Mlpp3e C06 Conventional
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Chapter 6
Conventional Financing
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Overview • Nearly half of all residential real estate lending is completed with conventional financing programs • This chapter discusses: – Different types of conventional loans (15year, 30-year, conforming, non-conforming) – How private mortgage insurance and secondary financing have made conventional loans easier to obtain Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Key Terms • • • • • • •
Amortization Conforming Loan Conventional Loan Declining Market Fixed Rate Loan Jumbo Loan Loan-to-Value Ratio (LTV)
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
• Negative Amortization • Prepayment Penalties • Private Mortgage Insurance (PMI) • Secondary Financing • Self-Liquidating 3
Chapter 6: Conventional Financing
Conventional Loans • One that is usually made by a bank or lender that is not insured or guaranteed by a government entity or agency, such as FHA or VA • Most are guaranteed or purchased by governmentsponsored entities (GSEs) in the secondary market and must meet appropriate guidelines • Conventional loans may be conforming (meeting criteria to be sold in the secondary market) or nonconforming • Just under half of all residential mortgages are handled as conventional financing – Percentage can change depending on market conditions or consumer trends Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Traditional Conventional Loans • Typically long-term, fully amortized, fixed rate real estate loans • Type of loan with which borrowers are most familiar • Anything other than 30-year fixed is considered nontraditional
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Long-Term Loan • Payments generally spread out over 25-30 years (even 40) • Before the FHA was formed in 1934, home loans were typically 5, 7, or 10 years – Payments were high, required balloon payments, and/or frequent refinancing
• Provide reasonable payment and security so borrowers can choose if, when to refinance Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Fully Amortized • Amortization: The reduction of the balance of the loan by paying back some of the principal owed on a regular basis – Payments applied to principal and interest • Fully amortized loan: Total payments over the life of a loan pay off the entire balance of principal and interest due at the end of the term – Also known as self-liquidating – Payments stay constant for the entire loan term Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Fully Amortized • Different from how things were before FHA – When loans had only partial amortization or none, resulting in negative amortization • Negative amortization: Occurs when loan balances increase rather than decrease due to deferred interest – With even larger balloon payments then due from the borrower
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Fixed Rate Loans • Interest rates remain constant for the duration of the loan • Borrower can refinance if rates decrease • Lenders have a guaranteed rate of return
• Benefit borrower or lender, depending on interest rates
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
15-Year Mortgage Loans • Often get better interest rates from lenders because shorter term means less risk • Over life of the mortgage, its total interest paid are about one-third less than a 30-year mortgage at the same interest rate • Homebuyer can attain full ownership in half the time of a 30-year mortgage
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
15-Year Mortgage Loans • Disadvantages: – Higher payments – Larger down payments required – Borrower loses the income tax deduction more quickly because home is paid for sooner
• Disciplined borrower could make additional payments each month on a 30-year mortgage (if allowed) – Borrower gets benefits of a 15-year mortgage without the contractual burden of higher payments Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• Conforming loans meet Fannie Mae/Freddie Mac standards and can be sold on the secondary market • Lenders prefer these loans because the ability to sell them on the secondary market allows them to liquidate if they need more funds
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• In order to obtain a conventional loan, borrower must qualify under both of the following: – 28% total housing expense ratio – 36% total debt service ratio
• Borrower should have: – 5% of their own funds for a down payment – 2 months of reserves on deposit
• For some lenders, these guidelines may be less rigid when automated underwriting is used Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• Nonconforming loans do not meet the previous standards and cannot be sold to Fannie Mae or Freddie Mac • Some other secondary markets will purchase nonconforming loans • Lenders that have the option of keeping loans in their own portfolio (e.g., banks and S & Ls) can, within limits of the law, deviate from the standards set by the secondary market
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• The distinctions between the two loans are becoming blurred • Fannie Mae and Freddie Mac constantly implement new loan program standards to meet the needs of consumers – Conforming market follows into territory that once was domain of nonconforming market
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
What Makes a Loan Nonconforming
1. Size of the Loan − Jumbo loans exceed the maximum loan amount established by Fannie Mae and Freddie Mac for conforming mortgage loans
1. Credit Quality of Buyer − Doesn’t meet standards and is classified as a B or C borrower by Fannie Mae/Freddie Mac − Loans can still be offered, but they can’t be sold to Fannie Mae or Freddie Mac
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
A-Minus Conventional Loans • Allow a borrower with less than perfect credit history, limited money for down payments, or higher debt service ratio to get a loan that could be sold on the secondary market • Instituted to meet increasing consumer demand and limit loss of market share to nonconforming lenders • Note: Final interest rate and fees are determined on basis of risk factors present in loan
