Chapter 43
The Adjustable Rate Loan, the Graduated Payment Loan, and Other Loan
Arrangements
INTRODUCTION
When interest rates are generally stable from year to year, the fixed-rate amortized
loan works well for both the borrower and the lender. For the borrower, the fixedrate loan is easy to budget since each monthly payment is the same for the life of
the loan --usually 30 years. For the lender, the fixed-rate, level payment mortgage
results in few cases of default and foreclosure and a good margin of profit.
During times of high inflation and rising interest rates it is harder for purchasers to
qualify for fixed-rate loans and more difficult for lending institutions to rely on their
portfolio of fixed-rate loans to generate an adequate income stream. When interest
rates go up and stay up for an extended period, lenders face a unique problem. The
income from their fixed-rate loan portfolio stays the same; but to obtain new funds
to lend, they have to pay their depositors or investors more interest because
investment alternatives, such as money market funds, are available at much higher
returns. This financial problem for the lender is an "asset/liability
mismatch." Inflation also causes lenders to increase interest rates on traditional,
fixed-rate loans, pricing many home buyers out of the market. New ways of
financing can make homes more affordable for the buyer while shifting the risk of
interest rate increases from the lender to the borrower.
Such conditions motivated the real estate lending industry to create alternative loan
agreements during the late 1970's and early 1980's, a time of high inflation and
rising interest rates. That period led lenders to become more flexible in the
construction of payment schedules and in the methods of qualifying prospective
buyers. Two of the principal payment methods they created to fill the need for
flexibility are the adjustable rate loan and the graduated payment loan. Other
payment forms are the shared appreciation, buydown, and growing equity loans.
Some of the alternative financing programs developed during periods of high rates of
interest and inflation are applicable under any market conditions. Others may be
useful only in periods of high rates of inflation. Although the fixed-rate loan has
served home buyers and lenders well over the last 50 years and will continue to do
so in the foreseeable future, it is no longer the exclusive residential financing
arrangement.
LEGAL ADVICE AND THE LICENSEE IN THE ALTERNATIVE LOAN AGREEMENT
PROCESS
If a licensee represents the seller, the licensee's role is simply to offer assistance to
the purchaser in his or her efforts to finance the purchase. If a licensee represents
the purchaser, his or her role may be more active. Nevertheless, using alternative
financing techniques to solve affordability problems for the buyer does not entitle a
licensee to practice law. It only allows the licensee to perform his or her duties more
effectively. Because of the legal relationships involved and the potential liability
involved for licensees, the attorney is a vital part of every alternative financing
transaction. Failure of the broker to involve a knowledgeable attorney can result in
many serious problems. An unexpected increase in monthly payments, a buyer's
mistaken belief that he or she owns the property when he or she really does not, a
loan balance that is more than the original loan amount, or a purchaser's finding out
the monthly payments did not go toward paying off the mortgage loan -- each may
result in untold legal problems for the sales associate, the broker, and the client or
customer.
The primary purpose of this section is to acquaint licensees with some of the
alternative financing solutions that can solve affordability problems that fixed-rate
loans cannot. Yet, there are pitfalls to avoid when using these methods. This
material does not cover all there is to know about alternative financing. Practitioners
constantly revise these techniques to meet the demands of an ever changing
economy. Since the home buying public looks to brokers and sales associates for
assistance in overcoming affordability problems, licensees must stay constantly
abreast of what is happening in the local mortgage market. For instance, wellprepared licensees will always know the types of loans currently available from
traditional and special sources; the current interest rates, downpayment
requirements, closing costs, and discount points; the basic requirements for
qualifying; and the sources for second or junior loans.
ADJUSTABLE RATE MORTGAGES (ARM)
An adjustable rate loan, more commonly known as the adjustable rate mortgage
(ARM), has a very important basic feature, a rate of interest that changes
periodically with market conditions. This feature allows lenders to reduce some of
the financial risks associated with the asset-liability mismatch that is inherent for
them in fixed-rate loans. If a borrower has a fixed-rate loan at a low interest rate,
he or she may stay in his or her present house and enjoy payments that are below
the market rate. Only if the lender could get the money back (if the owner sold the
house or refinanced and paid off the old loan) could the lender obtain a higher rate
of interest on the money. However, if the loan is an ARM, the interest rate on the
borrower's loan would change periodically to reflect market conditions; and the
lender would not be in the position of holding a low interest rate loan in the portfolio
of assets. Because the lender takes less interest rate risk on an ARM, the interest
rate is typically lower than a borrower could obtain with a fixed-rate loan. While
there are several different types of ARM loans, they share several features in
common.
