Financing Residential Real Estate. Conventional Financing

Financing Residential Real Estate Lesson 10: Conventional Financing

Introduction In this lesson we will cover: conforming and nonconforming loans, characteristics of a conventional loan, qualifying standards for conventional loans, and special programs and payment plans.

Introduction Loans made by lenders can be divided into two main categories: conventional loans government-sponsored loans

Introduction Conventional loan Any institutional loan that isn t insured or guaranteed by a government agency.

Conforming & Nonconforming Loans Most conventional loans comply with underwriting guidelines of Fannie Mae and Freddie Mac.

Conforming & Nonconforming Loans Most conventional loans comply with underwriting guidelines of Fannie Mae and Freddie Mac. Conforming loan = complies with Fannie Mae/Freddie Mac guidelines. Nonconforming loan = doesn t comply with Fannie Mae/Freddie Mac guidelines.

Conventional Loan Characteristics Lenders want to be able to sell their loans on secondary market. As a result, Fannie Mae and Freddie Mac, underwriting guidelines are widely followed and very influential in mortgage industry.

Conventional Loan Characteristics Property types/owner-occupancy occupancy rules Conventional loan may be secured by: principal residence, (up to 4 dwelling units)

Conventional Loan Characteristics Property types/owner-occupancy occupancy rules Conventional loan may be secured by: principal residence, (up to 4 dwelling units) second home, (no more than 1 dwelling unit)

Conventional Loan Characteristics Loan amounts Conforming loan limits are set annually by Fannie Mae and Freddie Mac. Agencies g won t purchase loan if it exceeds limit. Different loan limits for different parts of Different loan limits for different parts of U.S.

Conventional Loan Characteristics Loan amounts Jumbo loan Loan that exceeds conforming loan limits. Extralarge loans are sometimes called super jumbos. About half of jumbo loans are ARMs.

Conventional Loan Characteristics Loan amounts Jumbo loan Loan that exceeds conforming loan limits. Extralarge loans are sometimes called super jumbos. About half of jumbo loans are ARMs. Higher h interest t rates.

Conventional Loan Characteristics Repayment periods Repayment periods can range from 10-40 years. 30-year loans still standard. 15-year loans gaining popularity.

Conventional Loan Characteristics Amortization Majority of conventional loans are fully amortized. Partially and interest-only loans also available.

Conventional Loan Characteristics Loan-to-value ratios Common conventional LTVs: 80% 90% 95%

Conventional Loan Characteristics Loan-to-value ratios Less common conventional LTVs: 97% 100%

Conventional Loan Characteristics Loan-to-value ratios Conventional loans are often categorized by LTV ratio, with different underwriting rules applied to each category.

Conventional Loan Characteristics Loan-to-value ratios Fannie Mae and Freddie Mac require private mortgage insurance for any conventional loan purchased with LTV over 80%.

Conventional Loan Characteristics Loan-to-value ratios High-LTV loans also have: higher interest rates and fees, and stricter underwriting rules.

Conventional Loan Characteristics ARM LTV ratios At one time, Fannie Mae and Freddie Mac didn t buy ARM mortgages with LTVs over 90%.

Conventional Loan Characteristics ARM LTV ratios At one time, Fannie Mae and Freddie Mac didn t buy ARM mortgages with LTVs over 90%. Now, both are willing to buy ARMs with LTVs up to 95% if certain conditions are met.

Conventional Loan Characteristics Private mortgage insurance Private mortgage insurance (PMI) is designed to protect lenders from risk of high-ltv loans. Makes up for reduced borrower equity.

Private Mortgage Insurance How PMI works Private mortgage insurance company assumes only a portion of risk of default. Covers upper portion of loan. Typically 25% to 30% of loan amount.

Private Mortgage Insurance How PMI works Upon default and foreclosure, lender makes claim for reimbursement of actual losses. Can also relinquish property p to insurer.

Private Mortgage Insurance How PMI works Insurers have own underwriting standards, which have also been influential on mortgage market.

