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FINANCING ASSET
  ACQUISITIONS
FINANCIAL LEVERAGE
The use of borrowed fund to supplement the investor’s own
dollar investment (equity) to increase the scale of investment.

The keys to leverage are:
  1.   lower interest rate on loan than the return on the
       investment.
  2.   the ratio of borrowed funds to one’s own equity.
      EXAMPLE OF FINANCIAL LEVERAGE

ASSUME:
  HOUSE PURCHASED FOR $100,000
  3.3% APPRECIATION AFTER 1 YEAR

CASH        YEAREQUITY       % GAIN
DOWN        END       (END OF      ON
PAYMENT     VALUE      YEAR)       INVESTMENT

$100,000   $103,300   $ 3,300     3.3%
$ 50,000   $103,300   $53,300     6.6%
$ 20,000   $103,300   $23,300     16.5%
                        Margin Trading
• Margin is borrowing against the market value of securities such
  as stocks or bonds.
• The purpose is to enhance the return on investment by using
  financial leverage.
• Example: If the margin interest rate is 7% and you borrow 50%
  of the value (100,000) so that you can purchase more shares,
• Buyer puts up $50,000 and borrows $50,000 on
  margin at 7% to buy $100,000 of stock. The investor
  holds the stock exactly one year, and the price
  increases 10%.
•   10% of $100,000 = $10,000 gain.
•   7% on $50,000 borrowed = $3500 expense.
•   Net gain to investor = $6500.
•   Return on investor $50,000 investment = 13%.
Borrowing to invest gave the investor 30% greater
  return than if he or she had not used leverage.
               Equity Requirements May Vary


Equity percentage requirements are set by the Federal Reserve:
• Stocks listed on the NASDAQ or the NYSE generally require that the
  investor put up 50%.
• U. S. Treasury bonds generally require an equity investment of 10%.
• High-grade corporate bonds generally require 30% equity.
Note: Investment firms often require more than the Federal Reserve
  minimums to protect their accounts.
DETERMINING HOW MUCH HOME ONE CAN AFFORD
  FRONT END RATIO
     Example: Monthly gross income is $8,000 and lender has
     a limit of 32%. Therefore the maximum PITI is $2,560

DETERMING THE MAXIMUM MORTGAGE AMOUNT
 Assume:
      Taxes and Insurance = $650 mo.
      Buyer can pay             = $1,910 mo. ($2,560 – T&I)
  What mortgage amount generates a P&I payment of $1,910?
      Set calculator to 12 payments per year. 1,910 is PMT,
      6 is I/Y, 360 is N, cpt PV, which equals $318,572.

  If the down payment is $25,000, they can afford 318 + 25 or a
  house with a price of $343,000. (Ignores points and closing
  costs).
    IMPACT OF THE MORTGAGE NTEREST RATE
              ON AFFORDABILITY

Using the same example as before:
  Can pay $1,910 (principal and interest)

Mortgage
Interest
Rate           Value
6%             $318,572
7%             $287,087
8%             $260,301
9%             $237,378
10%            $217,646
             TYPES OF MORTGAGE LOANS

Government and Conventional Loans

Type of Interest Rate
       (fixed versus variable)
GOVERNMENT LOANS
  1. FHA LOANS
      Loans are guaranteed by the Federal Housing
      Administration. Have lower down payment requirements
      and are easier to qualify for than conventional loans.
      These loans cannot exceed the statutory limit. (Maybe
      $200,000-$275,000 but it varies greatly by geographical
      area).

     They make homeownership possible for people who might
     not qualify for conventional mortgage programs. They
     offer:
     1.     Low down payment and closing costs, with the
            option to use gift money for 100% of the down
            payment and closing costs.
     2.     Flexible approval requirements for people who
            have less-than-perfect credit or lack a traditional
            credit history
     3.     Expanded qualifying ratios for people with low-to-
            moderate incomes
2.   VA LOANS
      Guaranteed by the U.S. Dept. of Veterans Affairs.
      Generally available only to veterans. Usually without a
      down payment. Easy qualification. Limit of about
      $200,000.