(a)
THE INTEREST RATE OR PAYMENT ADJUSTMENT PERIOD: THE
FREQUENCY OF THE RATE OR PAYMENT CHANGE - The interest rate or
the payment amount on an ARM can change as often as the lender and
borrower agree for them to change in the loan agreement. However,
six months to five years has become the generally acceptable range in
the market, with a one year change period being most common for
ARM's on residential property loans.
(b)
INTEREST RATE INDEX - A financial index determines the initial interest
rate and the periodic change in the interest rate on the ARM. At the
time of loan approval, the index plus an add-on component known as a
margin or a spread establishes the interest rate in effect until the first
adjustment. This financial index is an indicator of current interest rate
conditions in the market. With an ARM, regulations allow a lender to
adjust the interest rate on a loan to reflect the current
economy. However, this adjustment cannot be arbitrary. For this
reason, the lender and the borrower must agree on a market indicator
(or index). The requirements for this index are that:
(1)
the index cannot be under the control of the lender, and
(2)
information about the index must be readily verifiable by the
public.
If the index goes up at the adjustment interval, the lender may
increase the interest rate. If the index goes down at the adjustment
interval, the lender must decrease the interest rate. Indexes used by
lenders include the rate on one year Treasury Bills or on three or five
year Treasury Notes; the Federal Reserve Discount Rate; the London
Interbank Offering Rate (LIBOR), and the Eleventh District Cost of
Funds Index. At this writing, the two most common indexes used in
Georgia are the One Year Treasury Bill rate and the LIBOR.
Many lenders offer first year interest rates on the ARM that are below
the prevailing market level of interest rates on ARM's. Borrowers need
to be aware that these "teaser" rates are a one time, first year
reduction and must be prepared for larger monthly payments in the
second year. At that time, the contract interest rate will increase back
to the market level; and loan payments can increase by a large amount
if there is a significant gap between the size of the "teaser rate" and
market rates.
(c)
MARGIN OR SPREAD - The margin or spread is the percentage added to
the index to derive the interest rate for the ARM. The lender usually
states the margin in basis points which equate to a percentage
rate. For example, 200 basis points are equivalent to 2%. The margin
serves the purpose of covering the lender's administrative costs of
servicing the loan. While the interest rate from the index represents
the cost of money at the time of the loan, it does not compensate the
lender for the administrative costs.
The level of the margin or spread is a point of agreement when the
borrower and the lender discuss the specifics of the loan
agreement. In practice the lender will simply inform the borrower of
the amount of the margin. In most cases, the margin is constant over
the term of the loan; but it can change in a predetermined and
mutually agreeable fashion. If the index on an ARM loan has a current
market rate of 7 percent and the margin is 250 basis points (2.5%),
the interest rate on the ARM will be 9.5% per year. If, at the next
adjustment, the index is 7.25% and the margin is constant, the new
rate would be 9.75%. If at the time of the next adjustment interval
the index dropped, the new interest rate on the loan could also drop.
(d)
CAPS OR RESTRICTIONS ON THE SIZE OF THE INTEREST RATE OR
PAYMENT ADJUSTMENT - Caps restrict the size of the interest rate or
payment adjustment. There are "caps" that restrict the change in the
interest rate or the payment from one adjustment period to another,
and there are "caps" that restrict the total change in the interest rate
over the term of the loan.
(1)
THE ADJUSTMENT PERIOD CAP - The adjustment period cap
limits the amount of the adjustment in the interest rate from one
period to another. For instance, if a borrower receives a 2%
annual cap on a one year ARM, regardless of the increase in the
index, the interest rate on the loan cannot increase more than
2% per year. The cap also limits any decrease in the interest
rate when the index declines from one adjustment period to
another.
(e)
(2)
LIFETIME CAP - A lifetime cap sets a maximum that the interest
rate can increase over the entire term of the loan. For instance,
a "6% lifetime cap" means that over the life of the loan, the
interest rate can only increase from its original level to a level
that is 600 basis points (6% ) higher regardless of the
movement of the index. For example, assume a one year ARM
with caps of 2% and 6% on a contract (or initial) rate of
8%. The first year rate would be 8%. The second year rate
could not exceed 10% (8% + 2%, assuming a maximum
adjustment the first year), the third year rate could not exceed
12% (10% + 2%), and the rate may never exceed 14% (8% +
6%). It is quite common for ARM's to feature both a periodic
and a lifetime cap.
