Highlights • Chapter 16 ½ 9
Chapter 16: financing real estate transactions
Chapter Highlights
1. Who loans mortgage funds?
While mortgage funds may be obtained from a friend, relative, or other private party, institutional lenders supply most mortgage funds. A variety of institutions participate in the primary mortgage market, a term used to describe the origination of mortgage loans. These institutions include: savings and loan associations, commercial banks, mutual savings banks, life insurance companies, credit unions, finance companies, real estate investment trusts, pension funds, and mortgage companies. Certain institutions tend to specialize in particular types of mortgage lending. For example, savings and loan associations tend to specialize in home loans, whereas life insurance companies tend to specialize in commercial loans.
2. What is an S&L?
A savings and loan association (S&L) is a financial institution that accepts deposits that it uses primarily to make loans. Early commercial banks specialized in serving the needs of business enterprises. Therefore, S&Ls were created to serve the financial needs of individuals; their principal function is to promote thrift and home ownership. For this reason S&Ls (together with mutual savings banks and credit unions) are sometimes referred to as thrifts or thrift institutions. Additionally, thrifts and commercial banks are collectively referred to as depository institutions because they accept deposits.
3. What types of home loans do S&Ls write?
They write all types of mortgage loans, including FHA,VA, conventional, mobile home, and home equity loans. They may write conventional loans with a loan-to-value ratio as high as 90 percent. The loan-to-value ratio expresses the relationship between the loan amount and the lesser of the sales price or appraised value of the property. These loans must be amortized on a monthly basis with a maximum amortization period of forty years.
4. How does an S&L operate?
As is the case for most other types of depository institutions, an S&L must obtain permission before it can begin operations. Organizers secure a charter from the appropriate state or federal government authority. The amount of mortgage loans that an S&L can or must make is subject to regulation. Historically, the exact lending requirements depended on the type of charter the institution held.
5. Explain the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA).
Three important provisions of FIRREA focus on S&L real estate lending activities. First, each S&L is required to have at least 70 percent of its portfolio assets in housing-related investments. This provision is intended to return S&Ls to their original purpose of making home loans. A second provision of FIRREA was specifically designed to limit S&L non-residential mortgage lending. Prior to FIRREA, S&Ls could make such loans up to 40 percent of total assets; under FIRREA the limit was set at 400 percent of capital (the owners’ investment in the firm). Most financial institutions operate on capital investments close to the regulatory minimum, and FIRREA requires a minimum capital requirement of 6 percent of assets for S&Ls. Other types of financial institutions operate on similar capital contributions; on average, commercial banks have capital approximately equal to 6 percent of assets, and credit unions operate at approximately 9 percent capital. FIRREA also requires that licensed or certified appraisers perform most real property appraisals. This provision was included in FIRREA because it was believed that a substantial portion of the losses incurred by S&Ls during the 1980s involved loans justified by bad appraisals
6. What is a commercial bank?
A commercial bank is a financial institution designed to act as a depository and lender for many business activities. Commercial banks rely heavily on short-term sources of funds. Therefore, commercial banks tend to write short-term loans in an attempt to balance the maturity of their assets with the maturity of their liabilities. By doing so, if their cost of funds increases, they can cover the increase fairly quickly by charging higher rates on new loans.
7. How are commercial banks involved in real estate lending activities?
Some own mortgage companies directly or through holding companies, and a few own real estate investment trusts through holding companies, both of which are described later in this chapter. Many banks provide lines of credit to other financial institutions that, in turn, make real estate loans. Commercial banks prefer to make short-term loans to finance construction, or to finance mortgage company operations. Construction loans made by commercial banks typically have maturities ranging from six months to two years. When providing such temporary, or interim financing, bankers usually require a takeout loan from another lender, who agrees to issue a permanent loan (long-term) when the construction project is complete. Construction loans are riskier than long-term mortgages and, therefore, usually carry a higher rate of interest. In addition, commercial banks offer the full spectrum of residential mortgage loans. They can write fully amortized, uninsured conventional loans with loan-to-value ratios up to 80 percent, and with a maximum amortization period of thirty years. Insured conventional loans can be written up to a 95 percent loan-to-value ratio.
