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REAL ESTATE FINANCINGby Maya Bandolon-Cartojano, REC, REA, REB
PHILIPPINE ASSOCIATION OF
REAL ESTATE BOARDS, INC (PAREB)Gensan-Sarangani REB
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TOPIC AREAS – 4hrsO Debt Financing
O Time Value of Money
O Cash Flow AnalysisO Financing Terminologies
O HDMF/PAGIBIG Financing, Principles and Guidelines
REAL ESTATE FINANCING
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Debt Financing for Real Estate
O Discussion Outline
O Why Investors Use Leverage
O Behavioral Effects of Financing
O Types of Loans
O Legal Issues in Real Estate Finance
REAL ESTATE FINANCING
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Why Borrow Against
Real Estate?O Decrease Equity Exposure
O Extend limited resources in a capital intensive asset class
O Limit risk exposure to any single asset
O Tax Deductibility of InterestO Reduce taxable income
O Positive LeverageO Before and after tax returns to equity are greater with than
without debt
O As long as debt costs less than equity, it takes less than it’sproportionate share of a property’s cash flow
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How Debt Affects Real
Estate Investment BehaviorO Influences value at the margin
O Increases focus on operational efficiency
O Lengthens holding periods by reducingliquidity
O Increases risk of loss of investment capital
O Causes tax driven behaviors
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REAL ESTATE FINANCE TERMS
Mortgages – borrowed money, considered capital
instruments because payback periods are usuallymore than 10 years
Equity– buyer’s contribution, usually downpayment
Original Loan Amount – face amount of loan
Amortization– monthly payments over a specified
time period to retire a mortgage. Consist ofPRINCIPAL + INTEREST
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REAL ESTATE FINANCE
Interest – money earned for the right to use the
capital. Usually compound interest method
Payment or Debt Service– comprise both interest
and principal
Loan to Value Ratio – percentage of the original
loan amount to the value of the property (OLA/PV).BSP allows LTV ratio up to 80%.
Annual Constant – ratio of mortgage payment to
the original loan amount (MP/OLA)
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Debt and Market LiquidityOStructure and terms of most long term debtincreases holding periods, illiquidity in themarket
O Loans are structured to lock in lender yieldsO Prepayment prohibitions, penalties
O Features compensate lenders for risks ofextending creditO Default – loss of principal
O Prepayment – potential opportunity cost of lost yieldO Interest rate risk – loss of value due to changes in the yield
curve
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Debt and Equity
Principal RiskO Debt has legal priority over equity ownership
O Equity owners must balance the benefits of
positive leverage with the risk of foreclosureand loss of capital
O Equity often accepts lower levered returns for reducedrisk (ie, REITs, core investment funds)
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Debt and TaxesODeductibility of interest expense enhances
the “tax shield” already in place from
depreciation
OTax impact is generally an individual issueO Private markets hold real estate primarily in “flow
through” vehicles (partnerships, etc.)
O Tax motivated investors may structure deals for
maximum tax benefitO Typically, does not effect pricing at the margin
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Is Inflation Good for
Levered Real Estate?O In inflationary times, leverage benefits real
estate equity returns
O Debt principal is paid in the future with pesos thatare worth less
O Holds true only in hyper-inflationary
periods
O Loan pricing reflects the yield curve
OShould have inflationary expectations built in
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Residential vs.
Commercial LendingOResidential lending:O Smaller in size
O Non-recourse to the borrower
O Totally dependent on market value of home for collateral
O Fully pre-payable at any time
O High percentage of prepayments at any given time
O government heavily involved in pricing and
structuringO Loan terms largely standardized, un-negotiable
O Widely disseminated pricing information12/17/2015Real Estate Finance by Maya Cartojano REC, REA, REB 12
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Residential vs.