(3)
PAYMENT CAP - While not as common as an interest rate cap, a
lender and borrower may agree upon a maximum amount the
payment may adjust at each interval, such as 7.5%. Therefore,
if the payment were $1,000.00, the payment would not change
more than $75 ($1,000.00 X 7.5%) at the next adjustment
interval, regardless of the interest rate change.
NEGATIVE AMORTIZATION - Because the index can change by more
than the interest rate cap over one adjustment period, the ARM loan
can create a situation in which the lender receives an interest payment
based on the index and the margin that is less than the lender's cost of
money plus administrative costs for the loan. To avoid this situation
the lender may ask to allow "negative amortization" of the ARM
loan. The term negative amortization refers to a situation when the
unpaid balance of the loan increases from one period to the
next. Positive amortization, which always exists in a fixed-rate loan,
means that the loan balance drops with each loan payment. Negative
amortization is the reverse. Lenders rarely make ARM loans that
include negative amortization, but when they do, the loan agreement
must be specific in giving the lender the ability to amortize a loan
negatively. In the event that a negative amortization provision exists,
the extent of negative amortization can be "capped" at a mutually
agreeable level such as 125 percent of the original loan amount.
OTHER FEATURES OF ARM LOANS
While the index, margin, adjustment interval, and caps are common to the ARM,
most ARM's include other provisions, some of which are also common to the fixedrate loan.
(a)
MORTGAGE INSURANCE - As in the case of fixed-rate loans, if the LTV
exceeds 80%, the ARM lender will most likely require mortgage default
insurance. It also is not uncommon for the premium to be slightly
higher than for a fixed-rate loan, reflecting the potentially higher risk
for the lender of an ARM in the event the payments increase and the
borrower defaults.
(b)
PREPAYMENT OPTION - With an ARM, a borrower may prepay, all or in
part, without penalty. A unique result of this option with an ARM is
that if the borrower pays a substantial amount of principal, this
prepayment lowers the borrower's monthly payment at the next
adjustment since the lender computes the payment at the intervals
based on the new interest rate, the term remaining, and the current
principal balance.
(c)
DUE ON SALE CLAUSE - Some ARM's contain a due on sale clause
allowing the lender to call the loan due upon the sale or transfer of the
property. If a subsequent purchaser wishes to assume the debt as part
of the purchase price, the lender will use this provision to require the
new borrower to qualify financially and/or increase the interest rate to
the market rate, if the lender will allow the assumption at all.
(d)
CONVERSION OPTION - Many borrowers like having the ability to
change from the ARM to a fixed-rate loan. If the lender agrees to the
borrower's request, the loan agreement will contain a clause that fully
identifies the borrower's right to exercise the conversion option and
any associated conditions and fees. For example, the lender may wish
to specify that upon conversion, the interest rate for the fixed-rate loan
will be at or above the current rate for new fixed-rate loans. The
lender may also limit the time during which the borrower has the right
to convert and set a fee for the conversion to cover the administrative
costs of making the change.
(e)
MODIFICATION TO THE APPLICATION OF THE INTEREST RATE CAP The loan agreement can carry the provision that an increase in the
market interest rate not obtained by the lender due to the 2 percent
cap on the interest rate change could be recouped in a subsequent
year. For example, if the contract rate in year 4 is 7 percent and if the
index rate increased from 5 percent to 8 percent between years 4 and
5 of the loan, the contract rate in year five will be 9 percent. Even
though the index increased 3 percent, the 2 percent cap would hold the
increase in the contract rate to 9 percent from the previous year’s 7
percent. If in year six the index rate declined from 8 to 6 percent, a
corresponding decrease in the contract rate from 9 percent to 7 percent
would normally occur. However, by agreement in this case, the lender
could recoup all or part of the one percent increase that the lender had
to forego in year five. So, the contract rate could be 7, 9 and 8
percent respectively for years 4, 5 and 6 instead of 7, 9 and 7 as might
be expected. The specific language of the loan agreement determines
whether the lender has the right to recoup past interest increases
which the interest rate caps precluded.
TRUTH IN LENDING ACT DISCLOSURE REQUIREMENTS FOR THE ARM
Federal regulations in the Truth in Lending Act require a lender to disclose to a
borrower, at or before the time of application, the financial features of the ARM
including the interest rate adjustment, the index, the margin, the adjustment period
and caps, and any negative amortization and conversion options. The lender must
provide an APR for the ARM using the initial contract interest rate that exists at the
time of the closing. The lender must also provide a historical example that shows
the monthly payments on a $10,000.00 ARM using the actual interest changes over
the last fifteen years. When the loan is in effect, any change in the payment level
requires an advance notice. This disclosure must come at least 25 days prior to the
change but not more than 120 days before the change in payment.