8. What are MSBs?
Mutual savings banks (MSBs) are depository institutions that were originally developed to meet the financial needs of blue-collar workers. Unlike the other types of institutions, MSBs operate in only seventeen states, most in New England and the Middle Atlantic States. From the mortgage borrower’s viewpoint, the difference between an MSB and a savings and loan association is insignificant. MSBs also offer a full spectrum of mortgage loans, including FHA and VA loans. MSBs may write insured conventional loans with a maximum loan-to-value ratio of 95 percent and maximum amortization period of thirty years. They may write uninsured conventional loans with a loan-to-value ratio up to 80 and, in some states, 90 percent.
9. Explain a credit union.
Like other depository financial institutions, a credit union can be chartered at either the state or federal level, but credit unions are unique in a couple of respects. One distinction is that credit unions are the only privately owned mortgage originators that are not subject to income taxes. Congress granted this exception to encourage the growth of credit unions. Without the burden of income taxes, credit unions should be able to offer higher interest rates on deposits, and lower rates on loans. A second difference between credit unions and other mortgage originators is that credit unions do not make loans or accept deposits from the general public. Membership in the credit union is a prerequisite for obtaining a loan from a credit union.
10. How does one qualify as a member of a credit union?
To qualify as a member of a credit union one must meet the common bond requirement specified in the credit union’s charter. Common bond requirements are based on some factor that the members have in common, such as employment.
11. What types of real estate loans do credit unions offer?
Credit unions make first and second home mortgage loans and home equity loans. Most credit unions are prohibited from offering mortgage loans on commercial properties.
12. What do life insurance companies primarily do?
Life insurance companies are primarily involved in writing insurance policies (contracts) which entitle them to receive periodic premiums (payments) from the insured party in exchange for the company’s promise to pay a third party (beneficiary) a certain amount should the insured die while the policy is in force. The company invests the premiums to help accumulate the amount needed for future payoffs and to generate a profit. Compared to the other institutions, life insurance companies are particularly well suited to invest in mortgage loans due to the long-term nature of their policy obligations, the cash requirements of which can be fairly accurately predicted by actuaries. Life insurance companies can select mortgages with appropriate terms to match their investment requirements.
13. What do life insurance companies prefer to invest in?
Life insurance companies prefer to invest in large-scale projects such as multifamily dwellings and commercial properties, and most do not originate single-family home mortgages. Instead, they underwrite mortgages originated by a mortgage banker or mortgage broker. Life insurance companies have been subject to fewer regulatory restrictions concerning permissible investments compared with depository institutions, and they tend to shift among different types of investments to secure the highest return possible. During periods of tight money, life insurance companies tend to move away from mortgages to investments with a higher yield.
14. Explain a mortgage company and how it operates.
A mortgage company is a business firm that originates mortgages that are usually quickly sold to other parties. Many mortgage companies are subsidiaries of commercial banks or bank holding companies, although some are independent organizations. Mortgage companies can operate in one of two ways, either as a mortgage banker or as a mortgage broker. Both mortgage bankers and mortgage brokers originate loans that are placed with an investor. The investor pays for this service with a loan origination fee, which is typically 1 percent of the loan amount.
15. What are the differences between a mortgage banker and a mortgage broker?
First, a mortgage bank may elect to hold some mortgages in its own portfolio. Second, mortgage bankers, unlike mortgage brokers, for an additional servicing fee (typically three-eighths of 1 percent of the outstanding loan balance), will continue to service the loan (collect payments, pay property taxes and insurance premiums, and attend to delinquencies) after origination.
