Mortgage Risk Analysis (Part 2)

Mortgage risk is the danger of impairment of expected yield or of invested principal. It is the chance that the borrower will fail to meet the terms of the contract and that his failure to make debt service payments will reduce the yield on the investment, or that the principal of the debt will be impaired because the value of the collateral property is not sufficient to cover costs of foreclosure and the full amount of the unpaid balance of the loan.

The analysis of mortgage risk is mainly an evaluation of the defenses against loss. The borrower is the first defense. No lender wittingly makes a mortgage which he expects to have to foreclose. But there are many uncertainties in predicting the future of financial behavior of the mortgagor and thus some chance that that foreclosure will be necessary in every loan. For this reason, the lender must carefully judge the strength of the second line of defense against loss, the collateral real estate. The effectiveness of this protection will be measured by the relationship between the unpaid debt (and other accumulated obligations such as back interest) and the proceeds of the foreclosure sale when the collateral is liquidated. 

Note that mortgage risk is not a circumstance which exists only at the moment the loan is made. To the contrary, risk is present at all times during the life of the loan until it is completely extinguished by repayment.

Mortgage risk is the product of a set of relationships among borrower, property and the loan elements. The loan elements are the amount of the debt, the interest rate, the repayment plan, and the term of the loan. In relationship to one pattern of loan elements, a certain borrower might be a high risk, with another pattern, he would be low-risk borrower as for example if the amount of the debt were reduced, or the term extended so that the monthly payments would be smaller.

How Much Should a Family Pay for a Home? (Part 2)

A first step in the evaluation of the home investor’s financial position is a listing of assets which can be converted into cash for a down payment. This list should include assets which can be used as collateral for loans as well as sources of gifts or loans from friends and relatives. The following list suggests the usual items:

- Checking account
- Saving account
- Bonds (market value less broker’s fees)
- Real estate (market value of equity less broker’s commission)
- Life insurance (loan value)
- Potential gifts
- Potential loan from relatives (interest rate, terms of repayment)

The analysis of earning capacity must cover both the present and the prospective levels of income. In occupations where earnings fluctuate, such as in selling on commission, the average income based on the last three to five years is a sounder basis for judgement than the income for any one year. The earnings of secondary workers, wives and children should be judged in terms of how long they can be counted on. Income other than earned income-from investments, roomers, gifts and so on must be evaluated in terms of reliability and duration.

It is true that the level of income of the primary earner may change; it will then be unwise to undertake a long-term obligation which can be met only if the present level of income continues. The important point here is that both income and obligations must be forecasted over the period of the proposed mortgage loan contract in order to judge the probability that payments can be met over its entire term.

Obligations must be deducted from income to determine the balance available for housing expense and home investment. The first deduction is the income tax and the deduction for retirement benefits and other regular withholdings.  

Mortgage Risk Analysis (Part 1)

When an application for a mortgage loan is received by a financial institution, the mortgage loan officer or committee must decide upon its acceptability. It is usually assumed that the prospective borrower will pay the going rate of interest and that the mortgage loan will be repaid or amortized within some maximum term of years which represent the current policy of the lender. 

The mortgage loan officer is confronted with the problem of determining the acceptability of the mortgage investment under these conditions; or if it is not acceptable under the customary mortgage contract, he may propose modifications in the terms, such as a higher interest rate or faster amortization, which might make it a good investment. Of course, he may conclude that it does not meet minimum standards, even with adjustments in terms. The basic analytical problem of the lender is the evaluation of mortgage risk.

The objectives of the mortgage lenders are to make a loan which will produce a gross return sufficient to:

1- Cover the costs of making and servicing the loan

2- Provide a basic or pure interest return on the capital, and

3- Yield a sufficient reward for risk taking. The cost can be estimated with reasonable accuracy; the basic interest rate is a product of current money market conditions; but the degree of risk inherent in the mortgage investment situation is dependent on a complex of financial and real estate factors. 

The problems of evaluating mortgage risk are the most critical as well as the most difficult which confront the lender in selecting mortgage loans for investment.

Home: To Own or to Rent? (Part 2)

The question of whether it is cheaper to own or to rent a house deserves short shift. Few people actually seek the answer; the nearest issue is a matching of the satisfactions of tenancy related to its cost against the satisfactions of homeownership related to its cost. An attempt at direct comparison of tenants’ and owners’ costs is fruitless for these reasons: 

1- In real life, the comparison is not between equivalent dwellings and thus not between equal services received.

2- The costs of different dwellings types are not comparable

3- One of the largest costs of homeownership (depreciation) is not determinable without knowing the cost of acquisition and the proceeds from the sale at disposition. But the selling price will be strongly influenced by market conditions at time of sale, which is indeterminate

4- In a changing housing market, there are times when homeownership is a better bargain. There are also other times when market conditions favour tenancy. 

The true financial issue of home ownership is whether the family can meet the financial obligations without sacrifice of other officials. In many instances, sacrifice is required; undertaking the purchase and maintenance of house calls for reductions in other outlays, and the choice is open to each family. But in no event should the health and happiness of any member be endangered.