QUALIFYING THE BORROWER FOR THE CONVENTIONAL ARM
In qualifying a borrower for a conventional ARM, lenders generally use the 28%
housing expense ratio and the 36% total obligations ratio as they do for fixed-rate
conventional loans. Chapter 42 in section 42.20 presents these ratios and discusses
several compensating factors that allow borrowers to exceed these ratios and still
qualify. However, the size of the principal and interest payments in these two ratios
depends on the interest rate in the calculation. Since the initial interest rate on an
ARM is lower than that of a fixed-rate loan, the lender will estimate the level of
interest and principal using the maximum interest rate that will be in effect at the
end of the first adjustment period. (The lenders in the secondary mortgage market
set this requirement.)
THE FHA SECTION 251 ARM PROGRAM
A borrower can use the FHA Section 251 ARM program to purchase or to refinance a
single family to four family property. While the rules governing the loan amount and
the loan-to-value ratio are the same as those for the FHA section 203(b) plan, the
contract rate, the discount points, and the margin are items for negotiation between
the lender and the borrower. The index is the one-year Treasury securities
index. Other requirements for the FHA's ARM are a 30-year term, an annual interest
rate cap of 1%, a 5% lifetime cap, and no negative amortization. The lender must
also provide a loan scenario using the annual cap and the life time cap and figuring
the interest at the maximum rate for the duration of the loan term.
GRADUATED PAYMENT MORTGAGE (GPM)
Federal agencies designed the graduated payment mortgage, GPM, to overcome the
negative effect on first-time homebuyers caused by rising interest rates and rising
house prices. In a GPM loan, the payments are lower in the early years of the
loan. The size of the payments increase periodically, typically yearly, according to a
fixed schedule. Eventually (usually after five years) the payments level off to a fixed
amount, but at a higher level than the payment would have been on an equal
payment loan. The loan then amortizes down to zero, just as an equal payment loan
would.
Several important features are unique to the GPM.
(a)
LOAN PAYMENT CALCULATION - The calculation of the loan payment
begins with the selection of a number called the loan constant. This
number is derived from the interest rate on the loan; the term of the
loan, typically 30 years; the gradation period or the length of time
between the beginning of the loan term and the time when the
monthly payment reaches the maximum level; and the annual rate at
which the monthly payments increase. (A discussion of the calculation
of the loan constant is beyond the scope of this reference text.)
Multiplying the loan constant times the amount of the loan determines
the loan payment for the first year. For example, if the market
interest rate is 10%, the loan term is 30 years, the gradation period is
five years and the annual growth rate for the loan payment is 7.5%,
the GPM loan constant is 0.00667. For a loan of $90,000.00 the
monthly payment in the first year of the loan is $600.30 (.00667 x
$90,000.00). In the second year the payment increases by 7.5% to
$645.32. For the third, fourth and fifth years the payments become
$693.72, $745.75 and $801.68 respectively. At the start of the sixth
year which is at the end of the gradation period, the monthly loan
payment becomes $861.81 and remains at this level for years six
through thirty.
In contrast, the monthly loan payment for a fixed-rate, equal payment
loan of $90,000.00 at 10% per year for 30 years is $789.81. Thus
while the GPM loan payments for first four years are less than for the
fixed-rate, level payment loan, the GPM monthly payments in the fifth
and subsequent years are higher.
(b)
NEGATIVE AMORTIZATION AND THE LOAN BALANCE - Negative
amortization is a basic feature of the GPM. In the first year of the
loan, the GPM returns a payment of $600.30 per month to the
lender. But, at an interest rate of 10%, the lender expects to receive
an interest payment of $9000.00 per annum or $750.00 per
month. The lender and the borrower agree to add the difference
between $750.00 and $600.30 to the loan balance. So, after the first
month the loan balance increases from $90,000.00 to
$90,149.70. The borrower borrows the $149.70 difference between
the payment and the interest due at the contract rate for the term of
the loan. As monthly payments increase, the differential declines
although the amount of interest on the growing unpaid balance
increases. The differential disappears when positive amortization
occurs at the end of the fifth year.
This process continues for the first five years. At the end of the fifth
year the loan payment for the GPM exceeds the required interest
payment for the accumulated loan balance and positive amortization
starts in the sixth year (the year after the gradation period). At the
end of the gradation period the loan balance for this loan example is
$94,839.80. Negative amortization is $4,839.80.
