© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 10: Conventional Financing.

© 2012 Rockwell Publishing

Financing Residential Real Estate

Lesson 10:

Conventional Financing


Introduction

This lesson will cover:conforming and nonconforming loanscharacteristics of conventional loansqualifying standardsmaking conventional loans more

affordable


Introduction

Loans made by mortgage lenders can be divided into two main categories:

conventional loansgovernment-sponsored loans


Introduction

Conventional loan: any institutional loan that isn’t insured or guaranteed by government agency.


Conforming & Nonconforming Loans

Most conventional loans comply with underwriting guidelines set by Fannie Mae and Freddie Mac.

Conforming loan: complies with those guidelines.

Nonconforming loan: doesn’t comply.


Conventional Loan Characteristics

Fannie Mae/Freddie Mac underwriting guidelines:

widely followed in mortgage industry lenders want to be able to sell loans on

secondary marketmany of the rules covered here are

based on Fannie/Freddie guidelines


Topics: property types and owner-occupancy loan amounts repayment periods and amortization loan-to-value ratios risk-based loan fees private mortgage insurance secondary financing

Conventional Loan Characteristics


Fannie Mae and Freddie Mac buy loans secured by residential property, including:

detached site-built housestownhousescondominium unitscooperative unitsmanufactured homes

Property types and owner-occupancyConventional Loan Characteristics


Borrowers may intend to occupy property as:principal residencesecond home

Fannie Mae/Freddie Mac also willing to purchase investor loan: borrower purchasing property doesn’t intend to occupy it.



Conventional loan may be secured by:Principal residence

Up to 4 dwelling unitsSecond home

No more than 1 dwelling unitInvestment property

Up to 4 dwelling units



Conforming loan limits: set annually by Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac.

Agencies won’t buy loan that exceeds limits.

Loan limits vary based on area median home prices, and whether loan is for one-, two-, three-, or four-unit dwelling.

Loan amountsConventional Loan Characteristics


2011 conforming loan limits for one-unit dwellings:

in most areas: $417,000in high-cost areas: based on area

median house price, up to a maximum of $625,500

higher limits for Alaska, Hawaii, Guam, and Virgin Islands



Jumbo loan: exceeds conforming loan limit.Have higher interest rates and loan fees

than conforming loans.Underwritten using stricter standards.



Repayment periods can range from 10 to 40 years.

30-year loans are standard.15-year loans also popular.

Repayment periodsConventional Loan Characteristics


Standard conventional loan is fully amortized.Partially amortized and interest-only

loans also available.

AmortizationConventional Loan Characteristics


Traditional standard conventional LTV: 80%.Loans with LTVs up to 95% also

available.During subprime boom, higher LTVs

were available: 97% or even 100%. Now uncommon. Loans with LTVs of 90% or 95% also

harder to get.

Loan-to-value ratiosConventional Loan Characteristics


Conventional loans may be categorized by LTV ratio.

Different underwriting rules applied to each category.

Fannie Mae and Freddie Mac: LTV over 80% must have private mortgage insurance.



High-LTV loans also usually have:higher interest rates and fees, andstricter underwriting rules.



If there are other mortgages against property, lender will be concerned with the combined loan-to-value ratio (CLTV).

Should not exceed usual LTV limit, but in some cases a higher CLTV allowed.

Combined loan-to-value ratiosConventional Loan Characteristics


Loan-level price adjustments (LLPAs): risk-based loan fees.

Required by Fannie Mae and Freddie Mac of most borrowers.

Shift some of risk (cost) of mortgage defaults onto borrowers.

Riskier loans usually equal higher LLPAs.

Risk-based loan feesConventional Loan Characteristics


LLPA varies based on borrower’s credit score and LTV ratio.

Borrower with 650 credit score and 80% LTV might be charged 3% LLPA.

But borrower with 710 credit score and 90% LTV might be charged only 1%.

Additional LLPAs may be charged if loan is riskier (ARM, investor loan, interest-only loan)



Adverse market delivery charge:* flat fee levied by Fannie Mae and Freddie Mac on every borrower.

Purpose: help agencies recover losses caused by poor market conditions.

*Called market condition delivery fee by Freddie Mac.



Private mortgage insurance (PMI): helps protect lenders from risk of high-LTV loans.

Required for conventional loans if LTV over 80%.

