Chapter 16: Types of Real Estate Loan Products and Commercial and Residential Loans
Overview of Real Estate Loan Types and Systems
The lecture covers Chapter 16, specifically the third slide deck, which focuses heavily on different loan types and mortgage products.
Historical overview: Day 1 provided an overview of the residential real estate finance system; Day 2 covered the types of financial institutions; Day 3 (today) focuses on specific products and loan structures.
Term Loans and Interest-Only Mortgages
Term Loan: Also referred to as an interest-only mortgage or a single pay note (if short-term).
Structure: The borrower only pays the interest on the loan. No principal is paid back during the life of the loan.
Principal: Defined as the amount of money actually borrowed.
Example: If a borrower takes out a $100,000.00$ interest-only loan, they will still owe $100,000.00$ when the note comes due in five years because no principal was amortized.
Features and Applications:
The primary benefit is a significantly lower monthly payment compared to an amortizing loan.
Used extensively on the commercial side to improve cash flow.
Became common on the residential side during the run-up to the subprime mortgage crisis, often used to allow people to qualify for larger loans than they could otherwise afford.
Constant Amortization Mortgage (CAM)
Definition: A loan where the borrower pays back a constant amount of principal every month.
Amortization: The process of paying back principal over time.
Calculation Example:
Loan Amount: $100,000.00$
Term: $30$ years ($360$ months)
Monthly Principal Payment: $\frac{100,000.00}{360}$
Payment Dynamics:
The interest owed each month decreases because the principal balance is constantly being reduced.
Since the principal component is constant and the interest component is decreasing, the total payment gets lower and lower over time.
The very first payment is always the highest.
Historical context: This was a brief detour in mortgage development (1940s-1950s). Consumers disliked that the payment changed every month, as it required manually tracking payments in booklets before the era of Excel or automatic bank drafts.
Constant Payment Mortgage (CPM)
Definition: The standard mortgage type where the total payment (Principal + Interest) remains the same throughout the life of the loan.
Internal Mixture:
Early in the loan, the majority of the payment is interest, with a small amount going toward principal.
As the principal balance drops, the interest portion of the constant payment decreases, allowing more of the payment to go toward principal.
Toward the end of the loan, the borrower is paying off huge chunks of principal with very little interest.
Status: This is the normal, standard mortgage product.
Graduated Payment Mortgage (GPM)
Structure: The payment starts low and increases in predefined "steps" before leveling off.
Key Features:
It is a fixed-rate loan, but the payment schedule is structured to increase.
Common step increases: $5\%$, $7.5\%$, or $10\%$.
Common step durations: $4$ to $10$ years.
Target Audience: Targeted at younger people/first-time homebuyers who are just starting their careers. The expectation is that their income will rise rapidly in the first few years of the loan, allowing them to handle the increasing payments.
Societal Impact: Encouraged by the Community Reinvestment Act, banks use these to help lower-to-middle-income individuals access homeownership.
Negative Amortization Risk:
If the starting payment is artificially pushed too low, it may not even cover the monthly interest.
Unpaid Interest: The interest not covered by the payment is "tacked on" to the loan balance.
Result: The borrower owes more at the end of the month than they did at the beginning.
This is described as "negative amortization" or a "zombie loan."
Etymology of Amortization
Root Word: "Mort" comes from the Latin root for death (e.g., mortuary, mortify, "Le Morte d'Arthur").
Literal Meaning: Amortization literally translates to "killing the debt" over time.
Growing Equity Mortgage (GEM)
Structure: Similar to a CPM but includes a built-in schedule of small payment increases.
Purpose: To force the borrower to pay off the debt faster than a standard thirty-year schedule.
Psychology of Debt: While borrowers can always choose to pay extra on a standard mortgage, most tend to increase their lifestyle spending to match their income. The GEM structures the extra payment into the budget.