Private Mortgage Insurance PMI premiums Mortgage insurance company charges insurance premiums for coverage.

Private Mortgage Insurance PMI premiums Mortgage insurance company charges insurance premiums for coverage. Variety of payment plans, including: initial premium at closing, plus renewal premiums, or financed one-time premium.

Private Mortgage Insurance Cancellation of PMI Under federal Homeowners Protection Act, lenders must cancel loan s PMI under certain conditions: 1. once loan has been paid down to 80% of property s original value (upon borrower request); or 2. once loan reaches 78% of property s original value (automatic cancellation).

Private Mortgage Insurance Cancellation of PMI Homeowners Protection Act only applies to loans on single-family dwellings occupied as borrower s primary residence.

Private Mortgage Insurance Cancellation of PMI If payment plan involved initial premium and renewal premiums, cancellation of PMI reduces monthly mortgage payment.

Summary Conventional Loan Characteristics Conforming loan Nonconforming loan Investor loan Jumbo loans Loan-to-value ratios PMI Amortization Repayment period

Secondary Financing Lenders generally allow secondary financing. Most impose some restrictions due to increased risk of default.

Secondary Financing Restrictions Examples of restrictions lenders may impose: 1. Borrower must qualify for payments on both first and second mortgages. g

Secondary Financing Restrictions Examples of restrictions lenders may impose: 1. Borrower must qualify for payments on both first and second mortgages. g 2. Borrower must make 5% downpayment.

Secondary Financing Restrictions Examples of restrictions lenders may impose: 1. Borrower must qualify for payments on both first and second mortgages. g 2. Borrower must make 5% downpayment. 3 S h d l d t t b d l 3. Scheduled payments must be due on regular basis.

4 S d t t i b ll 4. Second mortgage can t require balloon payment less than 5 years after closing.

4. Second mortgage can t require balloon payment less than 5 years after closing. 5. If first mortgage has variable payments, second mortgage must have fixed payments.

4. Second mortgage can t require balloon payment less than 5 years after closing. 5. If first mortgage has variable payments, second mortgage must have fixed payments. 6. No negative amortization.

4. Second mortgage can t require balloon payment less than 5 years after closing. 5. If first mortgage has variable payments, second mortgage must have fixed payments. 6. No negative amortization. 7. No prepayment penalty.

Secondary Financing Piggyback loans Piggyback loan is another term for secondary financing. Used to either: avoid paying private mortgage insurance, or avoid jumbo loan treatment.

Secondary Financing Piggyback loans Using secondary financing to avoid PMI can backfire if second loan has high interest rate and steep fees.

Qualifying Standards Evaluating risk factors Fannie Mae and Freddie Mac have changed how they evaluate creditworthiness of applicants. Newer methods influenced by automated underwriting systems and computer analysis.

Qualifying Standards Evaluating risk factors Fannie Mae uses comprehensive risk assessment to evaluate risk factors. Two primary risk factors: applicant s credit history, and the loan-to-value ratio.

Qualifying Standards Evaluating risk factors Fannie Mae uses comprehensive risk assessment to evaluate risk factors. Two primary risk factors: applicant s credit history, and the loan-to-value ratio. Loans ranked as low, moderate, or high primary risk.

Qualifying Standards Evaluating risk factors Fannie Mae treats other aspects of application, such as debt to income ratio and cash reserves, as contributory risk factors. Each factor assigned value depending on whether it: satisfied basic risk tolerances, increases risk, or decreases risk.

Qualifying Standards Evaluating risk factors Freddie Mac evaluates each component of creditworthiness: capacity p y to repay, credit reputation, and collateral. t l

Qualifying Standards Evaluating risk factors Underwriter then considers overall layering of risk. Weakness in one component can be outweighed by strength in another.

Qualifying Standards Income analysis Fannie Mae and Freddie Mac consider income durable if it is expected to continue for at least 3 years after loan is made.

Income Analysis Obligations to income ratio Once lender finds amount of stable monthly income, next step is to determine if it is enough to support monthly payment.

