Topic 12.3: Common mortgage features

Learning Objective

After successfully completing this topic, you will be able to describe the various features of a mortgage including down payment, loan-to-value ratio, equity, interest, loan servicing, escrow account, PITI, discount points and loan origination fee.

Down payment

The amount of the down payment for a property is calculated by subtracting the mortgage balance from the purchase price of the property.

For example, assume Marston was purchasing a new home for $400,000. He could get a new mortgage for the home in the amount of $320,000. His down payment will be $80,000. (Calculation: $400,000 – $320,000 = $80,000)

Loan-to-value-ratio 

The loan-to-value ratio on a loan is calculated by dividing the loan amount by the property value. In the example above, the loan-to-value ratio is 80%. (Calculation: $320,000 ÷ $400,000 = 80%)

Equity

A property’s equity is the difference between the value and the mortgages. It’s a little different from a down payment, because it is often calculated for a seller at the time of sale, rather than for the buyer.

For example, assume an owner owns a house valued at $275,000. If her mortgage balance is $158,000, her equity in the property is $127,000. (Calculation: $275,000 – $158,000 = $127,000)  

Interest

Interest is the “rent” that is paid for borrowing money. Mortgage lenders normally charge interest on the outstanding balance of the loan. Most institutional lenders charge interest in arrears, meaning that the interest is paid at the end of the period.

Escrow (impound) account 

It is very important to lenders that they have first priority on the property, especially when the loan-to-value ratio is higher than 80%. Because property taxes come first, the lender often requires the borrower to pay taxes and insurance as part of the monthly payment. At the end of the year, the lender will have collected enough to pay the annual taxes and insurance premium. This protects the lender from tax liens and from uninsured losses from fire and windstorm.

The funds collected by the lender for taxes and insurance are held in an escrow account. Federal law limits the amounts that lenders can hold for this purpose.

PITI

When a lender requires an escrow account, the borrower’s payments to the lender consist of principal, interest, taxes and insurance (PITI).

Example of PITI payment:
Assume a borrower finances the purchase of a home with a $300,000 mortgage at 5 percent interest for 30 years. The monthly principal and interest on the loan is $1,610.46. The annual taxes are estimated at $2,600 and the hazard insurance is $1,580. What will the total payment be if the lender requires an escrow?
Solution:
Principal and interest                         $1,610.46
Taxes- $2,600 ÷ 12 months                     216.67
Insurance- $1,580 ÷ 12 months               131.67
Total Payment of PITI                                    $1,958.80  

Discount points       

Discount points are a fee charged by a lender to increase the lender’s total interest yield. Most lenders sell the mortgages immediately after a closing to secondary market investors. The investors set a required overall yield in order to purchase the loans. If the interest rate on the loans is lower than the investor’s required yield, the lender will have to “discount” the loan (sell it for less than the face amount of the loan).

A “point” is equal to 1% of the loan amount. For example, if a lender must sell the mortgage for 98 percent of its face amount, there is a 2 percent discount (100% – 98% = 2%). If the lender has made a loan for $300,000, the lender must sell it to the investor at $294,000 ($300,000 x .98). The lender has discounted the loan by $6,000, which is 2% of $300,000. The lender will usually require the borrower to pay the points. The borrower is willing to do this for a lower interest rate.

For each discount point, the yield on a loan is increased by approximately 1/8 of 1%. If the charge for points is 2%, the lender’s yield is increased by 2/8, or ¼ of 1%.

Example of points in the real world:
You are buying a house in Destin for $400,000 and have applied for a mortgage with Glendale Mortgage Company. You agree to make a down payment of 20% of the purchase price ($80,000) and finance the purchase with an 80% loan in the amount of $320,000. The interest rate on the loan is 4 percent but the investor who is buying the loan requires a yield of 4 3/8 percent. How many points must the borrower pay and what will be the cost of those points?  
To calculate how many points to pay, find the difference between the investor’s required yield and the mortgage interest rate: 4 3/8% – 4% = 3/8%. For each 1/8%,  the lender must charge 1 point, so the lender will charge the borrower 3 points.    

To calculate the cost of the points, multiply the number of points by 1%, so 3 points x 1% = 3% of the loan must be charged. The loan amount is $320,000, so the cost of the points is $9,600 ($320,000 x .03).

Should you pay points?

Probably not. If you kept the house and paid off the mortgage over thirty years, your interest cost would be 4 3/8 percent. But, if you sell the house in 3 years, you’d have to amortize the 3 percent over a three-year period, so your real interest rate would be 1% extra per year from the points plus the mortgage rate. You would be paying 5 percent interest. Your best action is to avoid paying any points and pay 4 3/8 percent interest on the loan.

Loan origination fee

A loan origination fee is a commission for creating a loan. The fees are typically 1% of the loan amount for residential properties. This is the amount a lender charges to offset the costs of the mortgage department payroll and rent.

Loan servicing

When a lender sells a loan to Fannie Mae or Freddie Mac after the loan transaction closes, the lender often agrees to service the loan by collecting payments, sending the principal and interest to the investor and paying taxes and insurance when those expenses are due.

Typically, a lender will receive about 3/8 of one percent for providing the service. Mortgage companies typically pay the loan staff from the origination fees, and receive 3/8 of one percent of the payment as a servicing fee. A mortgage company servicing $1 billion in loan payments (a common situation) would receive $37.5 million in annual income from fees. This is a very lucrative income producer for the lenders.

Take out commitment 

When a bank finances a construction loan for a large project such as an office building or apartment complex, the bank wants the developer to pay off the loan when construction is complete. Because most developers don’t have the funds to pay off the construction loan, the developer must obtain permanent (long-term) financing that will pay the construction loan. The construction lender will want a commitment from a permanent lender to “take out” (pay off) the construction loan when construction is completed.