(c)
THE GPM BECOMES A LEVEL PAYMENT LOAN AFTER THE GRADATION
PERIOD - After the gradation period when the loan incurs negative
amortization and the loan balance increases to $94,839.80, the GPM
becomes a level payment 10% loan for the 25 remaining years. The
monthly payment of $861.81 pays off the loan.
THE GPM COMPARED TO THE LEVEL PAYMENT LOAN
There are three major differences between a GPM and a level payment fixed-rate
loan.
(a)
The monthly loan payments for a GPM rise for a time rather than
remaining fixed for the term of the loan. Over the life of the GPM,
however, the borrower makes full payment of principal and interest.
(b)
Monthly payments in the early years of the GPM loan are not sufficient
to cover the interest on the loan resulting in negative amortization.
(c)
Negative amortization occurs in the GPM only during the gradation
period; positive amortization takes place over the remaining term of
the loan.
THE FHA SECTION 245 A PROGRAM: THE FHA GPM PROGRAM
The most common GPM is the FHA "Section 245 A" program. Only owner-occupied,
proposed or existing, single family homes which meet FHA minimum property
standards are eligible. Under the FHA/GPM program, the interest rate is fixed over
the full term of the loan, but the borrower selects one of three basic plans to
determine how much his or her payments increase and for how long.
On GPM plans, monthly payments increase annually. Starting in the 6th year (for the
5 year plan) or the 11th year (for the 10 year plan), the monthly payments are level
for the remaining term.
The table below lists the annual increases for the various plans.
Plan
Annual Payment Increase
Plan I (Code A)
2.5% each year for 5 years
Plan II (Code B)
5% each year for 5 years
Plan III (Code C)
7.5% each year for 5 years
Plan IV (Code D)
2% each year for 10 years
Plan V (Code E)
3% each year for 10 years
The FHA's GPM allows negative amortization but limits the permissible size of the
loan after the negative amortization occurs. The increased principal balance cannot
exceed the maximum insurable loan amount that is available through FHA's standard
203b program for that sales price at the time of closing the GPM. If the maximum
FHA insured loan is $70,000.00 under the standard 203b program, a GPM loan must
not exceed that amount during its period of negative amortization. It is for this
reason that down payment requirements for an FHA/ GPM will generally be more
than that required under the standard FHA 203(b) program.
THE BUYDOWN LOAN
A buydown loan is a fixed-rate loan agreement with an additional feature
incorporated into the plan. Either the borrower, or more typically the seller, provides
front-end funds to the lender to lower the borrower's monthly payments for a
specified period. Withdrawals from the front-end funds supplement the lower
payments each month so that the lender receives the full amount of the required
monthly payment as in the fixed-rate conventional loan. Buydown loan agreements
are most often fixed-rate conventional loans, but they can also be a variety of the
ARM or GPM.
The buydown loan is a more attractive loan agreement when interest rates are
relatively high. The higher interest rates and resulting reduction in sales volume
motivate the seller or builder to provide the buydown funds to facilitate the sale of
the property. However, the borrower may choose to use the buydown arrangement
to qualify for a higher-priced home than he or she would otherwise be unable to
purchase without the lower monthly payments in the initial years of the loan.
There are two forms of the buydown loan: the permanent buydown and the
temporary buydown. The temporary buydown has two aspects: the level payment
buydown and the graduated payment buydown.
(a)
THE PERMANENT BUYDOWN - In the most typical permanent buydown, a
front-end payment in discount points reduce the contract interest rate on
the loan. For example, if the current market interest rate is 9%, the
borrower would like to have an 8% interest rate. The lender can
accommodate the borrower by charging an offsetting number of discount
points. In reducing the contract interest rate, lenders typically use a rule
of thumb or guideline that six discount points are equivalent to 100 basis
points in the interest rate. (Other lenders apply a ratio of eight discount
points to 100 basis points.) If in the example, the borrower wants to
buydown the contract interest rate from 9% to 8%, he or she would have
to pay approximately six discount points. (Chapter 42 also discusses this
point in the section on discount points.)
