This chapter deals with market conditions, financing, type of mortgage, interest calculation, and capitalization rates. Examples and formulas are given to expose the student to calculating these figures.

CHAPTER LEARNING OBJECTIVES

Upon completion of this chapter, the learner will be able to:• Describe how current market conditions will affect pricing and marketability of real

estate including time the listing has been on the market.

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CHAPTER 4

CURRENT MARKET CONDITIONS

Market Conditions

Market conditions play an important role in pricing and marketability. There are some specific considerations when analyzing the current market conditions:

• General State of the Economy – this might include inflation, unemployment, the stock and bond markets, etc.

• The Availability of Money - types of loans being offered and interest rates• Competition – the amount of homes, both resale and new construction that are currently

on the market• Supply and Demand – If there is a plentiful supply and low demand, prices tend to fall.

Conversely, if there is a low supply and high demand, prices tend to rise.• Consumer Confidence – confidence in the economy, elections, employment, the stock

and bond markets etc. play a huge role in market conditions in real estate.• Local Conditions - local conditions such as employment, factories opening and closing or

tourism.

Financing terms and their effect on pricing and marketability

When money is easier to obtain, more buyers have the opportunity to purchase which can lead to an increase in sales and higher prices.

CASE STUDY:

Let’s look at the above situation in terms of an analogy of an auction:

If an auction is held during good economic times, a greater number of people will participate, there will be more activity and bidding and the auctioneer will most likely command higher prices for the items being auctioned.

When interest rates are low, a buyer can qualify for a more expensive home than if interest rates are higher. This affordability factor can allow more potential buyers to consider a greater number of homes. With more buyers looking at homes, the effect on the seller may be a higher sales price.

While interest rates play an important role, they are not the only factor in terms of obtaining financing. Loan programs and their availability are also key factors. This is the header needed for below.

The availability of loans is often dominated by the secondary market. The secondary market purchases loans from the primary market (those who originate the loans). If the secondary

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CHAPTER 4 - SECTION 1

CURRENT MARKET CONDITIONS

market is strong, primary lenders are able to offer a greater number of loan programs to the consumer. A greater amount of available loan programs usually equates to more potential buyers in the market place. Thus, prices of homes may rise. Conversely, a limited amount of loan options can lead to less potential buyers and prices can fall. Here are some of the loan programs that you should consider (and you should research their availability)

Interest Rates and the Market

Higher rates most likely mean the buyer will qualify for less. Buyers may find themselves unable to qualify because of the increased living costs. It’s important for them to be pre-approved or pre-qualified, to understand their upper limit.

Mortgages come in two primary types, fixed rate and adjustable rate, with some hybrid combinations of each.

The mortgage originator is the lender. Lenders come in several forms, from credit unions and commercial banks to mortgage brokers. Mortgage originators sell loans. They compete with each other based on the interest rates, fees and service levels that they offer to the consumers. The interest rates and fees they charge consumers determine their profit margins. Most mortgage originators do not portfolio loans (they do not retain the loan). They sell the mortgage loan to the secondary mortgage market. The interest rates they charge consumers are determined by their profit margins and the price they can sell the mortgage on the secondary mortgage market.

Lenders usually charge a lower interest rate for ARM’s than fixed rate mortgages when originating a loan. For a given amount, this makes payments on an ARM easier at first. The loan could be more or less expensive over a long period, depending on the movement of the interest rates.

Elements of an Adjustable Rate Mortgage (ARM)

What is an ARM?

With a fixed rate mortgage, the interest rate stays the same during the life of the loan. With an Adjustable Rate Mortgage (ARM), the interest rate changes periodically over the life of a loan. This change is usually in relation to an index. Payments can go up or down.

Lenders usually charge a lower interest rate for ARM’s than fixed rate mortgages when originating a loan. For a given amount, this makes payments on an ARM easier at first. The loan could be more or less expensive over a long period, depending on the movement of the interest rates.

There are risks for the borrower in that interest rates could sharply increase leading to higher monthly mortgage payments.

Questions to think about when considering an ARM:

• Is my income likely to increase enough to cover the payments if the rates go up?

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• How long am I planning on owning the home? If it is for a short period of time, rising interest rates may not be an issue as they would if you were planning to own the home for a long time.