Commercial LendingOCommercial Lending
O Dominated by private sources of capital
OA “relationship” business
O Increasingly influenced by the public
O Highly dependent on local market information
O Lender specialization by loan type
OSource of funding, market knowledge
O Terms and conditions highly negotiable
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Setting Loan TermsO Determining a loan amountO Based on ratio tests, collateral value
ODebt coverage ratio
OLoan to value ratioO Setting the terms and conditions
O Pricing based on underlying cost of funds
Oplus premiums for default, inflation, and
prepaymentO Reps and warranties, performance covenants
O Determination of sufficiency of collateral
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Alternative Loan StructuresO Loan structures reflect a trade off of risk and
return between lender and borrowerO Lender evaluates borrower capacity (ie., more
risk) for greater return
O Borrower evaluates more or less debt proceedsversus
OTiming and security of cash flowsO The “financial leverage” effect
OCurrent return (less risk) vs. residual return (morerisk)
OCost of incremental debt versus additional equity
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Fixed, Floating and
Interest Only LoansOFixed rate loans are the standard
OFloating rate loansO Construction and mini-perms
O Acquisition lines of credit
O Interest only loansO “balloon” or “bullet” payment at maturity
O Used for:O Construction
O Acquisition lines of credit
O Structured finance transactions12/17/2015Real Estate Finance by Maya Cartojano REC, REA, REB 16
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Participating LoansOLender trades risk for higher potential
returns
O Reduces LTV coverage
→ Increases loan amountO Takes a percentage of after debt service cash
flows
OStructured as “additional interest”
O Total of fixed payment and percentageinterest creates higher total yield on loan
dollars invested
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More on Participating LoansOBorrower benefits:
O Greater loan proceedsO Often cheaper than equity which might have to be raised
from outside sources
O Lower fixed debt paymentsO Less pressure on short term NOI
OBorrower decision:O What is the incremental cost of borrowing the extra
loan amount, vs. cost of equity?
O If the deal IRR is weighted toward the residual, thelender’s participation in the residual is probablyless than an equity investor’s would be
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More AlternativesOLand Sale LeasebackO Financing land separately from improvements
O Higher total loan proceeds
OFinances 100% of land value, vs. LTV if includedin typical loan calculation
O 100% of payments are tax deductible
OVs. only interest portion if financed by loan
ORisk is in subordination provisions
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More AlternativesO Accrual Loans
O “Pay rate” < stated interest rate
O Negative amortization situationO Tax benefits:
OCreates greater tax shield → deductible interestis based on the accrued rate, not the pay rate
O More risk to the lender → WHY?
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OConvertible LoansO Lender has an option to “convert” – ie, swap loan
proceeds for partial equity ownership
OWould convert if the equity value of the interest
exceeds the mortgage balance at conversion date
O Borrower benefits
OLower interest rate, greater current cash flow inexchange for potential loss of equity value in the
future
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More Alternatives
S O O S
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TYPES OF LOANS
Fixed Rate Mortgages – interest is fixed for the
term of the loan. Some fixed for 5-7 years, thenreadjusted for the remainder of term.
Adjustable Rate Mortgages – interest is based
on a certain index (eg TBills) plus spread
Buydowns – variation of FRM & ARM, but
interest is prepaid to lower payments in the
early years of the term. Prepaid interest usuallyby developers
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FORMS OF MORTGAGES
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FORMS OF MORTGAGES
Conventional Mortgages – most common,
secured by RE collateral, available throughbankers, banks and savings & loan institutions.