Equity Definition:
Value Creation: Homeownership is cited as a major driver of wealth creation. Over time, property value ideally rises while the debt is "killed" (amortized), creating a growing gap of equity.
Professor's Example: Purchased/built a home in Auburn for $535,000.00$ with $10\%$ down ($53,500.00$). The house is now worth approximately $1,000,000.00$, and the debt has drifted down to around $400,000.00$ to $405,000.00$, resulting in roughly $600,000.00$ in equity.
Reverse Annuity Mortgage (RAM)
Target Audience: Known as the "old person's mortgage." Borrowers must be at least $62$ years old.
Function: Reverses the normal process; instead of the borrower making payments to the lender, the lender pays the borrower over time.
Purpose: Designed to allow seniors to supplement their retirement income by tapping into the equity of a home they own free and clear.
Term: The "end" of the term is usually the death of the borrower (or the second of two spouses to die). The lender then takes ownership of the house to settle the debt.
Variations: Borrowers can now take a discounted lump sum at the beginning instead of monthly payments (similar to a zero-coupon bond structure).
Price Level Adjusted Mortgage (PLAM)
Mechanism: The outstanding balance of the loan is adjusted for inflation every year.
Adjustment: If inflation is $4\%$, the balance increases by $4\%$. A new payment is then recomputed to amortize that higher balance over the remaining term.
Regional Usage: Very common in South American and Eastern European economies where inflation is high and volatile.
US Status: Not allowed in the United States. High inflation would cause payments to skyrocket to unsustainable levels (described using the metaphor "Snoop Dogg high").
Asset-Integrated and Asset-Backed Mortgages
Asset Integrated Mortgage (AIM): Instead of a $20\%$ down payment, the borrower might put $5\%$ down and invest the remaining $15\%$ into an annuity or similar investment product, which is then pledged as additional collateral.
Asset Backed Mortgage: Similar to AIM, but the borrower pledges existing assets they already own as additional collateral rather than buying a new investment product.
Adjustable Rate Mortgages (ARM)
Rationale: From a lender's perspective, a $30$-year fixed commitment involves massive uncertainty regarding inflation and market rates. Notable events in the last thirty years (since $1996$) include the .com bubble, $09/11$, the $2008$ financial crisis, Ebola ($2003/2004$), and COVID-19.
Mechanics:
Index: The underlying rate the ARM is tied to (currently the $1$-year T-bill is common; LIBOR has been replaced by SOFR).
Margin: The percentage added to the index to account for the borrower's risk relative to the US government ($Index + Margin = Interest\,Rate$).
Adjustment Period: How often the rate changes, typically every $1$ year.
Features:
Teaser Rate: An artificially low starting rate to entice borrowers to choose an ARM.
Lock-in Option: Allows the borrower to convert from an ARM to a fixed rate for a small fee.
Caps and Floors:
Per-period Cap: Limits how much the rate can change in one adjustment period (e.g., $1\%$ or $2\%$).
Lifetime Cap: Limits how much the rate can change over the entire loan life (e.g., $5\%$ or $6\%$).
Notation examples: $1/5$ or $2/6$.
Payment Caps: Limits the increase in the monthly payment. This can lead to negative amortization if the required payment does not cover the interest generated by a high market rate (witnessed during the $9\%$ US inflation spikes).
Variable Rate Mortgage: Distinct from an ARM. The payment remains fixed, but the specific mixture of principal and interest fluctuates based on market rates. These are relatively rare.
Equity Loans and Lines of Credit
Standard Second Mortgage: A lump sum (pot of money) borrowed against home equity and paid back monthly.
Home Equity Line of Credit (HELOC): A revolving line of credit similar to a credit card. Borrowers have a limit, can spend up to that limit, pay it down, and reuse it. Usually has a set term (e.g., $10$ years).
Specialized and Commercial Loan Types
Hybrid Loan: Combines elements. Example: A $30$-year loan that is interest-only for the first $7$ years, then fully amortizing for the remaining $23$; or fixed for $10$ years and adjustable for the next $20$.