(b)
THE LEVEL PAYMENT TEMPORARY BUYDOWN - A level payment temporary
buydown might be a solution to a problem in which a buyer can qualify for
a loan based on creditworthiness, but cannot qualify for the size of loan
needed to purchase the home at market interest rates. If the borrower
can show evidence that his or her annual gross stable income will grow
over the next few years, a temporary buydown might work. (Other
compensating factors might come into play as well.) For example, if
current interest rates are 12% on a 30-year loan for $120,000.00, the
monthly payment is $1,234.34, an amount above what the borrower can
qualify for. Based upon income, the borrower can qualify for a 30-year
loan of $120,000.00 with a monthly payment of $1,097.69, which
represents an interest rate of 10.5%. Using this example, the borrower,
the builder (seller), and the lender can agree for the lender to receive
payments of $1,234.34 a month and the buyer to make payments of
$1,097.69 per month for the first three years of the loan. To make up the
difference between what the buyer pays and the lender receives monthly
for the first three years, the seller deposits a total of $4,919.40 into an
account with the lender. Each month the lender withdraws the difference
between $1,234.34 and $1,097.69. The following chart illustrates the
process.
YE
AR
MONT
HLY
PAYM
ENT
BUYD
OWN
INTER
EST
MONT
HLY
PAYME
NT
MONTH
LY
PAYME
NT
ANNUAL
PAYME
NT
DIFFER
@
12%
/ YR.
RATE
@
BUYD
OWN
RATES
DIFFER
ENCE
ENCE
1
$1,234
.34
10.5%
$1,097.
69
$136.65
$1,639.8
0
2
$1,234
.34
10.5%
$1,097.
69
$136.65
$1,639.8
0
3
$1,234
.34
10.5%
$1,097.
69
$136.65
$1,639.8
0
430
$1,234
.34
12%
$1,234.
34
0
0
$4,919.40
If the lender is willing to pay interest on the account compounded monthly
and if 4% is the appropriate market interest rate on savings accounts, the
builder would only have to deposit $4363.99 which along with the interest
earned would cover the monthly payment difference over the three
years. The lender and the builder could structure other arrangements to
deposit the front-end funds.
(c)
THE GRADUATED PAYMENT TEMPORARY BUYDOWN - A graduated payment
temporary buydown might be another solution to a problem in which a
buyer can qualify for a loan based on creditworthiness, but cannot qualify
for the needed size of loan at market interest rates. If the borrower can
show that his or her annual gross stable income will grow over the next
few years, a graduated payment temporary buydown might work. (Other
compensating factors might come into play as well.) For example, if
current interest rates are 12% on a 30-year loan for $120,000.00, the
monthly payment is $1,234.34, an amount that the borrower cannot
qualify for. Based upon income, the borrower can qualify for a 30-year
loan of $120,000.00 with a monthly payment of $965.55, which represents
an interest rate of 9%. Using this example, the borrower, the builder
(seller), and the lender can agree upon a graduated payment plan whereby
the buyer makes payments calculated at 9% interest the first year, 10%
the second year, 11% the third year, and 12% for the remaining life of the
loan. In every year the lender receives payments of $1,234.34 a
month. The first year the buyer makes monthly payments of $965.55; the
second year, $1,053.08; and the third year, $1,142.79. To make up the
difference between what the buyer pays and the lender receives monthly
for the first three years, the seller deposits a total of $6,499.20 into an
account with the lender. Each month the lender withdraws from this
account the difference between $1,234.34 and the borrowers monthly
payment amount for that year. The chart that follows illustrates a 3-2-1
buydown plan.
YE
AR
MONT
HLY
BUYD
OWN
MONTH
LY
MONTH
LY
ANNUA
L
PAYM
ENT
@
12%
/ YR.
INTER
EST
RATE
PAYME
NT@
BUYDO
WN
RATES
PAYME
NT
DIFFER
ENCE
PAYME
NT
DIFFER
ENCE
1
$1,234
.34
9%
$965.55
$268.79
$3,225.4
8
2
$1,234
.34
10%
$1,053.
08
$181.26
$2,175.1
2
3
$1,234
.34
11%
$1,142.
79
$91.55
$1,098.6
0
430
$1,234
.34
12%
$1,234.
34
0
0
$6,499.20
If the lender is willing to pay interest on the account compounded monthly
and if 9% is the appropriate market interest rate on savings accounts, the
builder would only have to deposit $5,018.57 which along with the interest
earned would cover the monthly payment difference over the three
years. The lender and the builder could structure other arrangements for
the deposit of the front-end funds if they agreed.
Lenders must consider the marketability of their buydown loans in the
secondary mortgage market. For this reason, they structure their
buydowns to comply with the following guidelines established by the
agencies which buy mortgages in the secondary market.
(a)
The term of the buydown period must be for a minimum of one year and a
maximum of five years.
(b)
The plan must not reduce the effective interest rate to the borrower by
more than 3%.
