The Hutchens Blog

What is Interest?
Interest is the price that someone pays for the temporary use of someone else’s funds. To repay a loan, a borrower has to pay interest, as well as the principal, the amount originally borrowed.

Interest is the compensation that someone receives for temporarily giving up the ability to spend money. Without interest, lenders wouldn’t be willing to lend, or to temporarily give up the ability to spend, and savers would be less willing to defer spending.

Interest rates are expressed as percents per year. If the interest rate is 10 percent per year, and you borrow $100 for one year, you have to repay the $100 plus $10 in interest.

Because interest rates are expressed simply as percents per year, we can compare interest rates on different kinds of loans, and even interest rates in different countries that use different currencies (yen, dollar, etc.).

What are “APR” and “APY”?
“APR” stands for “Annual Percentage Rate,” and “APY” for “Annual Percentage Yield.”

The APR includes, as a percent of the principal, not only the interest that has to be paid on a loan, but also some other costs, particularly “points” on a mortgage loan.

Points (a point equals one percent of the mortgage loan amount) are fees that the mortgage lender charges for making the loan. In a sense, points are prepaid interest, or interest that is due when the loan is taken out.

Some lenders charge lower interest rates but more points than other lenders. The APR therefore provides a useful gauge for comparing the total cost of mortgage loans.

For example, a 30-year mortgage with an interest rate of 8.0% and four points would have an APR of 8.44%, while a mortgage with an interest rate of 8.25% and one point would have an APR of 8.36%.

The principal used in calculating the APR is equal to the amount of the loan the borrower actually has to use at any time. Consider two one-year loans of $1,000, each with an interest rate of 10%, or $100 in interest.

The second loan has a higher APR, even though the amount of interest paid ($100) is the same on both loans. The second loan has a higher APR because the second borrower, unlike the first borrower, does not have the use of the entire $1,000 for the entire year, because the second borrower repaid $500 of the loan after six months. (Another reason the second loan has a higher APR is that the borrower paid half of the interest after six months and half at the end of the year, rather than all the interest at the end of the year.)

“APY” is the effective interest rate from the standpoint of a person receiving interest. If you have $1,000 in each of two bank accounts, each paying the same interest rate, but the interest is credited more often (let’s say, every month, rather than once a year) on one of the accounts, that account will have a higher APY, because the interest will build up more rapidly than on the other account.

Why Does Interest Exist?
From the lender’s point of view:

* Interest compensates lenders for the effects of inflation, or rising prices. Prices go up every year, so lenders are repaid with dollars that can’t buy as much as the dollars they lent; the lenders must be compensated for that loss of purchasing power
* Interest also compensates lenders for the risks they take. One risk is that nobody knows for certain how much prices will go up during the time that the borrower has the lender’s money. Other risks are that the borrower won’t repay the loan fully, on time, or at all
* For a lender such as a bank, interest covers the costs of staying in business, including the cost of processing loans, and interest also provides the profit that a lender needs to stay in business

From the borrower’s point of view:

* Individuals are willing to pay interest to borrow money in order to be able to spend now, rather than later, on cars and many other items
* Individuals are willing to pay interest in order to be able to afford a large purchase, such as a home, for which they don’t have enough funds of their own
* Individuals are willing to pay interest on loans to pay for education, which can increase their earning ability
* Businesses are willing to pay interest in order to borrow to invest in equipment, buildings, and inventories that will increase their profits
* Some borrowers are willing to pay interest on certain loans because of the associated tax advantages. Mortgage interest, for example, is tax deductible. That means that in calculating how much income tax you have to pay, you can subtract the mortgage interest that you pay from your income
* Banks are willing to pay interest on their customers’ deposits because they can lend the funds at higher interest rates and make a profit
Interest: Cost to Some, Income to Others?
Interest is income to people willing to give up the temporary use of their money. When you put money into a bank account, or when you buy a U.S. Savings Bond, for example, you receive interest income.

