Real Estate Finance I Book - Champions School of RE


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Real Estate Finance I Book - Champions School of RE

  1. 1. Do you knowthe qualityschool youare attending?Champions School of Real Estate’s Awards2009 National PaceSetter Award, RealtyU 2000 National Chairman’s Award, RealtyU2008 National PaceSetter Award, RealtyU 2002 WCR Texas Chapter Champions School of Real Estate2007 National Pinnacle Award, RealtyU A liate of the Year e National Pinnacle Award is givenin recognition of the school that provides Champions School of Real Estate had athe highest performance and lasting Top 10 Finalist in Every Season of thecontribution to real estate education. Real Estate Apprentice Program™2006 National Pinnacle Award, RealtyU 2008 Texas WCR Business Woman of the Year Rita Santamaria2005 National Pinnacle Award, RealtyU 2003 NAR REBAC Realtor® Hall of Fame2004 National PaceSetter Award, RealtyU Rita Santamaria2003 National Chairman’s Award, RealtyU 2007 John Branch RealtyU, Instructor of the Year2002 National PaceSetter Award, RealtyU 2002 and 2004 Sue Ikeler2001 National PaceSetter Award, RealtyU REBAC, RealtyU, Instructor of the Year ).!.#%Ò
  2. 2. Table of ContentsChapter 1 – Introduction to Residential Finance Page 5Chapter 2 – How Loans Are Repaid Page 27Chapter 3 – Residential Apppraisal Page 37Chapter 4 – Conventional and Government Loans Page 59Chapter 5 – Title and Closing Page 91 Table ofChapter 6 – Property Condition and Inspections Page 111 ContentsBibliography Page 129Answers to Chapter Pre-Test Questions Page 131Homework Page 133 Table of Contents Copyright 2010© Champions School of Real Estate™
  3. 3. Introduction Real estate agents representing buyers and sellers must have knowledge of a wide range of disciplines, including finance, inspections, title, and insurance. While by no means an expert in these fields, the agent should be able to discuss these topics, and should have a list of experts in each area to which they can refer their clients. Understanding the many details of a transaction from contract to close helps the real estate professional build lifetime client loyalty. This knowledge and attention to detail helps the agent bring real value to the process as they “stay ahead” of the many issues that arise in a transaction. This course takes the agent from the signing of the contract through closing, and addresses many of the tasks that are essential for a successful transaction. Because of the diverse needs of individual buyers and sellers, every transaction will be different. No attempt has been made to cover or anticipate every demand that will be placed on the agent. From Contract to Close The contract to close period begins when the contract becomes a binding agreement and ends upon the closing of the transaction. Many things must happen during this period, and they often must be done within specific timeframes. In this period, many people from different disciplines are involved including:Introduction 1. Title examiners 2. Mortgage brokers/bankers 3. Inspectors 4. Appraisers 5. Surveyors 6. Pest control companies 7. Insurance agents 8. Contractors 9. Buyers 10. Sellers 11. Real estate agents In Chapters 1-4 we discuss the mortgage loan process from an agent’s perspective. For most buyers obtaining a mortgage loan is a somewhat rare event in which they have little expertise. Because of the complexity of the mortgage loan process, they find themselves confused by the many decisions that must be made in obtaining a loan. In Chapter 5 title insurance and the closing process is discussed. Agents must be comfortable discussing issues that arise in a transaction. Included is a discussion of the title commitment and some of the issues that might delay or terminate a transaction. Prorations and typical entries found on the HUD 1 settlement statement are discussed. Chapter 6 addresses the all-important inspection process. Common issues with options periods and property condition are also discussed. 4 Copyright 2010© Champions School of Real Estate™
  4. 4. Chapter 1 –Introduction to ResidentialFinance
  5. 5. Chapter 1: Introduction to Residential Finance Pre-test 1. ____________ is the process of making a lending decision. 2. __________________________ in a contract means that all provisions must be carried out on time. 3. If financing approval has not been obtained, and the buyer’s time is about to run out, the buyer might lose their _________________ if they fail to close. 4. A federally-mandated form that gives a borrower information regarding loan costs and settlement charges is a _______________________. 5. When comparing loan offers from different lenders, the borrower can use the ____________________ found in the GFE. 6. Some expenses may be paid in the form of a seller contribution or other means. However, the borrower actually must have the funds on hand for the _______________________.Chapter 1 –Introduction to Fill in the letter of the word which makes the above sentence correct. Residential Finance a. Good faith estimate b. Earnest money c. Down payment d. Underwriting e. Shopping chart f. Time is of the essence 6 Copyright 2010© Champions School of Real Estate™
  6. 6. Chapter 1 – Introduction to Residential FinanceWhile considerable real estate is purchased by cash buyers, most will need some form of financing.Residential lending is complicated by the fact that these loans are quite large compared to the averageborrower’s income and ability to repay. Because of this, a mortgage loan goes through a fairly longprocessing procedure as the lender verifies the borrower’s ability to repay and the sufficiency of thecollateral in the event the buyer fails to do so.While the agent does not have to be knowledgeable in all aspects of mortgage lending, they do have arole which includes: 1. Arranging for the prequalification of buyers 2. Discussing general mortgage loan programs that buyers might consider 3. Answering finance and closing related questions 4. Providing buyers with a list of potential lenders 5. Preparing the contract with all terms of sale, including financing conditions 6. Tracking important dates from contract to close, including monitoring the time the buyer has to obtain financing approvalThroughout this text we will use a sample transaction in the majority of the forms and math examples.Bill and Sally Homeowner are purchasing a home, and will be obtaining an FHA loan with a minimumdown payment of 3.5%: Chapter 1 – Introduction Sale Price $250,500 to Down Payment: -8,768 Residential Base Loan Amount: $241,732 Finance Add: FHA UFMIP* 5,438 Total Loan Amount $247,170 *The FHA Upfront Mortgage Insurance premium is discussed in Chapter 3The home is a resale, and we will be using the TREC-Promulgated One To Four Family (Resale)contract, which will be referred to in this book as “the contract”.Buyer PrequalificationNote: Buyer prequalification is generally done prior to entering into a contract to purchase, and istherefore not a part of the contract to close process. Because of its importance in the financingprocess, it is included here for reference. Understanding the prequalification process and itslimitations is important to agents, buyer and sellers.Under ideal circumstances the buyer was prequalified for a loan prior to beginning the search for ahome. Prequalification benefits not only the buyer, but the seller and agents in several ways: 1) Buyers are able to be more realistic when setting their pricing goals 2) The buyer’s agent has a better understanding of the buyer’s ability to pay 3) The buyer’s agent can avoid showing properties that the buyer cannot afford 4) Sellers are somewhat reassured that the buyer has sufficient income and credit to close the transaction 7 Copyright 2010© Champions School of Real Estate™
  7. 7. Prequalification and preapproval letters are prepared on standard forms promulgated by the Texas Department of Savings and Mortgage Lending (SML). The standard prequalification is prepared using Form A, Conditional Prequalification Letter, and can be obtained from one or more lenders as one of the first steps in the house hunting process. Only after identifying a property can the buyer move from prequalification to preapproval. When the buyer is preapproved, they will obtain a Form B, Conditional Approval Letter. Regardless of the prequalification or preapproval letter, it is important that all parties understand that the letter is not an absolute guarantee that the lender will ultimately fund a loan for the buyer. The process of approving a loan isChapter 1 – called underwriting. This may beIntroduction done via an automated system, or, it to may be done by an individual known Residential as an underwriter. All loans go Finance through the underwriting processError! Bookmark not defined.. In underwriting a lending decision is made based upon the information that the lender has assembled regarding the borrower and the property being financed. All prequalification and preapproval letters are subject to underwriting approval or other conditions. Prequalification When the buyers are prequalified, they provide basic information to the lender including income, debt and credit history. A prequalification letter does not obligate the lender to extend credit, and it does not obligate the borrower to the lender. 8 Copyright 2010© Champions School of Real Estate™