(c)
If the buydown plan calls for graduated payments during the total term of
the plan, then such payments must be constant for each twelvemonth
period.
(d)
The borrower's payment increase from one payment phase to the next
should generally not exceed 7.5%. On the level payment buydown plan,
the 7.5% guideline may apply on a cumulative basis. For instance, a
buydown on a three-year term which results in the 37th payment being
22.5% higher than the 36th payment would be acceptable. The level
payment temporary buydown example given above passes this
test. Payments increase from an initial $1097.69 to $1234.34 over the
three years. The percentage increase over the three years is 12.45
percent ($136.65/$1097.69) which is less than the 22.5% allowed. The
graduated payment temporary buydown plan in the previous example does
not meet this criterion. The annual percentage increase is 9 percent, 8.5
percent, and 8 percent respectively for years one, two and three.
(e)
The amount of the buydown is limited to a percentage of the sales price or
the appraised value of the property, whichever is lower. The limits apply
to any contributions made by an interested party to the transaction -- the
seller (the builder) or the real estate licensee. If the loan to value ratio is
over 90 percent the maximum contribution allowed in the buydown is 3
percent of the sales price or the appraised value, whichever is lower. If
the loan to value ratio is 90 percent or less, the maximum contribution
allowed in the buydown is 6 percent of the sales price or the appraised
value, whichever is lower. The buydown limit does not apply to the funds
of third parties or disinterested parties to the buydown transaction. A
borrower could receive any sum of money from a parent, a family member
or an employer and apply them as a buydown.
If the buydown amount actually made by the seller exceeds the limit, the
lender must subtract the amount over the limit from the sales price or the
appraised value of the property. For example, a seller provided a
$7500.00 buydown on a property with a $125,000.00 sales price and a
$130,000.00 appraised value. All of the buydown money applies under the
rule. But if in this situation the seller gave a $8500.00 buydown, the
lender needs to subtract the excess $1000.00 from the sales price to
calculate the loan amount. The $125,000.00 sales price less the $1000.00
excess contribution to the buydown equals a $124,000.00 "adjusted sales
price." The $124,000.00 figure times the 80 percent loan to value ratio
yields a loan amount of $99,200.00.
THE BUYDOWN LOAN: QUALIFYING THE BUYER
The standards for qualifying the borrower for a buydown come from the guidelines of
the agencies in the secondary mortgage market. For the permanent buydown loan,
the guidelines provide that the borrower's housing expense be calculated at the
reduced or "bought down” interest rate.
For the temporary buydowns the two principal agencies in the secondary mortgage
market have different standards. FNMA's standards for qualifying a borrower for an
owner-occupied principal residence allow the lender to use the reduced first year
interest rate. However, the total obligations ratio must not exceed 33% which is
lower than the 36% for conventional fixed-rate loans. The guidelines do not allow
the consideration of compensating factors if the borrower is unable to meet the 33%
ratio.
FHLMC has its own standards for temporary buydowns. The lender can qualify the
borrower at the reduced first year rate, and the standard housing expense ratio and
total obligations ratios of 28% and 36% respectively apply. However, the temporary
buydown cannot exceed a two-year term and cannot have more than a 200-basis
point reduction in the interest rate for the temporary period. So FHLMC standards do
not allow the 3-2-1 buydown but do permit a 2-1 buydown.
FIXED-RATE LOAN WITH BALLOON PAYMENT
A fixed-rate loan with a balloon payment has two primary characteristics. The
monthly payment is the same as that for a long term fixed-rate loan, and the
borrower and the lender have agreed that the loan will be paid off in the short
term. For example, a borrower and a lender may agree to a $100,000.00 loan at
9% per annum for 30 years with a balloon for the unpaid balance at the end of the
tenth year. The monthly payment for this loan is the same as it would be for the 30year fixed-rate loan -- $804.62. The balloon payment is the unpaid loan balance at
the end of the tenth year -- $89,429.74. The payment schedule for this loan
agreement is $804.62 for 119 months and a final closeout payment of $90,234.35
($89,429.74 + $802.64). The borrower and the lender must cover three things about
the balloon payment in the loan agreement: (1) when is the payment due, (2) how
much the payment will be, and (3) whether the date of the payment is
deferrable. The borrower might like the possibility of deferring the balloon payment
because of the uncertainty of the future. Perhaps he or she will not have the funds
to meet the balloon when it comes due but will have it two years later. The lender
might be willing to allow a deferment but will want to assess a financial penalty. For
example, the balloon-payment deferment clause might say that if the borrower does
not make the balloon-payment at the end of the tenth year, the interest rate will
increase in some manner for the deferment period. The interest penalty could be set
at 150 basis points (1.5% points) over the market rate or over the contract rate
whichever is higher. The increased interest would compensate the lender for the
additional wait, and it would give the borrower an incentive to repay the loan as
early as possible.
