Now that you understand how loans and the mortgage market works, you can begin to understand how to approach financing. In Article 3, we discussed a variety of loan programs that differ based on the lender, the type of property, and the borrower. We will now turn to loan types that are generally available in most of the loan programs discussed thus far and the advantages and disadvantages of each. Before doing so, let’s explore some of the relevant issues we need to consider when borrowing money.

Interest Rate

The cost of borrowing money, that is, the interest rate, is one of the most important factors. As discussed in Article 1, interest rates affect monthly payments, which in turn affect how much you can

afford to pay for a property. It may also affect cash f low, which affects your decision to hold or sell property.

Loan Amortization

There are many different ways a loan can be structured as far as interest payments go. The most common ways are simple interest and amortized. As discussed in Article 1, a simple interest loan is calculated by multiplying the loan balance by the interest rate. So, for example, a $100,000 loan at 12 percent interest would be $12,000 per year, or $1,000 per month. The payments here, of course, represent interestonly, so the principal amount of the loan does not change. An amortized loan is slightly more involved. The actual mathematical formula is beyond a article like this, so we’ve provided a sample interest rate table in Appendix A. However, you can find a thousand Internet Web sites that will do the calculations instantly online (try mine at <www.legalwiz.com>—click on “calculators”). The amortization method breaks down payments over a number of years, with the payment remaining constant each month. However, the interest is calculated on the remaining balance, so the amount of each monthly payment that accounts for principal and interest changes. For the most part, the more payments you make, the more you decrease the amount of principal owed (the amount of the loan still left to pay).

The loan term or duration is important to figuring your payment. By custom, most loans are amortized over 30 years or 360 monthly payments. The second most common loan term is 15 years. The payments on a 15-year amortization are higher each month, but you pay the loan off faster and thus pay less interest in the long run.

15-Year Amortization versus 30-Year Amortization I

n general, 15-year loans tend to have a slightly lower interest rate. In addition, you reach your financial goal of “free and clear” faster. However, there are three downsides to the 15-year loan. The first is that you are obligated to a higher payment that reduces your cash f low. Second, the higher monthly obligation appears on your credit report, which affects your debt ratios and thus your ability to borrow more money (discussed later in this article). Third, your monthly payment is less interest and more principal. While this may sound like a good thing, it doesn’t give you the same tax benefits; interest payments are deductible, principal payments are not. Unless the interest rate on the 15-year note is significantly lower, opt for the 30-year note. You can accomplish the faster principal pay down by making extra interest payments to the lender.

Example: On a $100,000 loan amortized at 8% over 30 years, your payment is $733.76. If you make an additional principal payment each month of $100, the loan would be fully amortized in just over 20 years, saving you $62,468.87 in interest. You can use a financial calculator to calculate how much extra you need to pay each month to reduce the loan term (again, try mine at <www.legalwiz.com>—click on “calculators”). And, of course,

when times are hard and the property is vacant, you aren’t obligated to make the higher payment.

Balloon Mortgage

A balloon is a premature end to a loan’s life. For example, a loan could call for interest-only payments for three years, then be due in full at the end of three years. Or, a loan could be amortized over 30 years, with the principal balance remaining due in five years. When the loan balloon payment becomes due, the borrower must pay the full amount or face foreclosure. A balloon provision can be risky for the borrower, but if used with common sense, it may work effectively by satisfying the lender’s needs. Balloon notes are often used by builders as a short-term financing tool. These types of loans are also known as “bridge” or “mezzanine” financing.

Reverse Amortization

Regular amortization means as you make payments the loan balance decreases. Reverse amortization means the more you pay, the more you owe. How is that possible? Simple—by making a lower payment each month than would be possible for the stated interest rate. A reverse amortization loan increases your cash f low but also increases your risk because you will owe more in the future. If you bought the property below market, a reverse amortization loan may make sense, especially if real estate prices are rising rapidly (another option may be a variable rate loan, discussed later in this article).

Property Taxes and Insurance Escrows

In addition to monthly principal and interest payments on your loan, you’ll have to figure on paying property taxes and hazard insurance. Many lenders won’t trust you to make these payments on your own, especially if you are borrowing at a high loan-to-value (80 percent LTV or higher). Lenders estimate the annual payments for taxes and insurance, then collect these payments from you monthly into a reserve account (called an “escrow” or “impound account”). The lender then makes the disbursements directly to the county tax collector and your insurance company on an annual basis. Thus, the total amount collected each month consists of principal and interest payments on the note, plus taxes and insurance—hence the acronym PITI.