Interest is a cost to borrowers. You pay interest, for example, if you don’t pay your entire credit card bill at the end of the month, if you take out a mortgage loan to buy a house, or if you own a business that borrows in order to invest in machinery.

Interest is a signal that directs funds to where they can earn the highest rates, or to where loans can do the most for the economy.

Interest is a measure of the cost of holding money. The rate of interest that you could earn by lending your money is the cost to you of holding your money in a way (such as in cash) that doesn’t earn any interest. Economists use the term “opportunity cost” to refer to what you give up by choosing a certain course of action. By holding money, you give up the interest that you could have earned, so the interest rate measures the opportunity cost of holding money.

Posted by Sandy Hutchens

Buying a mansion can be an exciting time in a person’s life, as it typically signifies wealth, success and the feeling of having finally “arrived.” Along with that celebratory attitude, however, also comes a great deal of stress in the form of mortgage payments, homeowners associations and sizable down payments. So think long and hard about if a mansion is the right real estate move for you and, if so, what type property you’re on the market for.

1. Visit a financial planner or adviser to determine your price range, including how much you’re able to put down, how much a 30-year mortgage would amount to and how much you can expect to pay in property taxes.
2. Find a real estate broker who specializes in luxury properties and upscale communities. These brokers can be easy to find because they are usually the top brokers or star players within their given company. Another way to find an experienced broker is to talk to residents of the community you are interested in.
3. Determine why you want to buy a mansion. Do you need a lot of space? Do you yearn for privacy? Do you have a lot of people under one roof? These questions will help you determine what neighborhoods to browse, what type of property to buy and if, in fact, a mansion will really meet your needs.
4. Set up appointments with your broker to visit some suitable mansions. Ask many questions based on your housing criteria (which will hopefully be established once the above-mentioned questions are fleshed out).
5. Ask the listing agent or homeowner about any custom or upscale amenities the property may contain. This will both help you realize the property’s value (or lack thereof) and determine if the home is likely to have many costly repairs. You should research the types of weather, acts of God and insurance that are common in those parts, which will also help you determine what incidental expenses you may incur.
6. Bring your family to view any properties that have met all of your criteria. Take them on an outing after viewing homes in different areas to get a sense of the community, what the neighbors are like, what they do for fun and how they behave to determine if that neighborhood would fit with your family’s lifestyle.
7. Hire a professional appraiser and handyman to do a walk-through of the house before determining whether it is a good investment. Remember, the property may appear to be everything you want at first glance, but a professional will be able to assess whether major, costly repairs will be necessary in the near future.
8. Place a bid on the mansion you decide on and play the waiting game with your broker. From here, it is up to you whether you want to enter in any counter offers should you be outbid.

After an early close on Friday, rates ended slightly higher than where they began the week. The week ahead will be abbreviated as the market remains closed on Monday in observance of President’s Day.  But even though it will be a short week, the economic calendar is still fairly active.  So what’s in store for rates?

Last week, rates edged lower before reversing course and heading higher as the Obama stimulus plan worked its way through congress.  It will be interesting to see if the President’s stimulus package actually stimulates anything as proponents of the plan claim the plan is nothing more than the largest pork spending bill ever.

One thing is for sure, the stimulus package in its current form is the largest sum of money ever spent in the history of the world in an attempt to stimulate the economy – So will it actually work?  Only time will tell, but if history is correct like it so often is, it will likely not accomplish its goal.  Considering to date, a government has never been able to spend its way out of a recession.  The last time it was attempted was a few years ago when Japan passed a massive spending bill to correct their recessionary heading.  But like all other past spending bills including Roosevelt’s “New Deal,”  the only thing Japan gained was moving their economy deeper into a recession and a massive debt for their children and grandchildren to payback.

The abbreviated week ahead boasts several high impact reports that can influence rates, but it will likely be political news that will continue to leave the market volatile as investors try and figure out where the market is heading.