Makes up for reduced borrower equity.

Private mortgage insuranceConventional Loan Characteristics


Private Mortgage Insurance

Private mortgage insurance company assumes only portion of risk of default and foreclosure loss.

PMI covers upper portion of loan.Typically 25% to 30% of loan amount.

How PMI works



In event of default and foreclosure, lender, at insurer’s option, will either:

sell property and make claim for reimbursement of losses up to policy amount, or

relinquish property to insurer, and make claim for actual losses.

How PMI works



Insurers have own underwriting standards, which have been influential in mortgage industry.

How PMI works



Mortgage insurance company charges risk-based premiums for coverage.

Variety of payment plans include: flat monthly premiuminitial premium at closing, plus renewal

premiumsfinanced one-time premium

PMI premiums



PMI premiums are currently tax-deductible.No deduction if family income is over

$109,000. Deductibility set to expire end of 2011.

Deductibility of PMI premiums



Under Federal Homeowners Protection Act, lenders must cancel loan’s PMI when:

loan has been paid down to 80% of property’s original value (upon borrower request); or

loan reaches 78% of property’s original value (automatic cancellation).

Applies only to loans on single-family dwellings occupied as primary residence.

Cancellation of PMI


Secondary Financing

Lenders generally allow secondary financing in conjunction with conventional loan.

Most impose some restrictions to minimize increased risk of default on primary loan.


Secondary Financing

Examples of restrictions lenders may impose:

Borrower must qualify for payments on both first and second mortgages.

Borrower must make 5% downpayment.

Scheduled payments due on regular basis.

Restrictions


Secondary FinancingRestrictions

Second mortgage can’t require balloon payment less than 5 years after closing.

If first mortgage has variable payments, second mortgage must have fixed payments.

No negative amortization.

No prepayment penalty.


Secondary Financing

Secondary financing is sometimes referred to as a piggyback loan, especially when it is used to either:

avoid paying private mortgage insurance, or

avoid jumbo loan treatment.

Piggyback loans


Secondary Financing

With piggyback loan, LTV of primary loan isn’t

over 80%.So PMI requirement doesn’t apply.

With piggyback loan, loan amount for primary loan doesn’t exceed conforming loan limit.

So higher costs and stricter rules for jumbo loans don’t apply.

Piggyback loans


Secondary Financing

Popular during subprime boom, no longer widely used.

Advantages of piggybacking reduced by:tax deductibility of PMI premiumsloan-level price adjustments imposed

on secondary financing

Piggyback loans


SummaryConventional Loan Characteristics

• Conventional loan

• Conforming loan• Nonconforming loan• Conforming loan limits• Jumbo loan• Loan-level price adjustment (LLPA)• Adverse market delivery charge• PMI• Piggyback loan


Conventional Qualifying Standards

Fannie Mae and Freddie Mac have changed how they evaluate creditworthiness of applicants.

Newer methods influenced by automated underwriting systems, computer analysis.

Evaluating risk factors


Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors.

Two primary risk factors:applicant’s credit reputation, andloan-to-value ratio.

Based on these, loans ranked as low, moderate, or high primary risk.

Evaluating risk factorsConventional Qualifying Standards


Contributory risk factors: other aspects of application, such as debt to income ratio and cash reserves.

Factor assigned value based on whether it:satisfies basic risk tolerancesincreases riskdecreases risk



Freddie Mac’s underwriting guidelines:separate evaluation: credit reputation,

income, net worthconsider overall layering of riskweakness in one component can be

outweighed by strength in another



Fannie Mae’s approach vs. Freddie Mac’s approach: mainly difference in terminology.

Both agencies consider borrower’s overall financial picture, with positive factors offsetting negative ones, and vice versa.



Credit scores central factor in conventional underwriting.

Excellent score can offset weaknesses in other aspects of application.

Poor score may doom application.Fannie Mae and Freddie Mac won’t buy

loan if borrower’s score is under 620.

Credit reputationConventional Qualifying Standards


Credit scores from three main credit bureaus usually vary somewhat for given borrower.

Credit score used for underwriting (representative credit score) is:

lower of two scores, or middle of three scores.



When two people apply for loan together:lowest representative credit score used

for underwritingnot average



Stable monthly income: meets lender’s tests of quality, durability.

Durable income: income that is expected to continue for at least 3 years after loan is made.