Usually safe instruments to trade in Secondary
Market for Morgages
Insured Loans – include guarantee or insurance
to protect the lender in case of default by the
borrower
Blanket Mortgage– secured by group ofproperties or number of lots
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FORMS OF MORGAGES
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FORMS OF MORGAGES
Chattel Mortgages – loan for personal
property and secured by personal property
Package Mortgages – loan on both real and
personal property. (eg. Factory can bemortgaged on the land, improvements and
equipments)
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Legal Considerations In
Real Estate FinancingOReal estate cash flows can be legally allocated
to different “interest” holders via the capital
structure
OThe PV of each of these streams = value of theinterests claimed by each layer of capital
OThe legal system also establishes control over
other, non-monetary “interests”O Equity owners don’t necessarily get 100% of the “value”
of real estate interests
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Possessory InterestsOPossessory (current or potential)
interest is a right to control some of
the rights through some form of
financial consideration
O “Fee simple” ownership interest
O Tenant’s leasehold interest
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Non- Possessory InterestsONon-possessory interest is a right to use real
estate without ownership or financialconsideration
OMost pervasive form is the easementO Provides a right to use, but not legally own, an interest
O Power lines, fire access
O Some easements may be irrevocable
O An easement can affect value+ Right of way to reach the street
- Power line running down the center of property
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REAL ESTATE
FINANCINGO SPOT CASH
O DEFERRED CASH PAYMENT
O LONG TERM FINANCING
Each type of financing scheme has its ownadvantages and disadvantages. Todetermine which one is appropriate to you,
it is best to start looking at your ownbudget and financial capabilities
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BANK FINANCING SAMPLE
COMPUTATIONS
O *Let's say Bank Loan interest is 9.25% and the loan
term is 12 years -- therefore the Amortization Factor
(based on the table) is .0116637. There are manywebsites that provide an automated Mortgage
Calculator
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SAMPLE COMPUTATIONSGiven:
Actual Value of Property: P1,000,000
Borrower's Equity: 30%
Loanable Amount: 70%
Bank Loan interest: 9.25%
How much monthly amortization?
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MONTHLY AMORTIZATIONS PROBLEMSSELLING
PRICE/PROPERTY VALUE
less: DOWNPAYMENT
BALANCE
multiply: MONTHLY AMORTIZATION FACTOR*
MONTHLY AMORTIZATION
* Factor is usually given in the problem or a factor table is provided.
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SAMPLE COMPUTATIONSGiven:
Actual Value of Property: P1,000,000
Borrower's Equity: 30%
Loanable Amount: 70%
Bank Loan interest: 9.25%
Amortization Factor: .0116637.
How much monthly amortization?
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SAMPLE COMPUTATIONSGiven:Actual Value of Property: P1,000,000Borrower's Equity: 30%Loanable Amount: 70%
Bank Loan interest: 9.25%
Amortization Factor: .0116637.
How much monthly amortization?
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MONTHLY AMORTIZATION
Contract Price: = P1,000,000
less Equity: 30% 300,000
Balance 700,000multiply Factor: 0.0116637
Monthly Amortization P8,164.59
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Real Estate Finance Tools:
Present Value and MortgageMathematics
Real Estate Finance by Maya Cartojano REC, REA, REB 12/17/2015 35
Major Topics
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Major Topics
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Time value of money calculations
♦ Present value of a single sum or annuity payment
♦Future value of a single sum or annuity
♦ Mortgage loan constants
♦ Mortgage balance calculations
♦ Point charges and their effects on borrowing costs or yields
♦ Annual Percentage Rate
♦ Effective Cost of Borrowing♦ Net present value and IRR calculations
♦ Refinancing decisions
♦ Adjustable Rate Mortgage or ARM Calculations
♦ Price Level Adjusted Mortgage
♦ Reverse Annuity Mortgages (Future Value of Annuity)♦ Supportable mortgage calculations
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Introduction to the Time
Value of Money
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ A peso today is worth more than a pesoreceived in future
♦ In most economies we expect a return
on money or capital related to theproductivity of things capital can buy
♦ This is the fundamental source of thereal returns (not just inflationary
increases)♦ The required returns are cumulatively