 CONVENTIONAL LOANS
       May be conforming or non-conforming. Conforming
       loans meet the guidelines set forth by Fannie Mae and
       Freddie Mac who package loans and sell them to
       investors.

       Guidelines pertain to maximum loan amount, borrower
       credit, down payment, and suitable properties.

       2007 conforming loan limit for a single family is $417,000.
               FIXED RATE MORTGAGES
                         (6.25%)
                  (per $100,000 of loan)

TERM            MONTHLY
(Yrs.)          PAYMENT

Int. Only       $520.00
$567.74
40$615.7
30$857.42

The interest rate is set at the time of the signing of the loan,
  and does not vary over the life of the loan.

For financial planning purposes, fixed rate loans are the best
  choice when current interest rates are low, and the buyer
  intends to hold the property for many years.
              Features of Fixed Rate Mortgages


 • Very simple, but not very flexible.
 • Available terms are 5, 10, 15, etc. with 15 and 30 years the most
   popular.
 • Shorter loans usually have lower interest rates.




Note: Most, but not all, states now have laws that specify that the
borrower may pre-pay the mortgage without any penalty. Know the
law for your state.
WHICH COSTS MORE—
A 30 YEAR MORTGAGE OR A 15 YEAR MORTGAGE?

Loan Amount = $225,000
30 year fixed interest rate = 5.64%
15 year fixed interest rate = 5.23%

30 year loan
  Monthly payment = $1,297
  Total payments = $466,920

15 year loan
  Monthly payment = $1,806
  Total payments = $325,080

PV of 30 year payments @8% = $176,760
PV of 15 year payments @8% = $188,981
ARMs
Usually will save money over a fixed rate loan if the homeowner
is planning to keep the home for a short period, e.g. 3 years.
(Monthly payments normally remain lower for at least 2-3 years).
Are attractive when interest rates are high.

THE INTEREST RATE
INDEX AND MARGIN
The ARM rate is the “index rate” plus margin. Margin is a
constant amount, usually between 2.75% and 3.25%. The index
rate usually will be the T-bill rate, prime rate, cost of funds index,
or the LIBOR rate.
                        Common Indexes

• U.S. Treasury Bills - usually the one year rate.
• Prime rate – The prime rate is the rate that banks charge to their
  best customers, usually commercial.
• Cost-of-Funds index (COFI) – The COFI index is calculated by each
  of the Federal Reserves' regional districts, the most popular of which
  is the 11th District. The Cost-of-Funds index is a monthly survey of
  the cost to the banks of the money they have at their disposal.
• London InterBank Offered Rate (LIBOR) – The LIBOR index has
  become the index of choice for non-conforming lenders, especially
  with sub-prime (B/C/D/E) credit loans. The LIBOR rate tends to
  remain close to – though slightly higher – than the T-Bill rate.
             PRIMARY ADVANTAGE OF ARMs


ILLUSTRATIVE CURRENT INTEREST RATES (good credit)
                        3/27/07

    TERM                 RATE        APR          POINTS
30 Year Fixed            5.78%       5.90%        0.39
1/1 ARM                  5.57%       7.03%        0.57
3/1 ARM                  5.42%       6.91%        0.47
5/1 ARM                  5.53%       6.74%        0.43

Annual Percentage Rate (APR) is an expression of the effective interest
rate that will be paid on a loan, taking into account one-time fees and
standardizing the way the rate is expressed. In other words the APR is
the total cost of credit to the consumer expressed as an annual
percentage of the amount of credit granted. APR is intended to make it
easier to compare lenders and loan options.
ADJUSTMENT PERIOD
Range from 1 month to several years, but 1 year is most
common. Some are based on the prime rate and can be
adjusted at any time. 30-year amortization is standard.

Terminology: 3/1

This means the rate is level for 3 years and adjusts every year
thereafter.

Periods can be 5/1, 7/1, etc. or even more often, e.g.,
2 year/ 6 months
CAPS
  Periodic caps
     Limits how much the rate can change from one period to
     the next.
  Lifetime cap
     A limit on the maximum rate. Usually the starting rate is
     the lifetime minimum.
  Payment cap
     A limit on how much the monthly payment (not the rate)
     can change from one period to the next.
  Principal cap
     A limit on the amount of negative amortization. This
     occurs when the payment is not high enough to pay the
     interest due. Can result in higher or balloon payments in
     later years.