THE INTEREST-ONLY LOAN
The interest-only loan is a loan contract in which the lender and the borrower agree
that the periodic payment from the borrower to the lender will be a payment only of
the interest due. The borrower repays the total loan amount at the end of the loan
term. For example, an interest-only loan of $10,000.00 at 10% per annum with
quarterly payments for five years has quarterly interest payments of $250.00 for 19
quarters and a final payment at the end of the twentieth quarter of $10,250.00.
THE GROWING EQUITY LOAN
The growing equity loan or growing equity mortgage (GEM) is also a variety of the
fixed-rate loan. Although there are several possible arrangements, the simplest form
of the GEM requires a payment equal to the fixed-rate level payment amount for the
same loan amount, interest rate, and term. The borrower also agrees to make
additional monthly payments on the principal. While the basic payment pays the
interest due and amortizes the principal according to a standard amortization
schedule, the entire additional payment pays down the principal and, in effect,
shortens the term of the loan. For example, a borrower and a lender could create a
GEM agreement with a $100,000.00 loan at 9% for thirty years with the size of the
payment increasing by 5% each year beginning with the second year until the
borrower pays off the loan. The monthly loan payment in the first year is $804.62,
the amount needed to pay back the $100,000.00 at 9% in 360 payments. The
monthly loan payment in the second year is $844.85, 5 percent higher than the first
year payment. Since the interest due is already covered by the first year payment,
the additional $40.23 per month in the second year payment amount goes entirely to
reduce the loan balance.
The GEM starts as a thirty-year loan, but the additional funds work two ways to pay
the loan off faster. The additional amounts not only reduce the loan balance faster
than would happen in a level payment amortization, but the shrinking principal
balance means that less of the basic payment each month goes to pay interest and
more goes to pay principal than would be the case in a level payment fixed-rate
loan. Therefore the thirty-year loan becomes a twenty-five, twenty, or even fifteen
year loan, depending upon how much the payment amounts increase each year. An
amortization schedule would show exactly at what point the GEM loan is
off. Conventional lenders and the FHA offer GEM loans. The Section 245a insurance
program is the FHA GEM loan.
SHARED APPRECIATION MORTGAGES
A shared appreciation mortgage, or SAM, is a loan agreement between the borrower
and the lender is which the lender and the borrower split the increase in the value of
the property in some agreed upon proportion. For the right to share in the increase
in the value of the property, the lender agrees to charge a lower rate on the
loan. The borrower and the lender agree that the lender will receive monthly loan
payments at the below market rate and a single payment when the property is sold
or at a specified date whichever date is the earliest. For example, the lender gives
the borrower a loan for $100,000.00 to buy a $120,000.00 property. The lender and
borrower agree to a 6 percent interest rate on the loan although current interest
rates are 8 percent. For agreeing to forego the 2 percent in interest, the lender will
receive 40 percent of the increase in the value of the property upon its sale or on the
tenth anniversary of the loan, whichever comes first. If the borrower sells the house
for $160, 000.00 nine years later, the lender will receive 40 percent of $40,000.00 or
$16,000.00 as his or her share of the value increase.
THE REVERSE-ANNUITY LOAN
A reverse-annuity loan is an agreement between a real property owner and a lender
in which the lender makes monthly payments to the property owner for a time; and
at the end of that time, the property owner must repay the lender. The property
owner can repay the loan by obtaining the funds from any source, but typically the
property owner must sell the property to repay the loan. The need for a reverseannuity loan arises when a homeowner needs a steady income stream (monthly or
annual) to meet living expenses during retirement or to provide funds for anticipated
additional expenses in the near future such as medical bills.
For example, a property owner has a house valued at $100,000.00; and a lender
agrees to a reverse-annuity loan for $50,000.00 at 7 percent interest over a ten year
period. The lender is confident the property will be worth at least $100,000.00 in
ten years. The lender agrees to a monthly payment to the borrower of $288.88,
which at an annual interest of 7 percent will accumulate to $50,000.00 at the end of
the tenth year. The property owner gets $288.88 for 120 months, and the lender
earns interest on these funds at a rate of 7 percent each year and recovers all the
money loaned at the end of the tenth year.