Loan Costs Origination Fee

The cost of a loan is as important as the interest rate. Lenders and mortgage brokers charge various fees for giving you a loan (and you thought they just made money on the interest rates!). Traditionally, the most expensive part of the loan package is the loan origination fee. The fee is expressed in points, that is, a percentage of the loan amount: 1 point = 1 percent. So, for example, if a lender charges a “1 point origination fee” on a $100,000 loan, you would pay 1 percent, or $1,000, as a fee.

Discount Points Another built-in profit center is the charging of “discount points.” The lender will offer you a lower interest rate for the payment of money up front. Thus, if you want your interest rate to be lower, you can “buy down” the rate by paying ¹⁄₂ point (percent) or more of the loan up front. Buying down the rate only makes sense if you plan on keeping the loan for a long time; otherwise buying down the interest rate is a waste of money. Borrowers nowadays are smarter and try to beat the banks at their own game by refusing to pay points. Banks even advertise “no cost” loans, that is, loans with no discount points or origination fees.

Yield Spread Premiums: The Little Secret Your Lender Doesn’t Want You to Know The lower the interest rate, the better off you are, or are you? Lenders advertise “wholesale” interest rates on a daily basis to mortgage brokers, who then advertise rates to their customers. This wholesale interest rate can be marked up on the retail side by the mortgage broker.

Example: Say, for example, your mortgage broker offers you an interest rate of 7.25% on a $200,000, 30-year fixed loan. The monthly payment on this loan would be $1,364.35, which is acceptable to you. However, the wholesale rate offered by the lender may be 7.00%, which is $1,330.60 per month. This difference may not seem like much, but over 30 years, it amounts to about $12,000 in additional interest paid. The mortgage broker receives a “bonus” back from the lender for the additional interest earned. This bonus is called a yield spread premium (YSP) because it represents the additional yield earned by the lender for the higher interest rate.

Loan Junk Fees Even without points and at par (no markup on the interest rate), there is no such thing as a no-cost loan. Lenders sneak in their profit by disguising other fees, such as the following:

• Administrative Review

• Underwriting Charge

• Documentation Fee

These charges are given fancy names but are really just ways for the lender to make more profit. Lenders also pad their actual fees, such as the cost of obtaining credit reports, courier charges, and other “miscellaneous fees” (one lender admitted to me that he pays less than $15 for a credit report yet charges the borrower $85!). Understand that lenders are in business to make money, so if a loan sounds too good to be true, it probably is—look carefully at their fees and charges.

“Standard” Loan Costs While every lender has its own fees and points it charges, there are certain costs you can expect to pay with every loan transaction. These fees should be listed in the lender’s good faith estimate as well as on the second page of the closing statement. The closing statement is prepared at closing by the escrow agent on a form known as a HUD- 1, in compliance with the Real Estate Settlement Procedures Act (RESPA), a federal law. A sample of this form can be found in Appendix C. All of the following charges appear on page two of the form:

• Title insurance policy. While a lender secures its loan with a security instrument recorded against the property, it wants a guarantee that its lien is in first position (or, in the case of a second mortgage, second position). A lender’s policy of title insurance guarantees to the lender it is in first position (or, in the case of a second mortgage, second position). This policy costs anywhere from a few hundred dollars to a thousand dollars, depending on the amount of the loan and when the last time a title insurance policy was issued on the property; the more recently another policy was issued, the cheaper the policy. Also, if you are purchasing an owner’s title insurance policy in conjunction with the lender’s policy (very common), the fee for the lender’s policy is substantially reduced.

• Prepaid interest. While this is not a “fee,” it is a cost of financing you pay up front. Because interest is paid for the use of money the month before, you need to figure on paying prorated interest. For example, let’s assume your monthly payment on the mortgage note will be $1,000. If you close your loan on the 15th of the month, your first payment won’t be due for 45 days. The lender will collect 15 days of interest at closing for the use of the money that month, which is $500.

• Application fee. While standard among some lenders, this fee is really a “junk” fee. Nobody should charge you for asking you to do business with them. Lenders often waive this fee if they fund your loan.

• Document recording fees. Because the mortgage or deed of trust will be recorded at the county, there are fees charged. The usual range is about $5 to $10 per page, and the typical FNMA Mortgage or deed of trust is anywhere from 12 to 20 pages. In addition, some states and localities (e.g., New York) charge an additional tax on mortgage transactions based on the amount of the loan.

• Reserves. If the lender is escrowing property taxes and insurance, it will generally collect a few months extra up front. While technically not a cost, it is cash out of your pocket.

