Solutions to Questions - Chapter 4 Fixed Rate Mortgage Loans

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Solutions to Questions - Chapter 4
Fixed Rate Mortgage Loans

Question 4-1
What are the major differences between the CAM, and CPM loans? What are the advantages to borrowers and risks to lenders for each? What elements do each of the loans have in common? CAM - Constant Amortization Mortgage - Payments on constant amortization mortgages are determined first by computing a constant amount of each monthly payment to be applied to principal. Interest is then computed on the monthly loan balance and added to the monthly amount of amortization to determine the total monthly payment. CPM - Constant Payment Mortgage - This payment pattern simply means that a level, or constant, monthly payment is calculated on an original loan amount at a fixed rate of interest for a given term. CAM - lenders recognized that in a growing economy, borrowers could partially repay the loan over time, as opposed to reducing the loan balance in fixed monthly amounts. CPM - At the end of the term of the mortgage loan, the original loan amount or principal is completely repaid and the lender has earned a fixed rate of interest on the monthly loan balance. However the amount of amortization varies each month.

When both loans are originated at the same rate of interest, the yield to the lender will be the same regardless of when the loans are repaid (ie, early or at maturity).

Question 4-2
Define amortization.
Amortization is the process of loan repayment over time.

Question 4-3
Why do the monthly payments in the beginning months of a CPM loan contain a higher proportion of interest than principal repayment? The reason for such a high interest component in each monthly payment is that the lender earns an annual percentage return on the outstanding monthly loan balance. Because the loan is being repaid over a long period of time, the loan balance is reduced only very slightly at first and monthly interest charges are correspondingly high.

Question 4-4
What are loan closing costs? How can they be categorized? Which of the categories influence borrowing costs and why?
Closing costs are incurred in many types of real estate financing, including residential property, income property, construction, and land development loans.
Categories include: statutory costs, third party charges, and additional finance charges. Closing costs that do affect the cost of borrowing are additional finance charges levied by the lender. These charges constitute additional income to the lender and as a result must be included as a part of the cost of borrowing. Lenders refer to these additional charges as loan fees.

Question 4-5
Does repaying a loan early ever affect the actual or true interest cost to the borrower? When loan fees are charged and the loan is paid off before maturity, the effective interest cost of the loan increases even further than when the loan is repaid at maturity.

Question 4-6
Why do lenders charge origination fees, especially loan discount fees? Lenders usually charge these costs to borrowers when the loan is made, or “closed”, rather than charging higher interest rates. They do this because if the loan is repaid soon after closing, the additional interest earned by the lender as of the repayment date may not be enough to offset the fixed costs of loan origination.

Question 4-7
What is the connection between the Truth-in-Lending Act and the annual percentage rate (APR)?
Truth-in-Lending Act - the lender must disclose to the borrower the annual percentage rate being charged on the loan.
The APR reflects origination fees and discount points and treats them as additional income or yield to the lender regardless of what costs the fees are intended to cover.

Question 4-8
Does the annual percentage rate always equal the effective borrowing cost? The annual percentage rate under truth-in-lending requirements never takes into...
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