CONVERSION OPTION
     The right to convert, usually 1-5 years, to a fixed loan.
                   Negative Amortization
• Negative amortization occurs when the payment cap on a loan
  keeps the payment from covering the interest for that month.
• The deficit can be added to the loan’s principal.
• A principal cap can keep negative amortization from raising the
  principal due beyond a certain level.
• Loans on which negative amortization is possible are usually
  offered at very low introductory rates.
ADJUSTMENT PROCESS
When the rate is adjusted, it is amortized for the remaining period
of the loan.

DISADVANTAGES OF ARMs
  1.  Potential increases in rates.
  2.  Higher cost for mortgage insurance because ARMs have
      higher default rates.

JUMBO LOANS
The loan amount exceeds the guidelines of agencies like Fannie
Mae. Interest rate is higher because they are “non-conforming.”

Jumbo loans usually have a higher interest rate than conforming
loans. To lower the interest rate,
        Make larger down payment to bring the mortgage balance
        down to conforming limit.

       Use two loans: a conforming first mortgage and a second
       mortgage.
       HOME EQUITY LINE OF CREDIT

The borrower establishes a line of credit with a lender.
The line of credit can be used like a checking account.
It is a second mortgage, and the closing costs will be the same as
any other mortgage.
If the borrower does not use the credit, there will be no interest
charged.

Financial Planning Tool:
       Excellent safety net for the homeowner. Funds available
        immediately in emergency situation.
Investment Tool
       Instant liquidity allows investors to seize an opportunity
    without
        a lengthy loan application process.
     No interest is charged until the line of credit is used. This
   makes
      it a low cost option.
DEDUCTIBILITY OF HELOC INTEREST
IF USED FOR MAJOR HOME IMPROVEMENTS OR A SECOND HOME:
   Deductible if the amount of the loan is $1 million or less

IF USED FOR SOME OTHER PURPOSE (such as paying off car,
credit cards, etc.)
   The interest on up to $100,000 of debt is deductible.

EXCEPTION: IF USED TO BUY SECURITIES THAT PRODUCE TAX
FREE INCOME
  The interest is not deductible
                      REFINANCING

Why do homeowners refinance?

Usually to:
  1.   get a better interest rate
  2.   change the term of the loan
  3.   consolidate debt
  4.   get extra cash
                     Cost of Refinancing


Refinancing adds a new set of points, closing costs and fees to
  the cost of borrowing money.
• Points on an original mortgage are deductible in the year of
  purchase.
• Points on a refinancing generally must be allocated to the
  entire term of the loan, and cannot be written off immediately.
Thus, the rule of thumb that it does not pay to refinance unless
  the interest rate is at least 2% lower than the old loan.

Better:
  Assume the cost of refinancing is $3,400. The monthly payment
  will be reduced $42 for 30 years.

  At 8%, the present value of $42 per month for 30 years is about
  $5,724.
NEWER TYPES OF MORTGAGES
 1.   2-Step Mortgage
       Start with a fixed rate for a period of time (usually 5-7
       years) and then the interest rate changes to the current
       market rate and remains at that level.
 2.   Convertible ARMs
      Start as an ARM but the borrower has the option (usually
      during the first 5 years or so) to convert to a fixed rate
      mortgage.
 3.   Graduated Payment Mortgages
      Payments start low and gradually increase. The loan may
      actually be negatively amortizing in the early years and
      later payments will be higher than normal.
 4.   Buydown Mortgage
      The buyer pays an initial lump sum in return for a lower
      interest rate, usually for the first 1-3 years (but can be
      longer). The lender can pay the initial lump sum if the
      borrower agrees to a little higher interest rate.
5. BUY DOWN PROGRAMS
One of the parties, buyer, lender, or seller, pays points at closing
to get a lower interest rate. If the buyer pays the points the
advantages are (1) payments will be lower, (2) points will be
deductible, and (3) qualification for a larger loan amount. A
buyer should not pay points if he will stay in the home only a
short time.