  8. 8. The lender may or may not have obtained a credit report and other information that will be consideredin underwriting.As mentioned earlier, prequalification is a great benefit, but its value should not be over sold,especially to the seller.When the prequalification letter isissued the lender may know verylittle about the borrower’s history.Conditions that affect theborrower’s creditworthiness orability to pay may be discoveredduring the underwriting processthat were unknown or notdisclosed in the prequalificationprocess.PreapprovalThe Preapproval of a buyer is aconsiderably more involvedprocess, and is provided to thebuyer using Form B, Conditional Chapter 1 –Approval Letter. A preapproval Introductionrequires an application from the toborrower and the identification of Residentiala specific property. Therefore, Financebuyers will begin their propertysearch with a Form A,Conditional Qualification Letterat best.Even with Form B in hand thereare many qualifying conditionsthat must be met for a successfulclosing. Buyers and sellers mustbe cautioned that neither of thetwo letters guarantee ultimateapproval for a loan. So, now wehave a contract between the buyerand seller. The buyer has beenprequalified or preapproved. Avast array of tasks must becompleted in the coming days andweeks as the loan process movesahead. 9 Copyright 2010© Champions School of Real Estate™
  9. 9. Chapter 1 –Introduction to Residential Finance 10 Copyright 2010© Champions School of Real Estate™
  10. 10. Loan ApplicationThere are a number of issues and critical dates that must be tracked by agents. The contract is deliveredto the title company after it has been signed by all parties. When financing is involved, and if in thecontract the parties checked Paragraph 4A(2)(a) in the contract, the TREC Third Party FinancingCondition Addendum will be attached. In the Third Party Financing Condition Addendum the buyermust make application for a loan “promptly”. Because of the time limitation imposed for obtainingfinancing approval, this must be done as quickly as possible. The mortgage application form (FannieMae 1003) is discussed in detail in Chapter 4. Chapter 1 – Introduction to Residential FinanceAs a rule, if the buyer complies with the provisions of the contract and the Third Party FinancingCondition Addendum, they will be refunded their earnest money and the contract terminated if theycannot obtain financing. Paragraph 4 and the addendum differentiate between property approval andthe financing approval of the borrower. While the borrower has the time limitation stipulated in the 11 Copyright 2010© Champions School of Real Estate™
  11. 11. addendum, the lender is under no such constraints. The lender can, at any time prior to closing, decide that the property does not meet their approval, thus rejecting the loan. Time is of the essence. Note the bold print in the first paragraph of the Third Party Financing Condition Addendum. “Time is of the essence” means that the time allotted for loan approval will strictly enforced. Agents should carefully monitor the time allowed for financing approval. If financing approval has not been obtained, and the buyer’s time is about to run out, four options exist for the buyer: 1. Let the time expire and take their chances. The contract will no longer be subject to financing approval, and they might well lose their earnest money if they fail to close because they could not be approved for financing. 2. Obtain an extension of time from the seller. 3. Secure loan approval from the lender. 4. Terminate the contract.Chapter 1 –Introduction to Residential Finance 12 Copyright 2010© Champions School of Real Estate™
  12. 12. The seller would be under no obligation to grant an extension of time for loan approval. If the sellerverbally agrees to an extension of time for loan approval, the agent must follow up and get theagreement in writing. The agreement to extend must be signed by all parties. The failure to put verbalagreements in writing has been the source of major problems for agents that results in failedtransactions, lost business and even litigation. Paragraph 8 of the Contract Amendment (above) is usedfor the extension of time for loan approval.How Loans are PricedFrom the lender’s perspective, a mortgage represents an investment in an annuity. The lender invests inthe mortgage and receives regular monthly payments of principal and interest from the borrower (aswith an annuity). All investors are interested in the yield on their investments. The yield is the returnthat the investor receives over the life of the loan. Lenders generally make loans in anticipation of theirsale to investors in the secondary market. The yield requirements of these investors is the primarydeterminate of mortgage rates.The yield on a loan is determined by the rate of interest charged on the loan and the discount pointscharged by the lender at closing. One point discount is one percent of the loan amount, and is an up-front payment of interest paid by borrowers to reduce the interest rate on the loan.The rate and points charged on a loan are a function of many factors including the prevailing rates inthe market, the type of property being financed, the term of the loan, and the borrower’s credit, incomeand down payment, just to name a few. Therefore different borrowers will have different financialprofiles that result in them being quoted differing rates and terms. Chapter 1 – Introduction toLet’s say that a borrower is quoted a rate of 6% per annum on a particular mortgage product, and, at Residentialthis rate, the lender is charging no discount points. A loan with no discount points is known as a “par Financeloan” – a loan that is made at the current market rate of interest.The borrower, with the 6% quote, goes shopping for a better deal. After all, who does not want to get aloan at a lower rate of interest? Their quest will be quickly satisfied when they find a lender who willbe happy to quote them a rate of 5.75%, 5.5%, or even less. Does the lender have cheaper money tolend? Are they simply being generous? The answer to both of these questions is probably “no”.The lender quoting the lower rate added discount points to the quote to compensate for the lower rate.If the current market supported the quote of a loan at 6% with no discount points, a loan made at alower rate is clearly “below market” The loan can be sold to investors, but only at a discount. Investorswill buy the loan, but will discount it because it is below market – they might purchase a $100,000 loanmade at below market rates, but might only pay $98,000 for it. The lender is going to need to recoverthe loss incurred in making the loan at a below market rate. Discount points, which are pre-paidinterest, accomplish this for the lender.Therefore, the lower the rate offered the borrower, the higher the fees (points) that must be paid. Aloan offered to the borrower at a higher rate may result in lower fees.The Federal ReserveGiven that the lender is going to sell the borrower’s loan in the secondary market, mortgage rates mustbe affected by changes in the global financial markets. Actions taken by the Federal Reserve have afairly immediate effect on short-term rates, but their impact on mortgage rates is less direct. 13 Copyright 2010© Champions School of Real Estate™
