Mortgage loans can play a key role in achieving double-digit returns when investing in property, as long as the level of the mortgage interest rate meets some conditions (read the article Using Borrowed Funds to Finance Property Investments).
Mortgages are loans that are secured by property, which is used as the collateral for the loan. There are several types of mortgage loans in terms of the priority of the claim on the property that is used as collateral (first mortgage, second mortgage, etc.), in terms of interest rate structure, in terms of loan instalment structure, in terms of conversion to equity or participation in the property’s cash flows, in terms of amortization, in terms of the number of properties used as collateral, and in terms of the nature of the lender. The major types of mortgages that are available to property investors are discussed below.
Fixed-rate mortgages are characterized by a fixed interest rate and a fixed periodic payment over the entire term of the loan. This type of mortgage loans is less risky for the investor because it protects him from the risk of increasing interest rates and fluctuating mortgage payments. On the other hand, if interest rates decline significantly refinancing at the prevailing lower rate can be used, to replace the existing loan, but the borrower will have to pay a pre-payment penalty.
Adjustable-Rate Mortgages (ARM)
Adjustable-rate mortgages allow for a variable interest rate over the term of the loan. The interest rate charged changes periodically on the basis of some predetermined interest rate index, which is explicitly specified in the loan contract. For this reason investors need to have a mortgage rate forecast before deciding whether to go for this type of loan.
Adjustable-rate mortgage loans are more risky for the investor because the interest rate charged, and, therefore, mortgage payments, may rise, if the interest rate index on the basis of which the loan rate is adjusted increases. Within this context, lenders charge lower interest rates for adjustable-rate mortgages compared to fixed-rate mortgages. Some lenders may provide ARM loans that allow the borrower to extent the term of the loan in the case that the interest rate charged increases. By extending the term, the borrower may avoid an increase in his/her mortgage payment due to the increase in the interest rate.
Graduated-Payment Mortgages (GPM)
Graduated-payment mortgages, as the term implies, allow for gradually rising periodic payments. The objective of a GPM is to allow the borrower to have lower payments than a conventional mortgage would do in the early years of the loan. Mortgage payments will then rise gradually at a predetermined rate. This pattern of mortgage payments has been devised in order to match the income pattern of many borrowers, which is rising through time. Pyhrr, Cooper, Wofford, Kapplin and Lapides (1989) point out that in the early years of a GPM the lower mortgage payment may not be enough to cover the contractual interest rate, in which case the loan balance will be increasing.
Price Level Adjusted Mortgage (PLAM)
Price level adjusted mortgages allow the lender to increase or decrease the remaining balance of the loan periodically on the basis of a pre-determined price index, such as the consumer price index. The term and the interest rate of the loan remain fixed and the mortgage payment due is adjusted in each period in which the loan balance is adjusted, as a result of changes in the price index. According to Brueggeman and Fisher (2005), the interest rate charged for price level adjusted mortgages represents the real interest rate plus a risk premium representing the likelihood of loss due to default.
Convertible Mortgage Loans
According to Kolbe, Greer, and Rudner (2003), there are two common types of convertible mortgage loans: adjustable-rate loans that can be converted to fixed-rate loans and loans that allow conversion of a mortgage-loan position to equity position. Convertible adjustable-rate mortgage loans give the borrower the option over a limited time period to convert the loan to a fixed-rate loan. Upon conversion, a conversion fee needs to be paid by the borrower. This type of loan allows the investor to take advantage of the lower interest rates that come with adjustable-rate mortgages in periods of high interest rates. Furthermore, it allows the borrower to lock into a low rate, if interest rates drop to lower levels, by converting the loan to a fixed-rate loan.
According to Brueggeman and Fisher (2005), the second type of convertible loans gives the lender the option to convert a partial or full mortgage interest in the property to equity at the end of pre-determined period of time at a pre-determined price, which is the remaining mortgage balance or part of it at the expiration date of the option. The lender is likely to exercise its option on its expiration date, if the equity value of the mortgage interest that has been agreed to be converted into equity, is greater than the loan balance that corresponds to such (mortgage) interest. Such an arrangement is attractive to the borrower because he/she can get a significant reduction of the interest rate charged for this loan compared to conventional mortgage loans, in exchange for providing this option to the lender.
Participation loans are mortgage loans that allow the lender to participate in/receive part of the income produced by the property. Participation loans differ from convertible loans that give the option to the lender to convert its mortgage interest to equity, in the sense that the lender does not gain formal ownership of the property, but has a claim on part of its cash flows. Furthermore the right to claim part of the cash flows of the property at a pre-determined time is established upon the signing of the contract and is not an option that can be exercised by the lender at a pre-specified time.
The lender’s participation may be set as a percentage of gross income, net operating income (NOI), or cash flow after debt service, and a percentage of potential capital gains upon the sale of the property. In the case of development projects, the lender’s participation in the cash flow produced by the property starts usually after a pre-determined percentage of leasing and/or rental income level is achieved. The borrower’s motive to provide to the lender a share of the property’s income and capital gains is a considerably lower interest rate.
Fully Amortized Loans, Partially Amortized Loans or Interest Only Loans
Mortgage loans can be fully amortized with the full loan amount paid through periodic instalments by the end of the term of the loan; partially amortized, or balloon loans as they are referred to, with a significant part of the loan amount due at the end of the term of the loan, or interest-only loans with periodic payments of interest and the full loan amount due at the term of the loan.
Blanket mortgages represent notable financing instruments for investors targeting double-digit returns because they allow the investor to secure lower loan rates while maximizing leverage benefits from a property acquisition. Blanket mortgages are mortgage loans that are collateralized with more than one property, thus allowing for a lower loan to value (LTV) ratio, which is calculated using the total value of all properties used as security for the loan. The lower LTV of the blanket mortgage makes the loan less risky for the lender, thereby allowing the latter to charge a lower interest rate for the loan.
Purchase Money Mortgages
Purchase money mortgage is a mortgage issued to the buyer by the seller of the property as part of the purchase transaction. This financing tool is used usually when the buyer does not have sufficient cash to pay the full price over the existing mortgage and/or the buyer cannot qualify for a mortgage through traditional financing sources. The purchase money mortgage is often the difference between the remaining balance on the existing mortgage, which is assumed by the buyer and the purchase price, net of any cash down payment by the buyer. A seller may beome motivated to provide a purchase money mortgage to the prospective buyer in order to facilitate the sale.
Junior mortgages or junior liens refer to mortgages that are subordinated to the first mortgage and other liens of higher priority in terms of their claim on the property in case of default. For example, a second mortgage is subordinated with respect to the first mortgage, and a third mortgage is subordinated with respect to both the first and the second mortgage. The most common case of a junior mortgage is the second mortgage, which is sometimes used by buyers when they do not have the cash to pay the required down payment. Caution is needed when using second mortgages because the interest rate charged is significantly higher than the first mortgage, thus considerably increasing the debt service burden to the investor