Income Analysis Obligations to income ratio Income is adequate if total monthly obligations don t exceed 36% of stable monthly income.

Income Analysis Obligations to income ratio Income is adequate if the total monthly obligations don t exceed 36% of stable monthly income. Total monthly obligations = includes applicant s recurring obligations and proposed housing expense. Recurring obligations = installment debts revolving Recurring obligations = installment debts, revolving debts, and other obligations.

Income Analysis Obligations to income ratio Installment debts have a fixed beginning and ending date. Example: p a car loan.

Income Analysis Obligations to income ratio Revolving debts involve open-ended line of credit, with minimum monthly payments. Example: p credit card or department store charge account.

Income Analysis Obligations to income ratio Other category of obligations: alimony, child support, and similar ongoing financial obligations. Fannie Mae and Freddie Mac don t consider child care expenses part of recurring obligations.

Income Analysis Housing expense to income ratio Proposed housing expense (PITI) should not exceed 28% of loan applicant s stable monthly income.

Income Analysis Applying the ratios How to apply ratios: Add monthly obligations together to get total. $425 + 250 = $675 monthly obligations

Income Analysis Applying the ratios How to apply ratios: Add monthly obligations together to get total. $425 + 250 = $675 monthly obligations Multiply stable monthly income by obligations to income ratio. $6,100 36% = $2,196

Subtract S t monthly obligations from that t figure to get maximum mortgage payment. $2,196 $675 = $1,521

Subtract S t monthly obligations from that t figure to get maximum mortgage payment. OR $2,196 $675 = $1,521 Multiply stable monthly income by housing expense to income ratio to find maximum mortgage payment. $6,100 28% = $1,708

Income Analysis Applying the ratios Housing expense ratio is less important than total obligations ratio. Fannie Mae no longer applies a housing g pp g expense to income ratio.

Income Analysis Debt-to-housing to gap ratio Freddie Mac requires lenders to calculate a debt-tohousing gap ratio. Calculated by: S bt ti h i ti f t t l Subtracting housing expense ratio from total obligations ratio.

Income Analysis Higher ratios and compensating factors If compensating factors exist, Fannie Mae and Freddie Mac will consider income ratios that exceed benchmarks.

Income Analysis Higher ratios and compensating factors Compensating factors include: large downpayment; substantial net worth; demonstrated ability to incur few debts and accumulate savings; education, job training, or employment history indicating potential for increased earnings;

short-term h t t income that t doesn t count as stable monthly income; demonstrated ability to devote large portion of income to basic needs, such as housing expense; or significant energy-efficient features in home being purchased.

Income Analysis Factors that increase risk Some applications have factors that are considered an increased risk to lender. May include: mediocre credit score, or unsettled work history.

Income Analysis 95% loans Some lenders apply stricter standards for high-ltv loans. Fannie Mae and Freddie Mac are willing to buy 95% loans if they have been evaluated very carefully.

Income Analysis 95% loans Lender must pay special attention to applicant s: credit history, reserves, ability to accumulate savings, and potential for increased earnings.

Income Analysis ARMs ARMs must be underwritten more carefully than fixed-rate loans.

Income Analysis ARMs ARMs must be underwritten more carefully than fixed-rate loans. ARM borrower should either have: strong t potential ti for increased earnings, significant liquid assets, or demonstrated ability to manage finances.

Income Analysis ARMs ARMs are commonly offered at much lower interest rate than fixed-rate loans. May y be easier to qualify with lower monthly payments. Subject to greater application scrutiny.

Net Worth Gift funds Both Fannie Mae and Freddie Mac set limits on use of gift funds. Donor must be: borrower s relative, fiancé, or domestic partner; borrower s s employer; municipality; or nonprofit religious or community organization.

Net Worth Gift funds Borrower required to make downpayment of at least 5% of sales price out of her own resources. Rule doesn t apply if LTV is 80% or less.

Net Worth Reserves Conventional borrower may be required to have 2 months worth of mortgage payments left in reserve after downpayment and closing costs.

Net Worth Credit reputation Credit scores have become central factor in conventional underwriting. Excellent score can offset weaknesses in other aspects of application.