  13. 13. The countrys economic performance is influenced by many factors--economic performance abroad, fiscal policy determined by the legislative and executive branches of government, and monetary policy carried out by the Federal Reserve. The Federal Reserves most critical role is to keep the economy healthy through the proper application of monetary policy. The objective of monetary policy is to influence the countrys economic performance to promote stable prices, maximum sustainable employment, and steady economic growth. How the Fed Guides Monetary Policy The Feds monetary policy actions affect prices, employment, and economic growth by influencing the availability and cost of money and credit in the economy. This in turn influences consumers and businesses willingness to spend money on goods and services. The Fed uses three monetary policy tools to influence the availability and cost of money and credit: open market operations, the discount rate, and reserve requirements. Open Market Operations The Feds most flexible and often-used tool of monetary policy is its open market operations for buying or selling government securities. The Federal Open Market Committee (FOMC) sets the Feds monetary policy, which is carried out through the trading desk of the Federal Reserve Bank of New York. If the FOMC decides that more money and credit should be available, it directs the trading desk in New York to buy securities from the open market.Chapter 1 –Introduction The Fed pays for these securities by crediting the reserve accounts of banks involved with the sale. to With more money in these reserve accounts, banks have more money to lend, interest rates may fall, Residential Finance and consumer and business spending may increase, encouraging economic expansion. To tighten money and credit in the economy, the FOMC directs the New York trading desk to sell government securities, collecting payments from banks by reducing their reserve accounts. With less money in these reserve accounts, banks have less money to lend, interest rates may increase, consumer and business spending may decrease, and economic activity may slow down. The Discount Rate The discount rate is the interest rate a Reserve Bank charges eligible financial institutions to borrow funds on a short-term basis. Unlike open market operations, which interact with financial market forces to influence short-term interest rates, the discount rate is set by the boards of directors of the Federal Reserve Banks, and it is subject to approval by the Board of Governors. Under some circumstances, changes in the discount rate can affect other open market interest rates in the economy. Changes in the discount rate also can have an announcement effect, causing financial markets to respond to a potential change in the direction of monetary policy. A higher discount rate can indicate a more restrictive policy, while a lower rate may be used to signal a more expansive policy. Reserve Requirements By law, financial institutions, whether or not they are members of the Federal Reserve System, must set aside a percentage of their deposits as reserves to be held either as cash on hand or as reserve account balances at a Reserve Bank. The Federal Reserve sets reserve requirements for all commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks. Depository institutions use their reserve accounts at Federal Reserve Banks not only to satisfy reserve 14 Copyright 2010© Champions School of Real Estate™
  14. 14. requirements, but also to process many financial transactions through the Federal Reserve, such ascheck and electronic payments and currency and coin services.So, the actions of the Federal Reserve partly affect rates. Rates are also affected by governmentspending and borrowing, and the general state of the economy overall.So, how does the smart shopper compare offers from different lenders? Perhaps a Good Faith Estimatewill help.Good Faith Estimate (GFE)A Good Faith Estimate (GFE) is a detailed loan quote provided by a lender. For many years lendershave given prospective borrowers Good Faith Estimates. Each lender had their own form for a GoodFaith Estimate, and in many cases it was difficult to compare loan offers based on the GFE.On January 1, 2010, a new nationwide standardized GFE became mandatory. The GFE lists a varietyof charges, and may give the borrower several options that will affect their rate of interest, monthlypayment, and fees. The GFE is divided into several important sections. Let’s look at each in detail. Chapter 1 – Introduction to Residential Finance 15 Copyright 2010© Champions School of Real Estate™
  15. 15. Important Dates The Important Dates section of the GFE includes key dates of which the buyer should be aware:Chapter 1 –Introduction • Line 1 discloses the date and time through which the interest rate offer is good. to Residential • Line 2 discloses the date through which “All Other Settlement Charges” are good. This date Finance must be open for at least 10 business days from the date the GFE was issued to allow the buyer to shop and consider other offers. While this and other elements of the GFE might help the borrower shop for a loan, there are some obvious pitfalls. By the time the GFE has been prepared, the buyer/borrower may have already made loan application and may have already selected a loan product. • Line 3 discloses the interest rate lock time period, such as 30, 45 or 60 days, on which the GFE is based. “Locking in” the rate and points at the time of application or during the processing of the loan will keep the interest rate and points from changing until the rate lock period expires. • Line 4 discloses the number of days prior to going to settlement that the buyers must lock the interest rate. Line 4 is often left blank. 16 Copyright 2010© Champions School of Real Estate™
  16. 16. Summary of your loanThe summary of the borrower’s loan terms discloses the loan amount, loan term, the initial interest rate Chapter 1 –and the principal, interest and mortgage insurance portion of the monthly mortgage payment. It also Introductioninforms the buyer’s if the interest rate can increase, if the loan balance can rise, whether the mortgage topayment can rise and if there is a prepayment penalty or balloon payment. Residential FinanceIn the example above, the loan amount is $247,170, which will be paid over 30 years at an interest rate of5.25 percent. The monthly mortgage payment is $1,475.67, which includes principal, interest andmortgage insurance, but does not include any amounts to pay for property taxes and homeowner’sinsurance.In our example, the loan has a fixed interest rate. Since the interest rate cannot rise, the ‘no’ box waschecked. This example does not contain a balloon payment or a prepayment penalty. A prepaymentpenalty is a charge that is assessed if the buyer’s pay off the loan within a specified time period, such asthree years. A balloon payment is due on a mortgage that usually offers a low monthly payment for aninitial period of time. After that period of time elapses, the balance must be paid by the borrower,orthe amount must be refinanced.Escrow account informationThe GFE also includes a separate section referred to as ‘‘Escrow account information,’’ whichindicates whether or not an escrow account is required. This account holds funds needed to pay 17 Copyright 2010© Champions School of Real Estate™
  17. 17. property taxes, homeowner’s insurance, flood insurance (if required by the lender) or other property- related charges. If the GFE specifies that the loan will have an escrow account, the buyer will have to pay an initial amount at settlement to start the account and an additional amount with each month’s regular payment. Summary of the borrower’s settlement charges The final section on page 1 of the GFE contains the adjusted origination charges and the total estimated charges for other settlement services which are detailed on page 2 of the GFE. As mentioned earlier, the price of a home mortgage loan is stated in terms of an interest rate and settlement costs, which include discount points. The borrower can often pay lower total settlement costs in exchange for a higher interest rate and vice versa.Chapter 1 –Introduction to Residential Finance 18 Copyright 2010© Champions School of Real Estate™
  18. 18. The Borrower’s Adjusted Origination Charges, Block 1-2Block 1, “Our origination charge” contains the lenders and the mortgage broker’s charges and point(s)for originating the loan.Block 2, “The borrower’s credit or charge point(s) for the specific interest rate chosen.” • If box 1 is checked, the credit or charge for the interest rate is part of the origination charge shown in Block 1. • If box 2 is checked, the borrowers will pay a higher interest rate and receive a credit to reduce Chapter 1 – the adjusted origination charge and other settlement charges. Introduction • If box 3 is checked, the borrowers will be paying point(s) to reduce the interest rate and will to pay higher adjusted origination charges. Residential FinanceAfter adding or subtracting Block 2 from Block 1, “The borrower’s Adjusted Origination Charge” isshown in Block A. In the example shown, the origination charge is $8,976.96. No points were paid toreduce the interest rate. Instead, because of the interest rate chosen, the offer contains a $4943.40 creditthat reduces the adjusted origination charge to $4033.56. 19 Copyright 2010© Champions School of Real Estate™