Basic Features of ARM’s

Adjustment Period

With most ARMs, the interest rate and payment changes once every year, 3 year or 5 year period. The time between one rate change and the next is called the adjustment period. So an ARM with an adjustment period of 3 years is called a 3 year ARM.

Index

Most ARM’s are tied to an index rate. If the index rate goes up, so does the mortgage interest rate. Conversely, if the index goes down, the mortgage interest may go down.

There are many different indexes, but the most commonly used are the rates on 1, 3, or 4 year Treasury securities. Another common index is the cost of funds to commercial banks. It is important for a borrower to know what index is being used and to have an idea of the index’s past fluctuations.

The Margin

To calculate the interest rate, lenders take the index rate and add a few percentage points. These percentage points are called a margin.

Index Rate + The Margin = ARM Interest Rate

Interest Rate Caps

An interest rate cap places a limit on how much an interest rate can increase. There are two types of interest rate caps:

• Periodic Caps - which limit the interest rate increase from one adjustment period to the next

• Lifetime or Overall Caps - which limit the interest rate increase over the life of the loan

Let’s look at an example of an ARM with a periodic cap rate of 3% with 1% margin.

First year interest rate# # 5%If the index rises # # # 1%Second year interest rate## 7%

A decrease in the interest rate does not always mean there will be a decrease in an ARM’s monthly payment. The payment could even increase if the index has stayed the same. This could happen when an interest rate cap has been holding the interest rate down below the sum of the index and the margin. If a cap rate holds down your interest rate, increases to the index that did not happen due to the cap may carryover to future rate adjustments.

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Let’s look at an example of a carryover using a periodic rate cap of 2%

First year interest rate# # 6%If index + margin rise # # 3%Second year interest rate## 8%(because there was a 2% cap rate)

If the index now stays the same

Third year interest rate# # # 9%

Even though the index between the second and third year stayed the same, the interest rate increased due to the carryover

Payment Caps

Some ARM’s have payment caps which limit the monthly payment increase at the time of each adjustment. Some ARM’s with payment caps don’t have periodic interest rate caps.

Negative Amortization

If an ARM contains a payment cap, there is the possibility of negative amortization. That happens when the mortgage balance increases and the monthly mortgage payments are not large enough to pay all of the interest due on the loan. Because payment caps limit the amount of the payment increases only, and not the interest rate increases, payments sometimes do not cover the interest due on the loan. When this happens, the interest shortage is automatically added to the debt, and interest is charged on that amount.

Convertible ARM’s

Some ARM’s contain a convertible clause which allows you to convert to a fixed rate mortgage at designated times. When the conversion takes place, the new rate is generally set at the current rate for fixed rate mortgages. There may be an extra fee to get an ARM with a convertible feature.

Fixed Rate Mortgage With a fixed rate mortgage, the interest rate stays the same during the life of the loan.

Interest and Amortization Definitions and How Interest is Computed

Interest Defined

Interest is the cost of borrowing money. This would include loans, credit cards and lines of credit. Interest may be calculated as either a fixed or variable rate and can be simple interest or compound interest.

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Simple Interest (no compounding)

The nominal interest rate is an annual rate quoted in percentages. The simple interest method does not consider the effects of compounding. This method calculates interest as the product of the original balance, the nominal interest rate, and the time period (in years).

EXAMPLE:

Consider a $5,000 savings account balance with a 12% nominal interest rate, using the simple interest method. In one year, your account would equal the interest payment of $5,000 x 12% = $600 plus your original balance of $5,000, for a grand total of $5,600.Let’s suppose you could request to be paid in half of a year. In this case, your balance would be $5,000 x (1 + 12% x 0.5) = $5,300. As you can see, when you use the simple interest method, the yearly interest of $600 is exactly double the semi-annual interest of $300.

To generalize, simple interest can be computed once you know:• The balance of the loan or savings account (P)• The annual nominal interest rate (r)• The time in years (t)

The general formula is:Balance after t years = P x (1 + r x t)

Compound Interest

Compound interest is calculated very much like simple interest, but it takes into account that the balance changes after each time interest is paid out.

Consider a $5,000 savings account with a 12% simple interest rate ; interest is paid semi-annually, but this time use the compound interest method.

What is the account balance in one year? For the first half of the year, no interest has been paid, so the compound method is the same as the simple method. The balance grows to $5,300 ; $5,000 x (1+12%/2) in half of a year.