known as the opportunity cost ofcapital
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Present & Future Value of a Single Sum
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ PV = FV / (1+r)
♦ FV = PV (1+r)
♦ PV is the present value
♦ FV is future value
♦ r is the total expected rate of return▪ r includes the risk free and risk
premium rates
▪ r is called “discount rate” when solving
for PV
▪ r is called “rate of return” when solving
for FV
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PV & FV over MultiplePeriods of Time
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ General formula for PV and FV acrossmultiple periods:
♦ PV = FV / (1+r)N
♦ FV = PV (1+r)N
♦ N is the number of periods between FV andPV
♦ If FV and PV are known the rate of returncan be found by the formula:
r = (FV/PV) 1/N – 1
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PV of an Annuity
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PV of an Annuity
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Annuity: stream of regular payments of equalamounts
▪ E.g.: monthly rental payments, mortgagepayments
PV = PMT -----------------
♦ ‘PMT’ is the equal amount of payments occurring
at end the of each consecutive equal lengthperiod of time
♦ ‘N’ is the number of payments
♦ ‘r’ is the interest rate per period to time,compounded at the end of each period
1 – 1/(1+r)N
r
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PV of Annuity
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PV of Annuity
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ For payments in advance the PV formulachanges to:
PV = PMT (1+r) ---------------
♦ Expressed in simple interest annual rateterms, the annuity formula assumes theforms:
1 – 1/(1+r)
N
r
PV = PMT ----------------------------1 – 1/(1 + i/m) Tm)
i/m
PMT = PV ----------------------------
i/m
1 – 1/(1 + i/m) Tm)
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Real Estate Finance by Maya Cartojano REC, REA, REB
Mortgage Constant
♦‘MMC’ is the monthly mortgage constant
♦It is the monthly payment per dollar of loan and it
includes both interest and principal amortization
MMC = ------------------
♦Here N & r are in months
r
1 – 1/(1+r)N
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Calculating a Loan Balance
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Calculating a Loan Balance
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Outstanding Loan Balance (OLB) equalsthe present value of the remaining loanpayments
♦ Original mortgage was for ‘T’ years at a
rate of ‘i’
♦ If ‘q’ payments have been made, the
formula will be:
OLB = PMT ----------------------------
OLB = PMT ----------------------------
(with m=12)
1 – 1/(1 + i/m) mT-q)
i/m
1 – 1/(1 + i/12) 12T-q)
i/12
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Calculating the Principal and InterestSeparation of a Mortgage
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Example: A P150,000 30yr mortgage at 9%
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Future Value of an Annuity
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Future Value of an Annuity
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ The FV of an annuity is the result of equalpayments compounding over time at a given
interest rate♦ Used in RAM (Reverse Annuity Mortgage)
♦ Formula:
FV = PMT -----------------
♦ ‘PMT’ is the annuity paid every month
♦ ‘r’ is the interest per period (month)
♦ ‘n’ is the number of months
(1+r)N – 1
r
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Calculating Yields or Borrowing Costs
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Calculating Yields or Borrowing Costs
Real Estate Finance by Maya Cartojano REC, REA, REB
Recap of terms:
♦ Contract interest rate♦ Index♦ Spread♦ Prime♦ Prime Rate of Interest♦ Discount Rate♦ Carry cost♦ Effective or true cost of borrowing♦ Effective yield
♦ Contract rate♦ Points♦ Yield
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More Mortgage Calcs on a
Financial Calculator
O The payment is based on the annuitythat equates to a present value of themortgage loan when discounted at thecontract rate of interest
Real Estate Finance by Maya Cartojano REC, REA, REB
Inputs:
♦ PV = $240,000 (Amount of Loan)♦ I = 8% (divide by 12)♦ N = 360 (30 year loan x 12
months/year)♦ Solve for PMT
♦ Result
♦ PMT = P1,761.03)
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Effective Yield Calculation
Real Estate Finance by Maya Cartojano REC, REA, REB
Loan Amount is P240,000 with 1.5 points andprepayment expected in 10 years withoutpenaltyStep 1: Calculate actual loan amountLoan Amount Disbursed
= P240,000 – 1.5%(240,000)= P236,400 netStep 2: Calculate loan balance due at end of 10yearsPMT = (P1,761.03)
I = 8% (convert to monthly)N = 240 (Months Remaining on the loan)Compute
PV = P(210,539) (Use as FV input)