Net Worth Credit reputation When two people apply for loan together, underwriter uses lowest credit score, not average.

Summary Secondary Financing & Qualifying Secondary y financing Piggyback loans Primary risk factors Contributory risk factors Income analysis Total obligations to income ratio Housing expense to income ratio Recurring obligations Net worth

Special Programs & Payment Plans Variety of alternatives are available with conventional financing.

Special Programs & Payment Plans Buydown plans In buydown, seller or third party pays lender a lump sum at closing to lower interest rate on buyer s loan.

Special Programs & Payment Plans Buydown plans In buydown, seller or third party pays lender a lump sum at closing to lower interest rate on buyer s loan. Increases lender s yield. Lowers buyer s monthly payment. Lower interest rate.

Buydowns Buydown plans Buydown can be permanent or temporary. Permanent buydown borrower pays lower interest rate for entire loan term. Temporary buydown interest rate and monthly payment reduced during first years of loan term.

Buydowns Permanent buydowns Permanent buydown reduces note rate (rate stated in promissory note). Cost of buydown calculated in terms of points of loan amount.

Buydowns Permanent buydowns Permanent buydown rule of thumb: It takes about 6 points to increase lender s yield on 30-year loan by 1%.

Buydowns Temporary buydowns Two types of temporary buydown plans: level payment plans, and graduated payment plans.

Buydowns Temporary buydowns Level payments Calls for interest reduction that stays same throughout buydown period.

Buydowns Temporary buydowns Graduated payments Calls for largest payment reduction in first year, with progressively smaller reductions in each remaining year of buydown period. 3-2-1 buydown = interest rate bought down 3 2 1 buydown interest rate bought down 3% the first year, 2% the second year, and 1% the third year.

Buydowns Temporary buydowns To find cost of temporary buydown: 1. Calculate buyer s monthly principal and interest payment without buydown, at full interest rate. 2. Calculate buyer s monthly payment with 2. Calculate buyer s monthly payment with bought-down interest rate.

3. Subtract bought-down payment from actual payment and multiply by twelve for annual buydown amount. 4. For level payment, multiply annual buydown amount by number of years in buydown plan.

Buydowns Temporary buydowns Graduated payment buydown is calculated in same way, except each year s buydown must be calculated separately and then added together.

Buydowns Buydowns and qualifying rules Permanent buydown Lender qualifies buyer at bought-down interest rate. Temporary buydown L d lif b t b ht d Lender may qualify buyer at bought-down rate, note rate, or an intermediate rate.

Buydowns Buydowns and qualifying rules Fannie Mae allows lender to use bought-down rate if: loan is fixed-rate, or ARM with a 3-year initial period.

Buydowns Buydowns and qualifying rules Freddie Mac has its own rules for temporary buydowns. Bought-down g rate can usually be used to qualify buyer. 3-2-1 buydowns with LTV of 80% requires 3 2 1 buydowns with LTV of 80% requires qualifying with second year interest rate.

Buydowns Limits on buydowns Fannie Mae and Freddie Mac limit amount of buydown to percentage of: sales price, or appraised value (whichever is less).

Buydowns Limits on buydowns Fannie Mae and Freddie Mac limit amount of buydown to percentage of: sales price, or appraised value (whichever is less). Also applies to other contributions accepted from seller or another interested party.

Buydowns Limits on buydowns Excess contributions are deducted from sales price before finding maximum loan amount.

Special Programs & Payment Plans Loans with lower initial payments Many first-time buyers are just starting their careers and expect their incomes to increase steadily. Loans with lower initial payments include: Hybrid ARMs Two-step T t mortgages Balloon/reset mortgages Interest first mortgages

Loans with lower initial payments Two-step mortgages Characteristics of two-step mortgages: 30-year term. Lender can adjust interest rate once during loan term. Offered d at lower initial iti rate than fixedrate loans. Two common types: 5/25 and 7/23.