  19. 19. The Borrower’s Adjusted Origination Charges, Block 3-11 In addition to the charges to originate the loan, there are other charges for services that will be required. For some of the services, the lender will choose the company that performs the service (Block 3). Lenders usually permit the borrower to select the settlement service provider for “Title services and lender’s title insurance” (Block 4). “Owner’s title insurance” is also disclosed (Block 5). Other required services that the borrower may shop for are included in “Required services that the borrower can shop for” (Block 6).Chapter 1 –Introduction to Residential Finance • Block 3 contains charges for required services for which the lender selects the settlement service provider. These are not “shoppable” services and will include items such as the property appraisal, credit report, flood certification, tax service and any required mortgage insurance. • Block 4 contains the charge for title services, the Lender’s title insurance policy and the services of a title company to conduct the settlement. • Block 5 contains the charge for an Owner’s title insurance policy that protects the buyer’s interests. NOTE: Under RESPA, the seller may not require the borrower, as a condition of the sale, to purchase title insurance from any particular title company. Note that in Texas the seller typically pays for the owner’s title policy. The cost of the policy must be shown in the GFE as a cost to the borrower even if the contract stipulates that the seller will pay for it. This and other inconsistencies will be sorted out with the lender and corrected on the HUD-1 Settlement Statement at closing. • Block 6 contains charges for required services for which the buyer may shop. Some of these items may include a survey or pest inspection. 20 Copyright 2010© Champions School of Real Estate™
  20. 20. • Block 7 contains charges by governmental entities to record the deed and documents related to the loan. Recording fees are charged per page, and therefore vary depending upon the size of the document recorded. • Block 8 contains charges by state and local governments for taxes related to the mortgage and transferring title to the property. Texas does not have transfer fees (taxes) on real estate transactions. Chapter 1 – Introduction • Block 9 contains the initial amount the borrower will pay at settlement to start the escrow account, to if required by the lender. Residential Finance • Block 10 contains the charge for the daily interest on the loan from the day of settlement (closing and funding) to the first day of the following month. The exact amount of this charge is dependent upon what day of the month the loan is funded. • Block 11 contains the annual charge for any insurance the lender requires to protect the property such as homeowner’s insurance and flood insurance.Total Estimated Settlement ChargesThe charges for All Other Settlement Services”, Blocks 3 through 11, are totaled in Block B. Blocks A andB are added together resulting in the total estimated settlement charges associated with getting the loan.These Blocks are carried forward to the bottom of page 1 of the GFE. 21 Copyright 2010© Champions School of Real Estate™
  21. 21. There are three different categories of charges that the borrower will pay at closing: • Charges that cannot increase at settlement • Charges that cannot increase in total more than 10% • Charges that can increase at settlement The borrower can use this as a guide to understand which charges can or cannot change. The borrower should compare the GFE to the actual charges listed on the HUD-1 Settlement Statement to ensure thatChapter 1 – the lender is not charging more than permitted.Introduction to Written list of settlement service providers Residential Finance A written list will be given to the borrower that includes all settlement services that the borrower is required to have, and those for which the borrower is allowed to shop. The borrower may select a provider from this list or they can choose their own qualified provider. If the buyer chooses a name from the written list provided, that charge must fall within the 10% tolerance category. If the buyer selects their own service provider, the 10% tolerance will not apply. 22 Copyright 2010© Champions School of Real Estate™
  22. 22. Using the tradeoff tableThe “tradeoff table” on page 3 will help the buyer understand how the loan payments can change basedupon different choices made available by the lender. If they pay higher settlement charges, they will becharged a lower rate of interest. If they pay less in settlement charges, they will be charged a higherrate of interest. Chapter 1 –The loan originator must complete the first column with information contained in the GFE. If the loan Introductionoriginator has the same loan product available with a higher or lower interest rate, the loan originator tomay choose to complete the remaining columns. If the second and third columns are not filled in, the Residentialborrower may ask lender if they have the same loan product with different interest rates. FinanceNotice the relationship between the initial interest rate, monthly payment and settlement charges. Asthe rate increases, settlement charges are reduced. Of course, the payment increases accordingly. Asthe rate decreases, settlement charges increase, and the monthly payment is reduced. 23 Copyright 2010© Champions School of Real Estate™
  23. 23. Using The Shopping Chart The borrower can use this chart to compare similar loans offered by different loan originators by filling in each column with the information shown in the “Summary of the borrower’s loan” section from the first page of all the GFEs they receive. As mentioned earlier, the borrower may not be shopping at this point, as they may have already made application with a lender.Chapter 1 –Introduction After a loan product has been selected, the borrower should notify the loan originator that they would to like to proceed with the loan. The borrower should keep the Good Faith Estimate so it can be Residential Finance compared to the final settlement costs stated on the HUD-1 Settlement Statement. The buyer or agent might ask the lender and closer if there are any changes in fees between the GFE and the HUD-1 Settlement Statement. Some charges cannot be increased, and the lender must reimburse the buyer if those charges were increased. New Home Purchases If the buyer is purchasing a new home that is being built or has not yet been built, the GFE could change. If the GFE can change, the loan originator must notify the borrower that the GFE may be revised at any time up to 60 days before settlement. Changed Circumstances If there are changes involving the borrower’s credit, the loan amount, the property value, or other information that was relied upon in issuing the original GFE, a revised GFE may be issued. Only the charges affected by the changed circumstance may be revised. When the borrower selects a loan product and a lender, they must submit a formal application to the lender. The standard application used in the industry is known as a “Fannie Mae 1003”, or simply a “1003”. The application form is discussed in detail in Chapter 4 24 Copyright 2010© Champions School of Real Estate™
  24. 24. Loan ProcessingOnce the application is complete, the file moves into the processing phase. During this phase the loanprocessor will “build a file” that will be used to make an underwriting decision. The informationcontained in the application will be verified, and a wide range of information will be collected on theborrower and the property.Credit reports will be ordered, possibly from all three major national credit reporting agencies:Experian, Equifax, and TransUnion. Because not all creditors report to all three, each reporting agencywill report a different credit score for the borrower. If three reports are obtained, the lender will usethe middle score for underwriting. If two reports are obtained, they will use the lower of the twoscores.The borrower’s funds will need to be verified. While some expenses may be paid in the form of a sellercontribution or other means, the borrower actually must have the funds for the down payment on hand.The source of the down payment may not be a loan of any kind.Employment will also need to be verified. If the employment status of the primary borrower or co-borrower changes prior to closing, the change must be reported to the lender. **************************** Chapter 1 – Introduction to Residential Finance 25 Copyright 2010© Champions School of Real Estate™
  25. 25. Chapter 2 –How Loans Are Repaid
  26. 26. Chapter 2: How Loans Are Repaid Pre-test 1. A ________ mortgage is a mortgage whose rate does not change during the term of the loan. 2. ____________ is the process of repaying a loan over time through periodic payments of principal and interest. 3. A mortgage whose rate will change over time with changes in the money market is known as an _________. 4. ___________ is the percentage of the sale price or appraised value that the lender is willing to lend. 5. When calculating the monthly payment, the lender will add an amount equal to 1/12 of the annual taxes and insurance for deposit into the _____________.Chapter 2 – Fill in the letter of the word, which makes the above sentence correct.How LoansAre Repaid a. Adjustable Rate Mortgage b. Fixed Rate c. Escrow Account d. Loan to Value Ratio e. Amortization 28 Copyright 2010© Champions School of Real Estate™
