of payment methods
every month. There is a "change
cap" limiting how much
payments can vary in a year.
Intermediate ARM
With an intermediate or hybrid
ARM, the rate is fixed for a
period of time, then adjusts on a
predetermined schedule. This is
shown by the number of years
the loan is fixed, and the
adjustment interval (e.g., 3/1
ARM is 3-year fixed, and 1
adjustable annually). The new
rate is determined by an
economic index (usually treasury
or treasury average index) plus
the loan margin (usually 2.25-
2.5%). 30-yr. term.
Convertible ARM
An ARM that can be converted
to fixed rate after a period of
time.
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 Mortgage Types (continued)
Veteran Administration
Loans
A zero-down loan offered to
veterans only, the VA guarantees
the loan for lenders.
Assumable Mortgage
An adjustable-rate loan, the
balance of which can be
assumed by a home buyer.
Residential Mortgage Overview
Federal Housing
Administration Loans (FHA)
Government-insured loan with
low down payment (i.e., as little
as 1-3%) and closing fees
included; the government
insures the loan.
Reverse Mortgage (HECHEM)
A loan to elderly homeowners
who need to borrow against the
equity of a home while still living
in it. The debt does not need to
be repaid until the house
changes hands. Interest is
commonly one-year treasury
rate, plus a margin and a cap on
a rate change.
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 What to Notice
• There are many different types of mortgages.

• Mortgage types are designed to accommodate customer requirements.

• More variety means more complexity and potentially greater risk.

• Adjustable / floating rate loans involve greater risk (higher uncertainty) for
the borrower (increased rates can increase their loan payments).

With greater variety comes the obligation for underwriters

and servicers to exert greater scrutiny to maintain quality.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Mortgage Terms / Tenors
Typical U.S. residential mortgage is 30 years
• Numerous variants exist, including: 15, 20, 25, and 30 years.

• Mortgages of 40 years are now available to some borrowers.

• The term (or “tenor”) of a mortgage should match the purpose and
financial means of the borrower, specifically the expected holding period.

• The expected holding period is how many years the borrower expects to
own the property.

• Because longer term loans virtually always involve lower payments, many
borrowers will opt for longer term loans simply to lower their regular
payments whether or not they expect to hold the property that long.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Impact of Tenor on Equity Value

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 What to Notice
• Mortgage types are designed to accommodate customer requirements.

• Shorter term mortgages result in more equity build-up, faster.

• Many residential home buyers acquire properties that are more expensive
than they can afford, and do so by extending the term of the mortgage.

• More variety means more complexity and potentially greater risk.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Mortgage Interest and Fees
• The perceived risk and return determines the level of mortgage interest
and fees charged by the lender (high risk = high interest + high fees).

• The rate of interest and amount of fees charged can greatly impact the
return on investment for a borrower.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Impact of Interest Rate on Cost

What to notice:
Small change of interest rates results in large change in cost.

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

 Terms & Conditions: Claim Priority
• First mortgage = senior lien
• Second mortgage = junior lien
• Third mortgage (etc.) = junior lien

• Lien priority established by date of recording in locality.

‒ Seniority establishes claim to real property assets.
‒ Seniority establishes claim to personal guarantee.
‒ “You snooze you lose.”
o Failure to record lien is significant cause of loss in foreclosure.
o Not an uncommon problem for lenders.

• Exceptions
‒ Property tax lien has seniority.
‒ Sometimes mechanics liens have seniority.
‒ Explicit subordination clauses.
‒ Bankruptcy proceedings may modify debt holder rights.

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 Priority Example
• First mortgage = $90,000
• Second mortgage = $20,000
• Third mortgage (etc.) = $10,000

• In foreclosure, assuming the property sells for $100,000…

‒ First mortgage holder receives = $90,000

‒ Second mortgage holder receives = $10,000
‒ Third mortgage (etc.) holder receives = $0

Residential Mortgage Overview © The Globecon Group, All Rights Reserved

Residential Mortgage
Overview
Duration: 42 Minutes

Russ Faulkner

© The Globecon Group, All Rights Reserved