Certain financial advantages of homeownership are frequently presented by its proponents:

1- It is an excellent and safe depository of savings; a hedge against inflation.

2- Payments on the mortgage represent enforced savings which might not be accumulated but for the contractual obligation.

3- Home ownership is an aid in establishing a favourable credit standing.

4- Income tax regulations permit the deduction of property taxes and interest on the mortgage debt.

5- When the homeowner sells his home at more than he paid for it, he is subject to no capital gains tax provided that he purchases another home of at least equal value within a year.

On the other hand, the tenant retains greater financial flexibility. At the end of his lease term, he is free to adjust his housing expenditure to either a decreased or an increased income by moving to another dwelling.

Definition of a Mortgage

At common law, a mortgage amounted to a conveyance of an estate to the mortgagee, which conveyance became void upon the performance of the terms of the mortgage. Today, it is considered more in the nature of a lien upon the estate to secure the performance, normally a money payment, specified in the instrument. The term mortgage is commonly used to denote the instrument by which such interest in property is transferred. Any instrument or legal form which conveys the an interest in property for the purpose of giving security is in effect a mortgage, regardless of its form.

Several of the terms used in the above definition require further clarification. We have the understanding that a deed is an instrument that conveys title to real property. A conveyance is a transfer of the interest in property from one person to another. In mortgage transactions, the debtor or borrower is called the mortgagor. The creditor of lender is called the mortgagee. The period for which the mortgage is made is called the term. 

In order that a conveyance of the type required in a mortgage transaction be valid, it must be in writing, must be executed by the mortgagor with all the formality prescribed by the statutes of the particular state in which the property lies, and must be delivered to the mortgagee. The laws of the state in which the property is located govern the mortgage transaction.

At the present time some states provide that the title, as well as the possession of the property, is kept by the mortgagor, the mortgage being regarded merely as a lien and not as an actual conveyance of title. These are called lien theory states, as contrasted with title theory states, in which the law more nearly resembles the earlier concept.

The arbitrary forfeiting of all rights in the property by the borrower in case he defaulted on the debt worked considerable hardship on the mortgagor, particularly in those cases where the value of the property was considerably greater than the debt. This aspect of the earlier law of mortgages was also changed. At the present time, all states require that some legal steps be taken by the mortgagee after default of the debt before the property can be proceeded against for debt payment. Such legal steps are now called foreclosures.

The Real Estate Market (Part 1)

In one sense, the real estate market is the sum of all the transactions of buying, selling and renting real property. A broader connotation would include all the factors and forces of demand and supply which influence market price and which affect the rate or intensity of market activity.
Thus, the real estate market is not a particular place, nor would it be feasible to draw a geographical line around all of the market influences which come to focus on the market transactions. True, we recognize the local nature of real estate markets and we refer to them by the name of the locality in which the property is found and within which the most powerful of the many market factors are know to originate. But market factors may be regional or national; the price of a small house in a village may be largely the product of local factors, but the price of an office in Chicago is set in a market where national factors play an important role.
Perhaps, you would wonder, why is an understanding of the real estate market essential to sound real estate investment decisions?
In the first place, an investor needs to know how the market currently evaluates properties of the type which he plans to buy or to sell. Thus he proceeds to analyze recent transactions involving similar properties; and in order to evaluate these sales, he must understand the nature and significance of the current market situation which conditions the transaction.
In the second place, a sound investment decisions, requires two kinds of forecasts based on predictions of real estate market conditions:

1- In forecasting the productivity of a given property, say an apartment building or a retail store building, the analyst must predict the future pattern of the level of rents. Changes in the balance of demand and supply will affect rent levels as will certain institutional factors. An understanding of market reactions to various kinds of forces is therefore essential to predicting future rental returns.

2- The forecasting of trends in transactions prices is a necessary part of real estate investment analysis. Every buyer will prefer to buy at the lowest possible price; if he anticipates a drop in the market price of the kind of property he plans to purchase he will postpone his offer; if he believes prices will soon rise he will act promptly.

The seller of real estate follows much the same lines of action though in reverse; his eagerness to sell and his asking price will be influenced by his forecast of market trends. Investors with a view to capital gain act only when they are able to foresee a rise in market price. No useful forecast of trends can be made by an investor without understanding the mechanism of the market and the nature of internal market interactions. 