  27. 27. Fixed Rate MortgagesThe fixed rate mortgage loan has dominated residential lending in the United States for many years.The typical mortgage loan is for a term of 15 or 30 years, with the rate remaining fixed for the entireterm of the loan. Most of these loans are fully amortized. In an amortizing loan, the monthly paymentincludes an amount that is applied to interest that is due, with the remainder of the loan payment beingapplied to the outstanding loan balance (also known as the principal balance).This monthly payment is referred to as PI – principal and interest. As the loan is repaid, the balanceof the loan is reduced over time until it is fully amortized (paid in full).Consider a loan for $247,170 for 30 years with a fixed rate of interest at 5.25% per annum (per year).The monthly payment is $1,364.88, which includes principal and interest. In the first year of the loan,the principal balance is reduced $3,485.23. Note that the interest portion of the payment goes downeach month as a result of amortization. Pmt Total Ending Cumulative No. Payment Principal Interest Balance Interest 1 1,364.88 283.51 1,081.37 246,886.49 1,081.37 2 1,364.88 284.75 1,080.13 246,601.73 2,161.50 3 1,364.88 286.00 1,078.88 246,315.73 3,240.38 4 1,364.88 287.25 1,077.63 246,028.48 4,318.01 Chapter 2 – 5 1,364.88 288.51 1,076.37 245,739.98 5,394.39 How Loans are Repaid 6 1,364.88 289.77 1,075.11 245,450.21 6,469.50 7 1,364.88 291.04 1,073.84 245,159.17 7,543.34 8 1,364.88 292.31 1,072.57 244,866.86 8,615.91 9 1,364.88 293.59 1,071.29 244,573.27 9,687.21 10 1,364.88 294.87 1,070.01 244,278.40 10,757.21 11 1,364.88 296.16 1,068.72 243,982.23 11,825.93 12 1,364.88 297.46 1,067.42 243,684.77 12,893.35Notice that the amount of interest is reduced with each monthly payment. In a like manner, the amountof principal reduction goes up with each monthly payment. So, how is the change calculated with eachmonthly payment? When dealing with loans, we must always first calculate the dollar amount of oneyears’ worth of interest. The rate on this loan is 5.25% per year. The annual calculation is done basedupon last month’s loan balance. For example, when the borrower makes payment number five, theannual interest is based upon the ending balance after payment number four was applied. Therefore,one years’ worth of interest would be: $246,028.48 X 5.25% = $12,916.50Because we are collecting monthly payments, the interest due each month is equal to the annual interestdivided by twelve: $12,916.50 ÷ 12 = $1,076.37When payment number five is made in the amount of $1,364.88, the interest due of $1,076.37 will bededucted and the balance will be applied to principal, reducing the loan balance once again. $1,364.88 – $1,076.37 = $288.51 (applied to principal) 29 Copyright 2010© Champions School of Real Estate™
  28. 28. Next month, when another payment is made the math is repeated again until the loan is paid in full. Later in the life of the loan the loan balance is reduced to the point that monthly interest is less than the principal reduction. This happens at payment number 203, which is 16 years and 11 months into this loan: Pmt Total Ending Cumulative No. Payment Principal Interest Balance Interest 199 1,364.88 672.92 691.97 157,490.94 181,932.44 200 1,364.88 675.86 689.02 156,815.08 182,621.46 201 1,364.88 678.82 686.07 156,136.26 183,307.52 202 1,364.88 681.79 683.10 155,454.48 183,990.62 203 1,364.88 684.77 680.11 154,769.71 184,670.73 204 1,364.88 687.76 677.12 154,081.95 185,347.85 The loan is fully amortized in 30 years, bringing the balance to zero: Pmt Total Ending Cumulative No. Payment Principal Interest Balance Interest 357 1,364.88 1,341.26 23.63 4,059.08 244,151.91Chapter 2 – 358 1,364.88 1,347.12 17.76 2,711.95 244,169.67How Loans 359 1,364.88 1,353.02 11.86 1,358.94 244,181.54Are Repaid 360 1,358.94 1,352.99 5.95 0.00 244,187.48 The loan will be paid off (fully amortized) more quickly if the borrower makes additional principal payments over time. So far we have discussed amortization and loan payments, which include principal and interest (PI). Most borrowers have a payment plan that includes principal, interest, taxes and insurance (PITI). When determining the total monthly PITI payment, the lender will add an amount equal to 1/12 of the annual taxes and 1/12 of the annual homeowner’s insurance. Consider our sample transaction: Sale Price $250,500 Loan Terms (From above) Down Payment: -8,768 $247,170 @5.25% for 30 years fixed Base Loan Amount: $241,732 Add: FHA UFMIP* 5,438 Total Loan Amount $247,170 *The FHA Upfront Mortgage Insurance premium is discussed in Chapter 3 Annual property taxes are $4,500. Annual homeowners insurance is $1,500. This loan is an FHA loan, and therefore has a monthly FHA Mortgage Insurance Premium (MIP) of $110.79.The total monthly payment, PITI will be: 30 Copyright 2010© Champions School of Real Estate™
  29. 29. Monthly loan payment (PI) $1,364.88 Mortgage Insurance Premium (MIP) 110.79 Monthly Taxes ($4,500 ÷ 12) 375.00 Monthly Insurance ($1,500 ÷ 12) 125.00 Total Monthly Payment: $1,975.67The borrower will be qualified for the loan based upon the total monthly payment, which is usuallyreferred to as the “house payment”.Some borrowers will want to pay off their mortgages early. Any payments of additional principalduring the term of the loan will speed up the payoff of the loan. Many borrowers use the bi-weeklypayment plan to do this.In the bi-weekly plan, the borrower makes one-half of a payment every two weeks throughout the year.A thirty-year mortgage will be paid off in just over 25 years. When a borrower makes a one-halfpayment every two weeks during the year they actually make thirteen full payments as opposed to theusual twelve. This accelerates the loan payoff, and saves the borrower almost five full years ofprincipal and interest payments. Chapter 2 – How Loans are Repaid 31 Copyright 2010© Champions School of Real Estate™
  30. 30. Adjustable Rate Mortgages – ARM High inflation and unsettled interest rates of the 1970’s, lead to the development of alternative methods of financing mortgage loans. In the 1970’s these alternative repayment plans were viewed as a means of assisting borrowers in qualifying for a loan larger than they would have otherwise qualified for using a standard fixed interest rate product. Alternative loan products allowed many Americans to purchase a home at a time when fixed interest products were at historically high rates. The most widely used alternative loan was as an Adjustable Rate Mortgage (ARM). A major risk undertaken by lenders on long-term mortgages is the risk that rates will increase in the future. If a lender is holding a portfolio of loans at rates in the 6% range, the portfolio looses considerable value if rates move significantly higher in the future. The adjustable rate mortgage is preferred by lenders because it limits the lender’s exposure to rising interest rates. Since the 1970’s, lenders have often encouraged borrowers to consider ARM programs by offering initial interest rates that are lower than traditional fixed rate loans. In effect, the lender is offering a lower initial rate in exchange for the borrower taking on more of the lenders risk of higher interest rates in the future. In an adjustable rate mortgage the borrower obtains a loan for a certain term, perhaps 15 or 30 years. The loan is funded at an initial rate of interest that will remain fixed for a period of time. That period will vary depending on the loan product. Rate changes in an ARM are determined by increases or decreases in a funds index that is not under the control of the lender. ARM TerminologyChapter 2 –How Loans Initial Rate - The rate at which an ARM program begins is called the initial rate. The initial rate andAre Repaid payment amount on an ARM will remain in effect for a limited period of time. The initial rate can range from 1 month to 5 years or more. Adjustment Period - The interest rate and monthly payment will change every month, three months, six months, 1 year, 3 years, 5 years or 7 years. The period between rate changes is called the adjustment period. For example, a loan with an adjustment period of 1 year is called a 1-year ARM, and the interest rate and payment can change once every year; a loan with a 3-year adjustment period is called a 3-year ARM. Index - The index is what the lender uses as an instrument for measuring changes in interest rates. It is the lender’s barometer of change in interest rates. One of the major protections offered to borrowers who accept an ARM loan is that any change in the rate of interest must be tied to the change in the index.1 As the index rate moves up, so does the interest rate charged by the lender to the consumer resulting in higher monthly payments to the borrower. As the index rate moves down, the interest rate charged by the lender to the consumer goes down, resulting in lower monthly payments to the borrower. Wiedemer, John. Real Estate Finance. 8th Edition. United State of America: South- Western/Thomson Learning, 2001 32 Copyright 2010© Champions School of Real Estate™