As the jobless rate continues to rise in response to the recession, servicers are reminded that income and mortgage default levels are inexorably linked. According to NeighborWorks America, nearly 50 percent of mortgage default is income-related. Thirty percent of borrowers cited a reduction in income, and 19 percent a loss of income, as primary reasons for falling behind on their mortgage. Without transparency into a borrower’s current employment and income status, lenders and servicers are unable to proactively reach out to troubled borrowers and offer loan workout options. Insight into current borrower employment and income information enables servicers to make early contact with distressed borrowers, which is essential in successfully executing loan modifications.

Through the recently created “Making Home Affordable Act,” the federal government is planning to help up to 9 million homeowners currently at risk of default. In April 2009, HOPE NOW members and the industry at large modified 127,000 mortgages and completed 143,000 re-payment plans totaling 270,000 interventions, “the largest number in any month” since the alliance started to compile data.

In response to such programs, servicers need better insight into borrower financials in order to manage the level of predicted loan defaults for the remainder of this year. Rather than taking on the significant burden of additional staff, servicers should consider looking to efficient and automated data providers that can verify income and employment instantly and more cost-effectively. And, rather than taking on additional risk with loan modifications, servicers should better position themselves to manage risk through data and information by using providers that offer a deeper insight into the borrower’s employment and income situation, from data sources such as employer payroll or IRS tax transcripts (Form 4506-T).

Historically, the Government Sponsored Enterprises required lenders to obtain a credit score and verbal Verification Of Employment (VOE) to complete a borrower’s loan application. Many lenders were forced to dedicate call center staff to manually contact employers or work directly with the IRS to attempt to verify employment status for the borrower – an inefficient, expensive, and inconsistent process. Compounded upon this, some lenders and servicers managed loan data across multiple business units and service centers, with differing information being provided.

Unfortunately, when unable to reach the employer to verify income and employment, many loan officers chose to rely on the credit score as the sole indicator of a borrower’s financial health and risk. Today, lenders are no longer willing to base lending decisions on the credit score alone – they want an in-depth review of all information on a consumer’s credit file. In addition to credit information, lenders require transparency into other credit bureau information including real-time employment and income verification to predict future loan performance and delinquency.

Help Is On the Way!

Engaging a third-party for proof of documentation provides servicers with a strategic option to effectively streamline their existing workflow when it comes to employment and income verification, while simultaneously improving the quality of data on which lending decisions are made. Specific information servicers can access through a single, secure, third-party provider include: the borrower’s current place of employment, employment status (active or not), the longevity of employment, job title and salary (including pay rate, YTD income, past two years income). Armed with insight, servicers can determine the best course of action for each individual borrower and thereby improve the performance of their portfolio.

Additionally, a compliant and complete third-party provider can provide great comfort to investors, who wants know a lender is tapping the most accurate source of borrower employment and income for greater transparency into borrower financial health. And, through greater data transparency, investors and lenders can improve analytics on a significant percentage of their portfolios to more effectively identify undervalued securities and improve the accuracy of loan-level delinquency, default, and prepayment predictions. Loan-level updated borrower information used in combination with powerful analytics gives investors the information needed to differentiate the “good deals” from the “bad deals” and better correlate risk with default rates.

Servicers tend to focus on debt-to-income ratios in performing loan modifications, but loan modifications have changed the debt-to-income requirements. How can servicers calculate debt-to-income ratio without an accurate view of the income portion? Servicers that rely on the stated income from a borrower’s loan application to calculate debt-to-income, in an economy where salary reductions and unemployment numbers are continuing to rise are simply exposing themselves to greater risk.

There are several viable solutions available today. Outsourcing employment and income verification to a trusted third-party allows servicers to focus on their core competencies of evaluating and modifying loans. Streamlining this step enables servicers to process more loan modifications in a timelier manner, which puts us on the path to a housing recovery.