Home: To Own or to Rent? (Part 1)

Many families find it difficult to decide as to whether to own or to rent a house. Furthermore, in terms of long-run objectives, this alternative has no meaning for most families. Homeownership is the accepted way of life and the almost universal goal. True there are families in large cities across the worlds that prefer the convenience of location and the freedom of responsibility which rental quarters can provide.
There are people who were raised in the neighborhoods of flats, tenements or apartments and for whom homeownership is so foreign from their own experience that it has no appeal. There are those among lower-income groups who assume that homeownership is beyond reach. 
In every corner of every country and in every walk of life, there are those who simply do not want to be bothered with the homey jobs of maintenance and upkeep which so many homeowners truly enjoy. Finally, the aged and the physically handicapped may find rental dwellings less demanding on their limited strength and energy.
But at the same time almost every family considers the pros and cons of homeownership. Though there are many variations, the general choice in living accommodations is between a free-standing single-family house with a yard, and a flat or apartment in a multifamily structure with little or no attached open space.
The rental unit is typically located in the older, more central and more congested part of town, while the house in the suburbs in a newly built neighborhood crowded with families of similar age, composition and income level.
Family circumstances, particularly family composition will strongly influence the relative evaluation of these two ways of life. The family with growing children values suburban living above convenience; the old couple prefers to live close to downtown facilities and to be free from yard work and snow shoveling. In short, the choice of a way of life as conditioned by living quarters and their location is largely based on subjective considerations not to be judged by others. 

How Much Should a Family Pay for a Home? (Part 1)

The question of how much a family can afford to pay for a home is not answerable by a simple ratio. Yet, it is very common, and too often very misleading, for bankers or real estate brokers to use such crude rules of thumb as “two and half times income”. Another common recommendation is to spend no more than 25% of income for housing.
The facts are that sound and satisfying homeownership can and does exist over a very wide range of ratios between income and the financial measures of housing cost. The only satisfactory answer to this question requires, as a first step, an evaluation of all family obligations other than housing and a determination of the residual resources in assets and income which are available for housing.

With such an estimate, it is possible to calculate how much of a debt can be supported and thus how much total capital, equity investment and borrowed funds can be assembled for home purchase. The three fundamental dimensions of the home investor’s financial situation which influence the financial arrangements which he can make for home purchase are

Assets: The nature as well as the amount; the ease with which they can be converted into cash by sale or as collateral for a loan with a minimum of delay and cost; the present rate of return on invested assets; potential cash in form of a gift or loan from friendly sources.
The amount of his assets will determine the upper limit of his down payment and the nature of the assets and his obligations will affect his decision on how much of his assets should be converted into cash for home investment and what should be kept intact for other purposes.

Earning Capacity: The present rate of family earned income; stability, dependability and trends of earnings all determine what can saved for home purchase. The present level of earnings will indicate the level of outlays on the home which can be supported but the prospective trends in earnings will help to determine an appropriate long-range pattern of payments.

Obligations: Debts, contractual payments and present and prospective family expenses are all items of obligations worthy of considerations. Present and prospective financial and family expense obligations will be factors in determining the amount of assets and income available for housing

Family Real Estate Problems

From the time the young couple sets up housekeeping, it is beset with an ever-changing succession of shelter problems. The small print in the first apartment lease raises doubt as to the rights and liabilities of a tenant and the responsibilities of the landlord. Just the matter of picking the right location and selecting a dwelling unit which will return the maximum dollar in comfort, quiet and satisfaction involves choices which call for knowledge of real estate productivity and its origins.
When inevitably the urge for a home of one’s own becomes irresistible, the young couple, now blessed with two or three little ones, faces an awesome array of decisions. How expensive a home can we afford? What is a good location where the investment value will be best protected? How can tell if a house is well constructed? Where do we go to shop for a home? Shall we use a broker and will his commission mean that our house will cost more? How do we tell whether $17,500 is too high a price for this home? Do we need a lawyer, an appraiser, a surveyor? How can we stretch our $2,500 down payment in order to have the home we want and need? Where and how can we secure the best mortgage financing?
These points of decision are just a few examples of problems of home buying or home financing. They are repeated when the family expands into another larger home and there are accompanying problems of selling or trading the original house.

Mortgage Home Refinancing

Mortgage is the most common credit instrument in home financing and the most frequent financing pattern is a combination of an equity contribution and a mortgage debt. But the terms of the mortgage loan are subject to wide variations which are the joint product of the borrower’s financial circumstances and the mortgage lenders attitude and policy. The elements which make up the basic home financing pattern are:

● Amount of equity contribution

● Amount of borrowed capital secured by the mortgage

● Interest rate

● Amortization or repayment schedule

The amount of the loan, the interest rate and the repayment schedule of the mortgage loan are called the “terms” of the mortgage. The payment called for, either interest alone or interest and principal retirement, are referred to as “debt service”. The repayment schedule takes one of three forms:

1-Straight Loan: Interest only is paid for a stated time period and then the full amount of the loan becomes due and payable.

2-Partial Amortization: The schedules calls for periodic interest and principal payments until a certain portion of the debt is retired at which time the balance of the debt becomes due. The final payment of this balance is known as the “balloon payment”.

3-Complete Amortization: The schedule requires periodic interest and principal payments until the debt is fully repaid. The debt service payments may be in equal amounts or may call for equal principal repayments with each interest payment determined by the then unpaid debt.
By simply varying any one of the terms of the mortgage, different levels and time patterns of debt service payments will results.