  31. 31. Lenders base ARM rates on a variety of indices. Among the most common indices are: • 1 Year Constant Maturity Treasury Rate (CMT) • 11th District Cost of Funds Index – COFI • London Interbank Offered Rate - LIBORThe LIBOR is a standard financial index used in U.S. capital markets, and can be found in the WallStreet Journal. The LIBOR is fixed on a daily basis by the British Bankers Association, and is theworlds most widely used benchmark for short-term interest rates. It is also the rate upon which manyARMs are based.Margin - The percent added to the index in order to calculate the payment interest rate is known asthe margin. Margins vary from one lender to another, remain fixed for the term of the loan and are notimpacted by the financial markets and movement of interest rates. Lenders use a variety of marginsdepending upon the loan program and adjustment periods.Note Rate - The rate that determines the amount of interest charged to the borrower.Discounted Initial Rate (“teaser rate”) - A lower interest rate is offered by the lenderduring the first year or more of the loan. These interest rate concessions are used as incentives toattract borrowers to ARM products. Chapter 2 –Interest-rate Caps - An interest-rate cap places a limit on the amount the interest rate can How Loansincrease or decrease. Rate caps limit how much interest can be charged, and come in three types: are Repaid • Per Adjustment Cap - This caps limits how much a payment may increase or decrease in any subsequent adjustment. In most cases, lenders base the per adjustment cap on the initial or starting rate. The per adjustment applies regardless of the rate change indicated by the Index+Margin. Per adjustment caps vary by lender, and are often in the 1% - 2% range. • Lifetime Cap - Limit the interest rate increases over the life of the loan. This is a worst case scenario, and determines the highest the payment will ever go regardless of increases in the Index. The lifetime cap is normally in the 5% - 6% range. • Initial Adjustment Cap - ARM’s that offer a fixed rate period during the first years of the loan usually have an initial rate cap that is higher than the per adjustment cap. In many ARM’s the interest payment rate may increase as much as 6% higher than the first year rate. • Payment Cap – some ARM products have a payment cap that limits payment increases to a maximum dollar amount. In some cases payment caps have resulted in a loan that has negative amortization for a period of time. Negative amortization occurs when the monthly payments do not cover all the interest owed. The interest that is not paid in the monthly payment is added to the loan balance. If a scheduled rate adjustment would give the borrower a payment that would exceed the payment cap, the payment is capped at the maximum amount. The remainder of the unpaid payment is added to the loan balance. 33 Copyright 2010© Champions School of Real Estate™
  32. 32. ARM Cap Lingo 5-1 ARM – Rate is fixed for the first 5 years of the loan. These loans often adjust annually after 5 years. 2/6 ARM – 2% per adjustment cap and a 6% lifetime cap 6/2/6 Arm – 6% initial adjustment cap, 2% per adjustment cap and a 6% lifetime cap. Making the Decision: Fixed Rate vs ARM For the borrower planning to remain in their home in the long term, the fixed rate mortgage is probably the best choice. The fixed rate mortgage is also ideal for the borrower who is adverse to risk, or who believes that the trend in mortgage rates is upward. An additional benefit of a fixed rate loan is that it is predictable, which allows the homeowner to budget and plan for the future with greater certainty. If a buyer plans to sell in the near future, an ARM might be a better choice. A buyer with a 5-1 ARM might well move before there is an opportunity for a rate hike (or reduction). An ARM might also be an ideal product for the borrower that believes that the trend in mortgages rates is downward. An ARM might be a desirable product for a borrower that wants to qualify at a lower initial rate to give them more purchasing power. ARMs with initial fixed periods of three years or more are underwritten at the initial note rate, which allows the borrower to qualify for a larger loan. ARMs with initial fixedChapter 2 – periods of six months or one year are underwritten at the rate that could be in effect at the end of theHow Loans first year (the “second year” rate), which negates some of the benefit if the borrower is trying to qualifyAre Repaid for a larger loan through the ARM. One risk factor that should be considered in selecting an ARM is the possibility of rate increases in the future that could make the payment difficult for the borrower to pay on a timely basis. Other Loan Plans Balloon Note Balloon loans are beneficial to some borrowers, especially those who do not plan to stay in their home for an extended period of time. In a balloon loan the principal is amortized over a period of time, possibly 15 or 30 years. The the difference between a balloon loan and a fully-amortizing loan is that the loan balance is due before the loan fully amortizes, possibly in one, five or ten years. Consider the following five year balloon: Loan Amount: $247,170.00 Rate: 5.25% Term: 30 years Payment: $1,364.88 34 Copyright 2010© Champions School of Real Estate™
  33. 33. If this loan was made as a five year balloon, payments 1-59 would be $1,364.88. Payment 60 would beoutsanding loan balance, which would be $227,765.89 assuming that no additional principal paymentshad been maded: Payment # Payment Principal Interest Balance 58 1,364.88 363.61 1,001.27 228,497.89 59 1,364.88 365.20 999.68 228,132.69 60 1,364.88 366.80 998.08 227,765.89A balloon loan can be benefical to the borrower because the loan is generally made at a lower rate ofinterest. The lender is willing to accept a lower rate of interest because they know that the loan will bepaid in full in five years vs. thirty.Interest OnlyInterest only loans are loans that do not amortize, either for a period of time, or for the entire term. Theborrower makes payments of interest only. The loan balance at the end of the interest only period is thesame as initially borrowed unless the borrower chose to make principal payments along the way. Theloan might be for a 30 year term, with an interest only period that might run for 3 to 10 years. If theinterest only period is for five years, the borrower has the benefit of lower payments in years 1-5, witha significant payment increase in the remaining 25 of the loan. This payment is higher because the loanis fully amortized over 25 years as opposed to 30 years.The interest only option might be a good choice for the buyer that plans to stay in their home for a short Chapter 2 –period of time. If the buyer anticipates a transfer in the not too distant future, they can benefit from a How Loans are Repaidlower payment and qualify for a larger mortgage. Because traditional loans amortize very little in thefirst few years of their term, the loan balance will be not that much more with an interest only asopposed to an amortizing loan. Interest only loans are typically ARMs.Construction to PermanentMost mortgage financing plans provide only permanent financing. The lender will not usually close theloan and release the mortgage proceeds unless the condition and value of the property provide adequateloan security. When rehabilitation is involved, this means that a lender typically requires theimprovements to be finished before a long-term mortgage is made.When a homebuyer wants to purchase a house in need of repair or modernization, the homebuyerusually has to obtain financing first to purchase the dwelling, additional financing to do therehabilitation construction, and a permanent mortgage when the work is completed to pay off theinterim loans with a permanent mortgage.Often the interim financing (the acquisition and construction loans) involves relatively high interestrates and short amortization periods.Fannie Mae and FHA both have construction-to-permanent loan products for properties with up to fourliving units.The FHA 203(k) program and similar conventional programs are designed to address this situation. Theborrower can get just one mortgage loan, at a long-term fixed (or adjustable) rate, to finance both theacquisition and the rehabilitation of the property. 35 Copyright 2010© Champions School of Real Estate™