Installment Contract: A type of seller financing used in both residential and commercial sectors.
Shared Appreciation Mortgage (SAM): The lender offers a below-market interest rate in exchange for a large share of the property's appreciation (often $40\%$ to $50\%$). It is usually partially amortizing, calculated over $25$ years but due as a balloon payment after $5-10$ years.
Participation Loan: The lender participates in the success of the property, often by taking a small percentage of retail sales from the tenants.
Convertible Mortgage: A debt position that gives the lender the option to convert the debt into an equity ownership stake (typically $35\%$ to $55\%$).
Construction Loans
Alternative Names: ADC (Acquisition, Development, and Construction), D\&C, or C\&D.
Structure: Not a lump sum. Money is released in "draws" only after the lender inspects the work to ensure progress. This prevents borrowers from taking a massive check and fleeing to a non-extradition country.
Features:
Minimizes "interest carry" because interest is only paid on the amount drawn so far.
Hands-on and local: Bankers visit the site personally.
Short-term: Usually $14$ months to $2$ years; rarely up to $3$ years.
High risk: Collateral is "a piece of land and a dream" rather than a finished building.
Financing Strategies and Miscellaneous Terms
Ground Lease: Leasing just the land for $30$ to $99$ years. The developer builds on the leased land. At the end of the term, improvements revert to the landowner.
Auburn Example: A condo building (The Watley) near Toomer's Corner and the downtown Publix. Built on a ground lease because the family/will of the owner forbade selling the land. The city owns the retail floor, while the condos above were built by a developer (Steve).
Blanket Mortgage: One mortgage covering multiple pieces of land.
Package Mortgage: Includes real property and personal property (e.g., high-end appliances like a refrigerator, washer, or dryer).
Affordable Housing Loans: Funded through municipal bonds to offer lower cost-of-debt to borrowers. Based on the belief that homeownership creates positive societal and cultural outcomes.
Wraparound Mortgage: A new mortgage that "wraps" around an existing mortgage that stays in place. Rare today.
Blended Rate Loan: When a lender offers a rate higher than the current low rate but lower than the current market rate to encourage a borrower to consolidate or refinance.
Buy Down Mortgage: Commonly used by homebuilders. The builder pays an upfront fee to the lender to lower the interest rate for the buyer, helping move inventory when rates are high.
Alt-A Mortgage: Loans to borrowers with good credit but poor documentation (No-doc, Low-doc).
Nina: No Income, No Assets.
CISA: Stated Income, Stated Assets.
Ninja: No Income, No Job, or Assets.
Subprime Mortgage: Loans made to individuals with poor credit scores. The combination of Alt-A documentation styles and subprime credit risks contributed to the financial crisis.
Questions & Discussion
Question: Why would a lender do a GPM?
Answer: To make loans attractive to people like young professionals whose income is expected to grow. It is also encouraged by the Community Reinvestment Act to help lower-income people reach homeownership.
Question: What is the danger of a GPM?
Answer: The starting payment might be too low to cover interest, leading to negative amortization where the balance increases.
Question: Why not just pay extra on a mortgage instead of a GEM?
Answer: While possible, most people find that as their income grows, their expenses rise to meet it, leaving no "extra" money. GEMs force the discipline by budgeting the increase into the loan itself.
Question: Why does the ARM have a lower rate than a fixed rate?
Answer: The borrower is taking on the interest rate risk that the lender usually bears. Since the lender takes on less risk, they charge a lower rate.
Question: Does a Ground Lease roll over to heirs if the owner dies?
Answer: Yes, the ground lease and the underlying property interest roll over to the heirs.
Question: What happens to tomorrow's class?
Answer: There is no in-person class tomorrow as the professor is attending a funeral. A video of last summer's lecture on the same slides will be posted in the main folder.