4 Mortgages and Real Estate Finance

Mortgage fundamentals

A mortgage loan provides money to purchase or refinance real estate. The borrower promises to repay the debt under a promissory note, while a mortgage or deed of trust gives the lender a security interest in the property. If the borrower defaults, the lender may use legal foreclosure procedures to sell the property and recover the debt.

The amount borrowed—or the remaining unpaid balance—is the principal. Interest is the cost of borrowing, usually stated as an annual percentage rate. The term is the time allowed for repayment, and the down payment is the buyer's portion of the purchase price that is not financed.

Equity is the property's value minus the debt secured by it. The Loan-to-value ratio (LTV) compares the loan amount with the property value. For example, a loan of $\$240{,}000$ on a property valued at $\$300{,}000$ has an LTV of $80\%$. A lower LTV generally means more borrower equity and less lender exposure.

Loan types and repayment structures

Mortgage products can be compared by loan type, term, and interest-rate type. Conventional loans are not insured or guaranteed by a federal housing program. Borrowers with smaller down payments may have to pay private mortgage insurance, depending on the loan and lender.

Government-backed or insured loans include FHA-insured loans, VA-guaranteed loans, and USDA loan programs. Eligibility and costs vary by program. For example, FHA loans are insured by the Federal Housing Administration rather than made directly by FHA.

A Fixed-rate mortgage keeps its interest rate and scheduled principal-and-interest payment constant for the loan term. An Adjustable-rate mortgage (ARM) typically starts with a fixed introductory rate and then adjusts periodically according to the loan's index, margin, adjustment schedule, and rate caps. Payments may rise or fall after an adjustment, so borrowers should consider whether they could afford a higher payment.

Other repayment structures change how much is paid during the loan or when the balance is due:

• Interest-only loans require interest payments for a specified period, so scheduled payments during that period do not reduce principal. Payments may rise substantially when the interest-only period ends.

• Balloon loans require a large final payment after a shorter payment period. The balance may not be fully amortized by the balloon's due date.

• Construction loans finance building or major renovation work, often with funds advanced in stages. Some are later paid off or converted into longer-term financing.

A first mortgage has priority over later-recorded liens in many foreclosure situations. A second mortgage, also called a junior lien, is another loan secured by the property; home-equity loans and home-equity lines of credit (HELOCs) are common examples. Because a junior lender is paid after the senior lender from foreclosure proceeds, junior-lien loans can carry greater risk.

Rates and borrowing costs

The interest rate is the annual cost of borrowing expressed as a percentage; it does not by itself include all loan fees. The Annual percentage rate (APR) is a broader measure that incorporates the interest rate and certain loan charges, such as points and some fees. APR can help compare similar offers, but it does not replace reviewing the full loan terms. This is especially important for ARMs, because their future rates are uncertain.

Discount points are upfront charges, commonly calculated as a percentage of the loan amount, that may reduce the interest rate. Lender credits reduce upfront closing costs in exchange for a higher rate. Whether either tradeoff is worthwhile depends partly on how long the borrower keeps the loan.

The monthly principal-and-interest payment is not necessarily the total housing payment. Total housing costs may also include property taxes, homeowners insurance, mortgage insurance, and other escrowed costs. Taxes, insurance, and insurance premiums can change even when a fixed-rate loan's principal-and-interest payment does not.

How amortization works

Amortization is repayment through scheduled payments that reduce principal over time. For a fully amortizing fixed-rate loan, each regular payment covers that period's interest and pays down some principal. Early in the schedule, the balance is high, so a larger share of the payment goes to interest. As the balance falls, less interest accrues and more of each payment reduces principal.

For monthly payments, the standard payment formula is:

Here, $M$ is the monthly principal-and-interest payment, $P$ is the starting principal, $r$ is the monthly interest rate, and $n$ is the number of monthly payments.

For example, a $\$300{,}000$, 30-year fixed-rate loan at $6\%$ annual interest has a monthly rate of $0.5\%$ and $360$ payments. Its scheduled principal-and-interest payment is about $\$1{,}799$ per month. First-month interest is $\$1{,}500$, calculated as $\$300{,}000 \times 0.005$, so about $\$299$ of that payment reduces principal. The payment excludes taxes, insurance, mortgage insurance, and closing costs. Assuming all payments are made as scheduled and the rate stays fixed, total interest over the full term is about $\$347{,}515$.

Investment property and lending risk

Borrowed funds create Leverage: an investor can control a property with less than its full purchase price in cash. Leverage can increase returns on the investor's equity if property income or value rises, but it also magnifies losses and creates required payments even when income or property values decline.

For income-producing property, lenders commonly assess both the collateral and the property's ability to support its debt. Two basic measures are:

• Loan-to-value (LTV): loan amount divided by property value.

• Debt-service coverage ratio (DSCR): net operating income (NOI) divided by annual debt service. A DSCR above $1.0$ means NOI exceeds scheduled debt payments; a DSCR below $1.0$ means NOI alone is insufficient to cover them.

Actual underwriting standards depend on the lender, property, and loan. Commercial lenders may also consider vacancy, operating expenses, lease quality, borrower finances, and the property's market value. LTV is only one factor in evaluating a real estate loan.

Comparing mortgage offers

When comparing offers, compare the same loan amount, term, rate type, and points or credits. Review the Loan Estimate for the projected payment, estimated closing costs, and whether the rate or payment can change.

A mortgage combines a repayment promise with a property lien securing the debt. Its cost and risk depend on principal, interest rate, term, fees, down payment, and repayment structure. Amortizing payments gradually reduce principal, while ARMs, interest-only periods, and balloon payments can make future costs less predictable. For investment properties, LTV relates debt to value, while DSCR relates property income to debt payments. Compare complete loan terms, not just the advertised interest rate.