16. What do most mortgage banks specialize in?
For loans to be held in their own portfolio, some mortgage banks supply permanent long-term financing, but most specialize in short-term and interim financing, using either their own funds or by borrowing from commercial sources. Mortgage banks are a major source of construction loans, and are active in lending money on commercial properties such as office buildings and shopping centers. They also specialize in originating FHA and VA loans in areas where mortgage money is scarce. Mortgage banks sell these mortgages to financial institutions in other areas where loanable funds are available. In this respect, mortgage bankers help correct imbalances in regional mortgage demand by providing a mechanism to move funds from surplus to deficit areas.
17. How do finance companies operate?
Finance companies raise money to make loans by selling securities and borrowing from commercial banks. They are organized either as a division of a corporation (such as General Motors Acceptance Corporation, which is a finance company subsidiary of General Motors) or as a private company. Historically, finance companies have been involved in both commercial and consumer lending. In recent years, however, finance companies have begun to originate second mortgage loans because they face less regulation in this area compared with consumer loans.
18. What is a pension fund?
A pension fund is an organization that acts in a fiduciary capacity. Pension funds collect contributions from workers, invest these contributions, and make payments to qualified retirees. Pension funds have predictable cash needs, therefore, investment in both mortgages and mortgage-related securities are excellent investment choices for them. Historically, however, pension funds have concentrated their investments in corporate and government securities with little investment being applied to finance real estate. With assets of more than 1 billion dollars, some view pension funds as having the potential to become a significant source of mortgage funds. However, some pension fund managers avoid mortgage-related securities because they are concerned about prepayments on the underlying mortgages. Prepayments make the cash flows of mortgage-related securities less predictable, and borrowers tend to prepay when it is least desirable for investors—when interest rates are low. Collateralized mortgage obligations offer investors some protection against prepayments.
19. Describe an amortized loan.
An amortized loan is one characterized by periodic payments that consist of both principal and interest. Today most mortgage loans are fully amortized. With a fully amortized loan, when the last payment is made the principal is paid in full. Further, with the traditional fixed-rate, fully amortized mortgage, the periodic payment remains constant over the life of the loan, but the portion of each payment representing interest and the portion representing repayment of principal change over time. Early payments consist largely of interest while later payments consist largely of principal repayment. In general, the periodic payment on an amortized loan could be set at any interval, but monthly payments are common for most types of real estate loans.
20. What is a partially amortized loan?
Occasionally a loan will be amortized so that the last payment must be substantially larger than the previous ones in order to pay off the principal. Such a loan is known as a partially amortized loan, or as a balloon loan, and the last payment is called a balloon payment. From the borrower’s perspective, the advantage of a balloon loan compared to a fully amortized loan is a lower (except for the last) payment; the disadvantage is that the borrower must somehow come up with the large balloon payment. One of the attractions for borrowers of the fully amortized, fixed-interest-rate mortgage is that the mortgage payment pattern is constant. This type of lending arrangement does not, however, fully meet all borrowers’ needs and has resulted in financial difficulties for some lenders.
21. What types of alternative mortgage instruments are designed to make borrowing more affordable?
Increased affordability is accomplished either by requiring (at least initially) lower payments - the graduated payment mortgage, the growing equity mortgage, and the shared appreciation mortgage, or by enabling the borrower to reduce the total amount of interest that must be paid over the life of the loan - the fast-pay mortgage. Still other mortgage instruments offer the borrower greater financial flexibility, including the wrap-around mortgage and the reverse annuity mortgage.
22. What is an ARM?
The adjustable rate mortgage (ARM), which enables the lender to periodically adjust the interest rate on an existing mortgage, is one of the most significant innovations in residential real estate financing. Adjustments to the interest rate are based on changes in an index, specified in the loan agreement, which generally reflects the lender’s cost of funds. In this way, lenders are able to transfer some, but not all, interest rate risk to the borrower. Interest rate risk results from the inverse relationship between interest rates and the market value of any fixed-income security (such as a corporate bond or a fixed-rate mortgage loan). If interest rates rise subsequent to the issue of the fixed-income security, its market value will fall.