  34. 34. To provide funds for the rehabilitation, the mortgage amount is based on the projected value of the property with the work completed, taking into account the cost of the work. The construction to permanent loan allows the funding of the repairs through a series of draws. A draw is an advance against a construction loan that is funded to the borrower as the construction progresses. This gives the lender some assurance that the project will be completed on budget and that the builder/remodeler will not run out of funds prior to completion. When all repairs have been completed the loan is then closed into a permanent loan. The first draw is generally for the purchase of the property. Three or more draws against the loan are taken down as work progresses on the property. This loan has somewhat higher fees because the lender must physically inspect the job as work progresses.Chapter 2 –How LoansAre Repaid 36 Copyright 2010© Champions School of Real Estate™
  35. 35. Chapter 3 –Residential Appraisal
  36. 36. Chapter 3: Residential Appraisal Pre-test 1. The ________ data approach is used as the best indicator of value for existing properties. 2. ____________ refers to the loss in desirability of the style, layout, or function of an element of a property over time. 3. _________ is the highest price likely to be paid for a property, assuming that the property was available to all potential buyers at a realistic price or a reasonable length of time, and neither buyer or seller was prevented from learning all the facts about the property and its place in the market. 4. ___________ is the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible and results in the highest value. 5. Types of depreciation include physical deterioration, functional obsolescence, and ____________obsolescence.Chapter 3 –Residential Appraisal Fill in the letter of the word which makes the above sentence correct. a. Functional obsolescence b. Market c. Highest and best use d. Market value e. external 38 Copyright 2010© Champions School of Real Estate™
  37. 37. Chapter 3: Residential AppraisalAn appraisal is defined as the appraiser’s estimate or opinion of value. Because lenders use appraisalsto determine the market value of the property being used to collateralize the loan, they are a criticalcomponent of any transaction where financing is involved. If the borrower does not repay the loan, thelender may be forced to sell the home to recover the loan amount. This process is known asforeclosure. The lender must ensure that the home’s value is great enough to cover the loan amountplus interest and the costs of foreclosure.The loan-to-value ratio is the percentage of value that a lender is willing to finance. Lenders establishloan-to-value guidelines so that their mortgage loans will be made in a prudent manner. Since anappraiser gives an expert’s opinion of a home’s value, the lender will use it to make sure that the loanamount does not exceed the established loan-to-value ratio. For example, if the loan limits the loan-to-value ratio to a maximum of 90%, and the appraised value of the home is $100,000, then the maximumloan amount permitted under that program is $90,000. When calculating the loan-to-value ratio, thelender will use the sale price or appraised value, whichever is lower. An appraisal that is less than thesale price will generally result in: 1. Termination of the transaction 2. Reduction of the sale price by seller to match the appraised value 3. Payment of the difference between sale price and appraised value by the buyer/borrowerThe seller is under no obligation to reduce the sale price to match a low appraisal, and the buyer isunder no obligation to pay the excess if an appraisal comes in low. Chapter 3 – ResidentialBuyers and sellers rely on appraisals to help them make good business decisions. Lenders need Appraisalappraisals to ensure that they don’t approve loans for more than the property’s worth. In some casesappraisals are required by law. Sellers often find an appraisal valuable because it prevents them fromoffering the home at an unrealistically high or low price. Buyers, who may be acting on emotions andpersonal preferences rather than objective reason, need appraisals to prevent them from paying toomuch for the home.How Lenders Handle AppraisalsFor residential mortgage loan underwriters, appraisal reports normally have a shelf-life of threemonths. If the appraisal report is older than 3 months but less than 12 months old, most lenders willaccept it as long as the appraiser can issue a re-certification letter, which states that the appraiser hasreviewed current data and that the original value estimate is still valid.When the appraisal report is completed, mortgage lenders will submit it to underwriting. Theunderwriter will review the appraisal data to confirm that the property meets the program requirements.The underwriter will occasionally submit the report through a formal appraisal review, conducted by anin-house specialist or an independent appraiser. The goal of the appraisal review is to double-check thefinal value. If the appraisal review returns with a lower appraisal value, the underwriter must acceptthat lower value. 39 Copyright 2010© Champions School of Real Estate™
  38. 38. There are two types of appraisal reviews: • Desk review. Most lenders, especially for conforming loan programs, conduct simple desk reviews – nominally at their desk. Such reviews simply go through a checklist of items as they analyze the appraisal report for completeness and acceptable conclusions. • Field review. Many non-conforming lenders, especially when dealing with high-LTV loans, will order a field review of the appraisal. An independent third-party appraiser will be contracted to review the appraisal report and then actually verify the accuracy of the data, elements and procedures used by the original appraiser. Lite Appraisals Increasingly, many conforming lenders require and accept lighter version of the standard appraisal report for their underwriting. Instead of a full-blown appraisal report, an exterior or “drive-by” appraisal is deemed acceptable. These exterior-only appraisals do not require the research and legwork of the standard appraisal report; so the costs are usually lower. A drive-by appraisal is often requested when the buyer is highly qualified for the loan and the loan-to-value ratio is low. Principles of Residential Appraisals As mentioned earlier, an appraisal is an opinion or estimate of value. The property being appraised is referred to as the “subject property”. Residential mortgage lenders typically employ an appraiser to obtain an impartial estimate of the market value of a piece of property that will be pledged as security,Chapter 3 – or collateral, for a mortgage. Appraisers are not supposed to produce appraisal reports for the purposeResidential of meeting specific valuation goals set by the party ordering the report. Appraisal The appraiser’s estimation of value is based on their knowledge, experience, research, analysis of pertinent data, and judgment. Lenders depend on the appraiser’s judgment which is substantiated by relevant facts. Principle of Substitution At the core of appraising is a basic economic concept referred to as the principle of substitution. According to this principle, the value of a commodity is influenced by the cost of acquiring a substitute or comparable item. An informed person acting rationally would pay no more for an item than he or she would to acquire an equally desirable substitute. Therefore, the prices at which similar items are sold in a market tend to be similar, and the value of one item can be inferred from the price at which a similar item is sold. In applying the principle of substitution to real estate valuation, one assumes that buyers, acting rationally, will pay no more for one property than they would for an equally desirable, comparable property. However, certain features of real estate and the real estate market complicate how the principle of substitution applies in appraisals. • Each parcel of real estate is unique. No two properties have identical characteristics; even those that are physically alike have different locations. The market typically reacts to such differences through variations in prices. Therefore, the value of one property cannot automatically be inferred from the prices at which other properties have been sold, no matter how similar they may be. 40 Copyright 2010© Champions School of Real Estate™