• Closing fee. The lender, company, attorney, or escrow company that closes the loan charges a fee for doing so. Closing a loan involves preparing a closing statement, accounting for the monies, and passing around the papers. The closer actually sits down with the borrower and explains the documents and, in most cases, takes a notary’s acknowledgment of the borrower (a mortgage or deed of trust must be executed before a notary in order for it to be accepted for recording in public records; the promissory note is not recorded but held by the lender until it is paid in full). The closer also makes sure the documents find their way back to the lender or the county for recording.

• Appraisal. Virtually all loans require an appraisal to verify value. An appraisal will cost you between $300 and $500, and even more if the subject property is a multiunit or commercial building. Appraisers often charge additional fees for a “rent survey,” which is a sampling of rent payments of similar properties. The lender will want this information to verify that the property can sustain the income you projected. • Credit report. Lenders charge a fee for running your credit report. The lender may charge as much as $85 for a full credit report. Vendors often run short-form credit reports, which are much cheaper. The lender may run a short-form version first to get a quick look at your credit, then a full report at a later time (called a “three bureau merge” because it contains information from the three major credit bureaus).

• Survey. A lender may require that a survey be done of the property. A survey is a drawing that shows where the property lies in relation to the nearest streets or landmarks. It will also show where the buildings and improvements on the property sit in relation to the boundaries. If a recent survey was performed, it may not be necessary to do a new survey. Rather, the lender may ask for a survey update from the same surveyor or another surveyor. In some parts of the country, an “Improvement Location Certificate” is used; it is essentially a drive-by survey.

• Document preparation fees. Some lenders will charge you an attorney’s fee for document preparation. Larger lenders have in-house attorneys and paralegals. Smaller lenders hire outside service companies to prepare the loan documents. The reason documents are not always done “in house” is because of the complexities of compliance with lending regulations. Document preparation companies pay lawyers to research the laws and draft documents for compliance. Based on the information provided by the lender, the document preparation company prepares the forms for the lender. The fee for this service is generally a few hundred dollars, which is passed on to the borrower. Now that you know how lenders make their money, you can negotiate your loan with confidence. Virtually every fee a lender asks for can be negotiated. However, don’t expect the lender to waive every fee, charge no points, and get no back-end fees (yield spread premiums). The lender has to make a profit to be willing to do business with you. Profit is also important to you as an investor, but so is the availability of the money you borrow. If you want a lender that is willing to work hard for you, make sure you are willing to pay reasonable compensation.

Pinching pennies with your lender will not get it excited about pushing your loan through the process faster. However, knowing what fees are negotiable will allow you to get a loan at a fair interest rate and pay a reasonable fee to get it.

Risk In addition to profit and cash f low, one of the major factors you should consider in borrowing money is risk. While maximum leverage is important to the investor, it is also higher risk to the investor. The more money you borrow, the more risk you could potentially incur. That is, while you have less investment to lose, you may be personally liable for the debt you have incurred. With larger commercial projects, the lender’s main concern is the financial viability of the project itself. In that case, the borrower does not necessarily have to sign personally on the promissory note. The lender’s sole legal recourse is to foreclose the property. With smaller residential loans, the investor/borrower signs personally on the note and is thus liable personally for the obligation. While the lender can foreclose the property, there may be a deficiency owed that is the personal obligation of the borrower. In the late 1980s, many leveraged investors learned this lesson the hard way when they were forced to file for bankruptcy protection. A smart investor finances properties with a cash cushion, positive (or at least breakeven) cash f low, and at a reasonable loan-to-value ratio.

Nothing Down While “nothing-down” financing is viable, it does not necessarily mean a 100 percent loan-to-value. For example, buying a $150,000 property for $150,000 with all borrowed money is not a bad deal if the property is worth $200,000. That’s a 75 percent LTV. Buying a property for close to 100 percent of its value and financing it 100 percent with personal recourse is very risky. If you don’t have the means to support the payments while the property is vacant, you may be in for trouble. Like any business, real estate is about maintaining cash f low. So, in considering your loan, factor in the following issues:

• Are you near the top of an inf lated market?

• Is the local economy’s outlook good or bad?

• If purchasing, are you buying below market?

• How long do you intend to hold the property and for what purposes?

• Are prices likely to drop before you sell it?

• Will you be able to refinance the property in the future?

• Are you personally obligated on the note, or is the debt nonrecourse (or signed for by your corporate entity)? All of these factors are relevant to risk and to whether you want to leverage yourself without a backup plan.