Now comes the interesting part. For the second half of the year, interest is computed on top of the interest that’s already accumulated. Interest is therefore computed using a $5,300 balance (instead of a $5,000 balance in the simple interest case). This is what differentiates compound interest from simple interest. After one year, the ending balance is $5,618 = $5,300 x (1+12%/2)^2, which is slightly higher than the $5,600 from the simple interest method.

Compound interest uses the same variables as simple interest, but we also need to know the frequency of compounding:

• The balance of the loan or savings account (P)• The annual nominal interest rate (r)• The time in years (t)• The frequency of compounding in one year (m)

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The compound interest formula is:Balance after t years = P x (1 + r/m)mt

The formula differs from simple interest in a few ways: • The nominal interest rate is expressed as an interest rate per m periods (so a 12% nominal

rate is a 6% semi-annual rate) • Interest is compounded on top of what’s already paid; the exponent takes care of

compounding m times each year.

Amortization Defined

 Amortization is the gradual repayment of a debt over a period of time, such as monthly payments on a mortgage loan or credit card balance.

To amortize a loan, your payments must be large enough to pay not only the interest that has accrued but also to reduce the principal you owe. The word amortize means "to bring to death." A fully amortized loan will have a zero balance at the end of the term. A partially amortized loan will have a balance due at the end of a term which usually is to be paid off as a balloon payment.

Straight Note (Interest Only)

With a straight note, payments are made on the interest only and not on the principal balance borrowed. At the end of the term of the loan the entire principal balance is due. This type of loan might be used when a borrower would like to reduce their mortgage payment amount in the beginning and then convert the loan to a fully amortized loan later on.

What Does Prepayment Penalty Mean?A prepayment penalty is a clause in a mortgage contract that says if the mortgage is paid off prior to a certain time period, a penalty will be assessed. The penalty is usually based on a percentage of the remaining mortgage balance or a certain number of month’s worth of interest.A prepayment penalty ensures the lender receives a minimum yield on money they lent. A prepayment penalty will discourage an early pay off before the lender has realized a return sufficient to offset the costs of making the original loan as well any anticipated yield for profit.

Some lenders will offer a lower rate on a loan that carries a prepayment penalty because of this assurance of overall yield. A “soft” prepayment penalty allows for annual principal reduction above and beyond the normal amortization up to but not exceeding a predetermined percentage of the principal balance. A “hard” prepayment penalty will become due on a note if at any time the loan is paid off prior to the contractual period stated including refinancing.

Most loans do not carry prepayment penalties. Borrowers should be careful to inquire of their lender as to the policy and read the fine print carefully before signing.A borrower should also be aware of the risks associated with a prepayment penalty. A

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prepayment penalty can substantially increase the cost of refinancing a mortgage when it would otherwise be economical.

Loans which do not have prepayment penalties are often referred to as open mortgages.

Bi Monthly Payments

Bi-monthly payments are made twice per month. One half of the payment is made on the 15th of the month and the other half of the payment is made at the end of the month. Because the lender is, in essence, getting half of the payment two weeks early, this substantially reduces the amount of interest and the term of the loan compared to traditional monthly payments.

Common Forms of Financing

Some of the more common forms of financing are:• Conventional financing• Government financing (FHA, VA)• Loan programs for 1st time buyers• Jumbo loans• Interest only loans• ARM’s (adjustable rate mortgages)• Down payment assistance programs• Second mortgages (Equity term loans and equity lines of credit)

Another important form of financing which could favorably affect the market value of a home would be seller financing. In this situation, the seller will grant a loan to the buyer for all or part of the purchase price. This is known as a purchase money mortgage. There can be many advantages or disadvantages to this type of financing for the buyer or the seller. The advantages to the seller offering this type of financing are:

Those who may not have the down payment for a conventional mortgage may be potential buyers.

Those who have credit scores which are too low to obtain a regular mortgage may be candidates.

Those who do not show sufficient income to qualify for a mortgage may be potential buyers.

A greater number of potential buyers equates to the possibility of the seller receiving a higher price for their property.

Summary

This chapter focused on market conditions, financing, type of mortgages, interest calculation, and capitalization rates. Formulas and example calculations were given to enable the student to perform basic math calculations for these items.

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Check your understandingUse this link to open a short quiz:https://www.bookwidgets.com/play/BSEEG

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