  39. 39. • Most buyers need to obtain a mortgage loan. The types, terms, and costs of available financing affect purchase decisions. For example, high interest rates mean many buyers can only afford to purchase less expensive houses. Therefore, mortgage terms affect the volume of real estate transactions and hence the supply, demand, and the price of homes. • Only a few buyers and sellers are interested in exactly the same type of property. Emotions – such as a seller’s sentimental attachment or a buyer’s personal preferences – can have a significant effect on the supply, demand, and price for a particular type of property in a given area. For example, one person may view the “gingerbread” on a Victorian-style house as being too costly to maintain; another person may view the same ornamentation as a desirable architectural feature that adds value. • The real estate market is heavily regulated by the government. Federal, state, county, and local regulations govern the ownership and transfer of real estate. Zoning laws often limit the use, and hence the availability, of real estate. • Buyers and sellers in real estate markets are not always well-informed. If the parties are not fully aware of all of the applicable details, a property’s selling price may be higher or lower than if both parties to the transaction were equally well-informed.Appraisals help overcome the difficulties of objectively estimating the value of properties.Market ValueMarket value is one of the most commonly misunderstood appraisal concepts. Many sellers and buyersare certain that a given property has some specific market value, and they mistakenly believe that theappraiser’s task is to discover this finite value. Because the appraisal is an estimate or opinion of value,two or more appraisers operating independently of each other will arrive at different values. This Chapter 3 – Residentialdifference does not necessarily indicate that one is in error. AppraisalA firm grasp of the concept of value is essential to understanding appraisal methods. The question“What is the value of the property?” is foremost in the minds of all real estate buyers, sellers, investors,and lenders.The Appraisal Standards Board of the Appraisal Foundation (a non-profit group that sets appraisalstandards) defines market value as follows: The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.Implicit in this definition is the consummation of a sale as of specified date and the passing of titlefrom seller to buyer under conditions whereby: • Buyer and seller are typically motivated. That means that neither the buyer nor the seller is under any undue pressure to buy or sell quickly • Both parties are well informed or well advised, and acting in what they consider their best interests • A reasonable time is allowed for exposure in the open market • Payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and 41 Copyright 2010© Champions School of Real Estate™
  40. 40. • The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone with the sale. Market value is the highest price likely to be paid for a property, assuming that the property was available to all potential buyers at a realistic price or a reasonable length of time, and that neither buyer nor seller was prevented from learning all of the facts about the property and its place in the market. These are, of course, ideal conditions. Seldom, if ever, do such perfect circumstances occur in one sale. For this reason, price and market value often vary. It is essential to recognize that value does not necessarily equal price. Price is the amount of money for which a particular property sold. Many factors can cause a price to rise above or fall below market value. A family might be willing to pay a premium for property located next to the home of a close relative. On the other hand, a seller might be willing to substantially reduce an asking price in order to sell immediately and obtain funds quickly to buy a home near a new job. The Appraisal Process The value of a property may be affected by social, economic, governmental, and environmental influences. An appraiser must be always aware of these influences and possible changes in them that would affect market value. The appraiser’s observations are noted on the appraisal. Appraisers are licensed or certified by the state in which they practice. Appraisers must follow a standard procedure known as the Uniform Standards of Professional Appraisal Practice (USPAP). These standards have been established by the Appraisal Standards BoardChapter 3 – ( Appraisal Fannie Mae and Freddie Mac have been instrumental in standardizing appraisal reporting through the widespread adoption of the Uniform Residential Appraisal Report (URAR), which is known as a Fannie Mae Form 1004 or a Freddie Mac Form 70. In the business the URAR is commonly referred to as simply a “1004”. Information Collected By Appraisers The appraisal includes a large variety of information that must be read and analyzed by the loan officer or processor. The appraiser examines the property to determine its worth and to provide the lender with a risk assessment. Whether the house will be single-family, multi-unit, condominium or construction affects the type of information that the appraiser must gather, which partially explains why the appraisal for a four-unit building costs more than the appraisal for a single-family home. The appraisal will contain the market value and an analysis of the following eight data categories: • Property Lender information • Neighborhood description • Site description • Improvements to the site • Cost Approach Analysis (if required) • Market data analysis • Income approach analysis (if required) 42 Copyright 2010© Champions School of Real Estate™
  41. 41. • Reconciliation of value estimates • Additional support documentsSubject PropertyThis first section presents information about the property, prospective borrower and lender. Thehomeowner should especially examine this section to confirm the appraiser’s researched informationabout real estate taxes, homeowner’s association dues and census tracts.Contract Chapter 3 – Residential AppraisalThe contract is generally analyzed by the appraiser. Of particular concern would be excessive financialassistance to the buyer/borrower from the seller that would call into question the value of the property.Neighborhood InformationThe appraisal describes the property’s neighborhood, providing the following information: • Location. The appraisal must label the property as (1) urban, (2) suburban or (3) rural. • Build up. A neighborhood’s level of development is measured with one of four classifications: (1) “fully developed” means that there is little or no potential for future development; (2) “rapid” usually indicates a hot market; (3) “steady” areas are average; (4) “slow” applies to depressed areas with much potential but no action. • Property Value Movement. The appraiser’s determination whether the property value is (1) increasing, (2) remaining stable or (3) declining. 43 Copyright 2010© Champions School of Real Estate™
  42. 42. • Demand and supply. This market indicator estimates whether (1) there is a shortage of marketable properties in the area, (2) there is a balance between the area’s supply and demand, or (3) there is an oversupply of marketable properties in the area. • Marketing time. The appraiser verifies the area’s listings and sales records to determine how long it is taking to sell properties: (1) under 3 months; (2) between 4-6 months or (3) over 6 months. Option 3 (over 6 months) may be problematic as it indicates a slow market, which creates a drag on property values. • Present land use. An estimate how the neighborhood’s parcels are currently improved and developed: (1) single-family, (2) properties with 2-4 units, (3) multi-family apartments, (4) commercial, (5) industrial, or (6) vacant. • Changes in land use. The probability of the area’s land usage drastically changing in the future: (1) not likely, (2) likely, or (3) already taking place. If the report indicates options 2 or 3, some lenders may request more information to determine if those changes will affect the property’s market value. • Predominant occupancy. An estimate of which type of occupancy is most prevalent in the area: (1) by the owner, (2) by tenants, or (3) mostly vacant. Option 3 (mostly vacant) can be bad news as it often indicates a depressed or declining neighborhood. • Price and age ranges. The range of market values and building ages for comparable properties in the area. Obviously, the subject property’s appraised value should fall within this range. • Description of favorable or unfavorable factors that will affect marketability. The appraiser addresses the demand for the property and provides brief reasons supporting favorable or unfavorable conditions. • Neighborhood boundaries. The neighborhood’s geographical boundaries must beChapter 3 – described. The appraiser will usually identify the streets or landmarks that make up theResidential Appraisal property’s boundary. Site Description The property’s site is described. The site appraisal section provides the following categories of information. • Lot Dimension. The area size of the property is usually described in square feet or acres. Some lenders limit allowable site size. • Zoning classification. The local zoning classification of the property is indicated in this entry. • Highest and best use for the property. The appraiser should indicate that present use would be the best use for the property. There are may be exceptions which could be a problem for a lender. 44 Copyright 2010© Champions School of Real Estate™