Income analysisConventional Qualifying Standards


Income Analysis

Lenders consider income adequate for conventional loan if total monthly obligations don’t exceed 36% of stable monthly income.

Total monthly obligations:proposed housing expenseother recurring obligations

Total debt to income ratio


Income Analysis

Housing expense includes PITI:principalinterestproperty taxeshazard insurancespecial assessments, mortgage

insurance, homeowners association dues (if applicable)



Income Analysis

Total monthly obligation includes recurring debts.

Installment debts: fixed beginning, ending date (car loan).

Revolving debts: open-ended line of credit with minimum monthly payments (credit cards).

Other: alimony, child support.



Income Analysis

Housing expense to income ratio:proposed housing expense should not

exceed 28% of stable monthly incomeless important than total debt to income

ratioFannie Mae no longer uses

Housing expense to income ratio


Income Analysis

Fannie Mae and Freddie Mac allow income ratios to exceed benchmarks if compensating factors such as:

large downpaymentsubstantial net worthdemonstrated ability to incur few debts

and accumulate savings

Compensating factors


Income Analysis

Even with compensating factors, income ratios shouldn’t exceed benchmarks by too much.

For manually underwritten loan, Fannie Mae and Freddie Mac won’t accept total debt to income ratio over 45%.

No set maximum for loan evaluated by automated underwriting system.

Compensating factors


Income Analysis

Some applications have factors that pose increased risk to lender.

Lenders may apply stricter standards to high-LTV loans.

Many lenders won’t accept high total debt to income ratio if LTV over 90%.

Factors that increase risk


Income Analysis

ARMs need careful underwriting to ensure borrower can handle rate and payment increases.

ARM borrower should have: strong potential for increased

earnings, significant liquid assets, or demonstrated ability to manage

finances.

ARMs


General rule:conventional borrower should have at

least 2 months of mortgage payments in reserve after closing

smaller amount will weaken loan application

Available funds – reservesConventional Qualifying Standards


Available Funds

Fannie Mae and Freddie Mac set limits on use of gift funds. Donor must be:

borrower’s relative, fiancé, or domestic partner

borrower’s employermunicipalitynonprofit religious or community

organization

Gift funds


Available Funds

Borrower may be required to make a downpayment of at least 5% of sales price out of her own resources.

Rule doesn’t apply if LTV is 80% or less.

Gift funds


SummaryConventional Qualifying Standards

• Comprehensive risk assessment• Primary risk factors• Contributory risk factors• Overall layering of risk• Representative credit score• Total debt to income ratio• Housing expense to income ratio• Compensating factors• Reserves• Gift funds


Making Loans More Affordable

Variety of alternatives are available with conventional financing:

buydownsloans with lower initial paymentslow-downpayment programsaccelerated payment plans



Buydown: seller or third party pays lender lump sum at closing to lower interest rate on buyer’s loan.

Increases lender’s upfront yield.Lowers buyer’s monthly payment.Lowers interest rate.

Buydowns


Buydowns

Buydown can be permanent or temporary. Permanent buydown: borrower pays

lower interest rate for entire loan term. Temporary buydown: borrower pays

lowerinterest rate for first few years of term.

Buydown plans


Buydowns

Permanent buydown:reduces note rate (rate stated in

promissory note)cost calculated in terms of points

(percentage of loan amount)

Permanent buydowns


Buydowns

Two types of temporary buydown plans:level payment plansgraduated payment plans

Temporary buydowns


Buydowns

Level payment plan: calls for interest rate reduction that stays same throughout buydown period.

Graduated payment plan: calls for largest payment reduction in first year, progressively smaller reductions each remaining year.

Temporary buydowns


Buydowns

Permanent buydown: lender qualifies buyer at bought-down interest rate.

Temporary buydown: depends on program , but borrower may be qualified based on the greater of:

note rate or note rate + percentage, or fully indexed rate.

Buydowns and qualifying rules


Buydowns

Fannie Mae and Freddie Mac limit amount of buydown to percentage of sales price or appraised value, whichever is less.

LTV > 90%: 3% limitLTV > 75% but < 90%: 6% limitLTV ≤ 75%: 9% limit

Amount over limit is deducted from sales price before calculating maximum loan amount.

Limits on buydowns


Buydowns

Limits also apply to other contributions from seller or another interested party, such as real estate agent or builder.