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Effective Yield Calculation
Real Estate Finance by Maya Cartojano REC, REA, REB
Step 3: Calculate the lender's yield on theamount disbursed, considering earlyrepaymentEnter PV = P 236,400
Enter PMT = P(1,761.03)Enter N = 120 (The expected time untilprepayment)
Enter FV = P (210,539)Compute I = 8.23%
This is the effective cost of borrowing
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Annual Percentage Rate (APR)
Real Estate Finance by Maya Cartojano REC, REA, REB
➢ When loans are held over full amortization term
the effective borrowing costs are based onAPR for annual percentage rate
➢ Truth in lending Act
➢ If there are no point charges, APR is equal toeffective borrowing costs
➢ APR is the yield which brings the futurepayment stream back to present value suchthat it exactly equals the net cash disbursedby the lender
PV = Mortgage Points = [1-{1/ 1+APR12)N}/APR/12]* PMT
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Points – A tool to increase Yield
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Points A tool to increase Yield
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Lender’s perspective: Decrease contractrate (looks attractive to borrower) andincrease points to compensate for it
♦ Question: How many points are needed tobring a mortgage yield up given thecontract rate is lower than required yield?
♦ Steps (using business calculator)
▪ Find monthly payment and input as PMT
▪ Find mortgage balance (consideringpayout) input as FV
▪ Input monthly interest rate (Requiredyield/12)
▪ Input the number of periods
▪ Compute for PV
▪ Loan amount – PV will give the points
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Mortgage Pricing
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Mortgage Pricing
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Which loan is best for a borrower depends onthe expected tenure or time they expect tohold the loan
♦ The 7.5% loan with 7 points is better if theborrower is fairly certain they will hold theloan for more then 10 years and if they don’t
believe rates will come down allowing themto refinance before 10 years
♦If the borrower is uncertain about holdingperiods or future rates, the 8.6% loan is thebest choice with the lowest cost for anythingunder a 10 year hold
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ARM and FRM
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ARM and FRM
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Fixed Rate Mortgage (FRM), where therate of interest charged remains
constant throughout the term♦ Adjustable Rate Mortgage (ARM),
where the rate of interest and hencethe mortgage payment is variable due
to the link with an index♦ Spread is the amount above the index
that is added to determine the newcontract rate of interest
♦ Typically ARMs are priced atsignificantly lower interest rates asmuch of the future interest rate risk isborne by the borrower
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ARM and FRM
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Annual rate caps is the maximum increase inthe rate that is possible per year
♦ Life time caps is the maximum total increasein the rate that is possible during the loanterm
♦ A 1.0% to 2.0% annual rate cap is common
♦ Typical life caps are 5% or 6% over thecourse of the loan, so a loan that starts at 6%can never be higher then 11% if the life cap is5%
♦ To calculate the new payment we first needthe balance of the loan and then we use thisbalance over the remaining term or N tocalculate payments at the new rate
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Choosing b/w FRMs and ARMs
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ FRM interest rate risk is borne by lender
♦ With ARMs much of the interest rate risk isborne by the borrower
♦ Borrowers who are just able to qualify for the
mortgage with little excess in their budget forthe risk of higher payments will often opt for theFRM, while wealthier borrowers with fewliquidity concerns will often opt for the ARMS
♦ Rather than lower aspirations many households
will start to consider taking on the risk of anARM as rate rise and the spread in the marketbetween FRMs and ARMs increases
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Refinancing
Real Estate Finance by Maya Cartojano REC, REA, REB
♦ Refinancing can save borrower money if
there is a drop in mortgage interest rates♦ Situations when refinancing is not advisable:
▪ Remaining term of the loan is short orexpected tenure with new loan is short
▪ Mortgage rates are expected to further
drop▪ Prepayment penalties are higher than
benefits
♦ Deciding whether refinancing is profitable ornot:
▪ NPV of expected savings exceeds thecost of refinancing then it is advisableand vice-versa
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