Loans with lower initial payments Two-step mortgages 5/25 loan is automatically adjusted after 5 years, to the current market rate. 7/23 loan is automatically adjusted after 7 years, to the current market rate.

Loans with lower initial payments Balloon/reset mortgages Characteristics of balloon/reset mortgages: Two types: 5/25 and 7/23. At end of initial 5- or 7-year period, entire loan balance is due. P t t b d 30 Payment amounts based on 30-year amortization schedule.

Loans with lower initial payments Balloon/reset mortgages At end of initial period, borrowers may either: refinance, pay off loan balance, or reset loan.

Loans with lower initial payments Balloon/reset mortgages By resetting loan, loan remains in place and interest rate is set at current market rate. Avoids refinancing charges. Borrowers can t be delinquent on payments. No other liens may exist on property.

Loans with lower initial payments Interest first mortgages Characteristics of interest first mortgages: 30-year loan term. Interest only payments during first part of loan term (10-15 years). P t f ll ti d f i d f Payments fully amortized for remainder of loan term.

Summary Buydowns & Low Initial Payment Loans Permanent buydown Temporary buydown Level payments Graduated payments Two-step mortgages Balloon/reset mortgages Interest first mortgages

Special Programs & Payment Plans Low downpayment programs Secondary market agencies have developed some conventional loan programs to make home ownership more affordable.

Examples of conventional alternatives: Loan with 95% LTV with 3% downpayment from borrower s funds, and 2% from alternative sources. Loan with 97% LTV with 3% downpayment from borrower s funds, and 3% contribution to closing costs from alternative sources. Loan with 100% LTV with no downpayment from borrower s funds, and 3% contribution to closing costs from alternative sources.

Special Programs & Payment Plans Low downpayment programs Allowable alternative sources of funds may include gifts, grants, or unsecured loans.

Special Programs & Payment Plans Low downpayment programs Allowable alternative sources of funds may include gifts, grants, or unsecured loans. Funds may come from: relative, employer, l public agency, nonprofit organization, or private i t foundation.

Low Downpayment Programs Affordable housing programs Many conventional loan programs are targeted at low- and moderate-income buyers.

Low Downpayment Programs Affordable housing programs Many conventional loan programs are targeted at low- and moderate-income buyers. Buyers y qualify if stable monthly income doesn t exceed median income of area. Cash requirements reduced. Eligibility based on income or property location.

Low Downpayment Programs Affordable housing programs Some programs waive income limits for buyers purchasing homes in low-income or rundown neighborhoods. Buyers with income above area median can still qualify.

Low Downpayment Programs Affordable housing programs Other programs are offered to specific groups such as: teachers, police officers, and firefighters.

Accelerated Payment Plans Bi-weekly mortgages Characteristics of a bi-weekly mortgage: Interest rate and payment amount fixed. Payments made every two weeks (26 per year). Each E h payment equal to half of monthly payment for 30-year, fully amortized, fixed-rate loan. Loan paid off in 20-22 years.

Accelerated Payment Plans Bi-weekly mortgages Disadvantages for lenders: More work to service 26 payments instead of 12. Less of a profit in interest.

Accelerated Payment Plans Growing equity mortgages Characteristics of growing equity mortgage (GEM): Interest rate is fixed over life of loan. First-year payments of principal and interest based on 15- or 30-year loan. Payments P t increased at specified intervals for all or part of loan term. 100% of annual payment increase used to reduce principal balance.

Accelerated Payment Plans Growing equity mortgages Annual payment adjustments usually increased by fixed percentage, such as 3% or 5% per year.

Accelerated Payment Plans Growing equity mortgages Equity builds up quickly with GEM and actual repayment period depends on interest rate and magnitude of annual payment increases. Most GEMs with 30-year stated terms pay off in 11 to 17 years.

Accelerated Payment Plans Growing equity mortgages Advantages of GEM: Reduced interest costs Lower interest rate Payments are predictable

Summary Low Downpayment & Accelerated Plans Affordable housing programs Conventional low-downpayment financing Accelerated payment plans Bi-weekly mortgages Growing equity mortgages