But usually don’t apply to someone not in transaction, such as employer or family member.

Limits on buydowns



Loans with lower initial payments appeal to buyers who expect income to increase steadily:

two-step mortgagesballoon/reset mortgagesinterest-only mortgages

Loans with lower initial payments


Loans with Lower Initial Payments

Characteristics of two-step mortgages:30-year termlender can adjust interest rate once

during loan termtwo common types: 5/25 and 7/23

Interest rate cap applies to adjustment.

Two-step mortgages


Characteristics of balloon/reset mortgages:two types: 5/25 and 7/23payment amounts based on 30-year

amortization schedulebut loan is partially amortized, with

balloon payment of entire balance due at end of initial 5- or 7-year period

at end of initial period, borrower may be allowed to reset loan

Balloon/reset mortgagesLoans with Lower Initial Payments


Under reset option:reset loan remains in placeinterest rate is set at current market rate rate and payment amount are level for

remaining 25 or 23 yearsborrower avoids refinancing charges



Borrower not allowed to reset if:payments aren’t current, orother liens have attached to property.

Borrower will have to refinance or sell property to make balloon payment.



Characteristics of interest-only mortgage:30-year loan terminterest-only payments during specified

period at beginning of loan termat end of interest-only period, payments

fully amortized over remainder of loan termRisk of payment shock: monthly

payment likely to rise sharply.

Interest-only mortgagesLoans with Lower Initial Payments


Fannie Mae and Freddie Mac:will buy fixed-rate loans with interest-only

periods ranging from 10 to 15 yearswon’t buy interest-only ARMs unless

initial fixed-rate period is three years or more

won’t buy interest-only balloon/reset loans or interest-only cash-out refinance loans

Interest-only mortgagesLoans with Lower Initial Payments


SummaryBuydowns & Low Initial Payment Loans

• Permanent buydown• Temporary buydown• Level payments• Graduated payments• Qualifying rate• Contribution limits• Two-step mortgages• Balloon/reset mortgages• Interest-only mortgages



Secondary market agencies have developed low-downpayment programs for first-time buyers and others who tend not to have much money saved.

Low-downpayment programs


Low-Downpayment Programs

Examples of low-downpayment programs:Loan with 95% LTV and:

3% downpayment from borrower’s funds2% downpayment from alternative sources

Loan with 97% LTV and:3% downpayment from borrower’s funds3% contribution to closing costs from

alternative sources

LTVs and downpayment rules



Allowable alternative sources of funds may include gifts, grants, or unsecured loans from:

relativeemployerpublic agencynonprofit organizationprivate foundation

Alternative sources of funds



Many low-downpayment programs are targeted at low- and moderate-income buyers.

Buyers qualify if stable monthly income doesn’t exceed median income of area.

Debt to income ratio rules are relaxed.Income limit may be waived for buyers

purchasing homes in low-income or rundown neighborhoods.

Affordable housing programs



Other low-downpayment programs are offered to specific groups such as:

teacherspolice officersfirefighters

Affordable housing programs



Accelerated payment plan allows borrower to repay loan in shorter period than stated term.

Pays less interest over life of loan.Builds equity faster.

Accelerated payment plans



Loans with accelerated payment plans include:

biweekly mortgagesgrowing equity mortgages (GEMs)

Accelerated payment plans


Accelerated Payment Plans

Characteristics of biweekly mortgage:interest rate and payment amount fixedpayments made every two weeks (26 per

year)each payment equal to half of monthly

payment for 30-year, fully amortized, fixed-rate loan

loan paid off in 20-22 years

Biweekly mortgages


Accelerated Payment Plans

Characteristics of GEM:interest rate fixed over life of loanloan must be paid off in 15 years or lessfirst-year payments of principal and

interest based on 15- or 30-year termpayments increase at specified intervals

for all or part of loan term100% of payment increase goes to

reduce principal balance

Growing equity mortgages


SummaryLow Downpayment & Accelerated Plans

• Low-downpayment programs

• Affordable housing programs

• Alternative sources of funds

• Accelerated payment plans

• Biweekly mortgages

• Growing equity mortgages

© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 10: Conventional Financing.

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Transcript of © 2012 Rockwell Publishing Financing Residential Real Estate Lesson 10: Conventional Financing.