A “temporary” buy-down reduces the interest rate only for a
year or two. Often offered by sellers or lenders.
              Buy-Down Programs – “Points”

Buy-down programs reduce the interest rate through prepayment
  of the loan's interest. The prepayment is called “points”, with
  one point being equal to 1 per cent of the total loan.
• Permanent Buy-Downs:
   – Reduces the interest for the life of the loan.
   – Generally takes 5 or more years to recoup the points, so
      should not be used by homeowners who intend to stay in
      their home for less than 5-7 years.
• Temporary Buy-Downs:
   – Only lower the interest rate for a few years.
   – Buyer can qualify for a larger home, but must show that
      higher income is expected in the future.
   – Generally the fixed rate is higher than it would be on a
      conventional mortgage.
            Effect of Points and Closing Costs


• Closing costs and points can add up to 4% to the amount of
  money borrowed (They are typically added to the loan amount).
• These costs can be looked upon as affecting the rate on the net
  amount being borrowed.
• Therefore the rate of interest that the borrower is paying over
  the life of the loan is greatly increased.
                How a Balloon Loan Works

• Payments are computed on a 30 year fixed loan basis or even
  on interest only.
• After the term ends (typically 5 or 7 years) the homeowner still
  has a very large principal still due.
• At that point, the homeowner has to either come up with the
  cash to pay the loan or refinance, unless a conversion option is
  built into the loan.
Advantages and Disadvantages of Balloon Notes to the
                    Borrower

• Shorter Term:
   – Shorter term     Less risk to lender   Lower interest rate.
• Longer amortization:
   – Lower payment required.
   – Fixed rate during the term.
• Main disadvantage is that the balloon note may require a larger
  down payment than a comparable 30 year fixed loan (At least
  10%).
OTHER TYPES OF LOANS

CONSTRUCTION LOANS
Borrower gets a loan commitment and locks in a rate for
permanent refinancing. Involves lower loan to value ratio.

No Income Verification (NIV) Loans
  Applicable Situations:
       Self employment.
       Recent job change.
       Uneven income such as commissioned employees.
      Income claimed must be within reason.
  Cost of NIV Programs:
       Higher rate -- 1.50 to 4.00 percentage points higher
       than comparable full documentation loans.
       Larger down payment: With A-credit, about 20 - 25%,
       with lower credit, 30-40%.
               Effect of Biweekly Payments


• Making mortgage payments biweekly rather than monthly can
  significantly reduce the term of a mortgage.
• The logistics of arranging this are non-trivial.
• There are companies that will do this for you, but make sure
  that their fees will not offset the savings.
LEASES
 OPERATING LEASES
     The lessor is the economic owner and the lessee rents
     the asset. The lessor maintains and insures the asset.
     The lessee does not “pay for” the asset completely
     over the term of the lease. Lessee can cancel the lease
     (probably with a penalty).

 FINANCIAL LEASES
     Are fully amortized over the lease term. Lessor does
     not provide maintenance and insurance. Lessee
     usually cannot cancel. The lessee is essentially
     “buying” the asset and the lease is simply a financing
     method.
ACCOUNTING FOR LEASES
An operating lease does not appear on the balance sheet.

A “capital lease” (most “financial” leases) must show:
       “Leased assets” (under assets)
       “Lease obligations” (as a liability)

A lease must be capitalized if any one of the following is true:
  1.    ownership is transferred to lessee at the end of the
        lease

  2.    the lease term is 75% or more of the estimated life of the
        asset

  3.    the lessee can buy the asset at a bargain price at the
        end of the lease

   4.   the PV of the lease payments is 90% or more of the fair
        market value of the asset at the start of the lease
REASONS FOR LEASING

 1.   TRANSACTIONS COSTS
      It might cost less to lease rather than buying an asset
      and financing it with debt or equity.

 2.   REDUCTION OF UNCERTAINTY
      The lessee might be able to cancel the lease if the
      asset becomes obsolete.

 3.   POSSIBLE TAX ADVANTAGES

				
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