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conventional Loan Programs • Can be classified by the percentage of down payment • Conditions and standards presented here are most typical • Remember some lenders offer high LTV loans where PMI is not necessary, but fees may be higher, or conditions and standards imposed
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
80% LTV Conventional Loan • LTV ratio refers to the amount of money borrowed (the loan amount of a first mortgage) compared to the value of the property • Lender will always use the lower of the appraised value or the sale price in order to protect its interest • Lower LTV = Higher borrower down payment, which means the loan is more secure Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Higher LTV Loans • If buyer wants a conventional loan but doesn’t have enough for a 20% down payment he can still try to get a: – 90% conventional with a 10% down payment – 95% conventional with a 5% down payment
• Loan with an LTV higher than 80% are possible due to PMI and secondary financing
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Higher LTV Loans • Qualifying standards tend to be more stringent • Lenders adhere to those standards more strictly even if the loan is insured through PMI • May have higher interest rate, higher loan origination fees, or impose additional conditions and standards
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
90% Conventional Loan • At least half of the 10% payment (5%) must be made from personal cash reserves • Remainder may be gift from family member, equity in other property, or credit for rent already paid
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
95% Conventional Loan • Requires owner occupancy • Down payment must be made from personal cash reserves (no secondary financing or gifts)
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Loans for Special Needs • For people who: – Can’t pass a stringent credit review, but have a larger down payment – Have good credit, but have a hard time proving stability of income • May be referred to as “no doc,” “low doc,” “stated income,” “no-ratio,” “NINA,” or “easy qualifier” loans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Loans for Special Needs • Lenders modify qualifying standards or loan criteria based on customers’ needs – May require same documentation, but relax qualifying standards due to increased equity borrower is putting into the home – May relax income verification standards for borrowers with good credit or down payments of at least 20%
• Current market conditions will drive the availability of such loans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Private Mortgage Insurance (PMI)
• Offered by private companies to insure lender against default on loan by a borrower • Evolved to compensate lender for reduced borrower equity, making loans easier for borrowers and safer for lenders • Both Fannie Mae and Freddie Mac require mortgage insurance on home loans with less than 20% down
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
How Mortgage Insurance Works • When insuring a loan, mortgage insurance company shares lender’s risk, but only part of the risk • Insurer does not insure entire loan amount – Rather the upper portion of the loan that exceeds the standard 80% LTV
• Amount of coverage is typically 20% - 25% of loan amount
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
How Mortgage Insurance Works • In event of default and foreclosure, insurer will take over property or allow lender to sell it • Lender can make a claim for reimbursement of actual losses (if any) up to the face amount of the policy
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Premiums Three ways a buyer can pay for PMI: 1. Fee at closing and renewal premium • Traditional way • One-time fee at closing when loan is made • Recurring fee 1. One-time PMI premium • Some PMI companies offer a one-time mortgage insurance premium, with no renewal fee continued on next slide Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Premiums 3. No PMI premium, but higher interest rate • Interest rate adjustment made at the time of closing in exchange for lender agreeing to “insure” home loan themselves • This allows money to be deducted as interest on a borrower's federal income tax • Higher payment will be in effect for the life of the loan—there is no cancellation
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Cancellation • When increased risk of borrower default is gone (LTV 80% or less), PMI has fulfilled its purpose • Homeowners Protection Act (HPA) of 1998 requires lenders to automatically cancel PMI when home has been paid down to 78% of its original value if borrower is not delinquent – Exceptions: Multi-family units, non-owner occupied homes, mortgages on second homes, and second mortgages – Law sets a minimum, market moves bar higher Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Cancellation Fannie Mae and Freddie Mac have: • Applied the 78% rule to all their mortgages – Even those closed before July 1999
• Expanded rules to cover investment properties and 2nd homes • Will consider present value of home, not just original value as required by law – Effectively cancels PMI more quickly (assuming home appreciates) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Cancellation • For loans closed after July 29, 1999, lenders must drop PMI at a borrower’s request if: – A new lender-approved appraisal shows loan has been paid down to 80% or less of home’s original value. – The borrower shows a history of repayment over the past 12 months.
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Cancellation • Fannie Mae and Freddie Mac: – Allow borrowers to use 80% of home’s current value if no payments have been more than 30 days late in prior 12 months for fixed rate loans (24 months for ARMS) – Rules apply to all loans, but can require up to 5 years of seasoning before they apply
• When PMI is terminated, lender cancels policy and reduces monthly mortgage payment by PMI amount • Law and Fannie Mae/Freddie Mac rules do not apply to any upfront or one-time PMI premium paid Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Underwriting PMI in Declining Markets
• Many factors could go into determining whether or not a market area is declining • May seem reasonable, but label can create problems – Label may not account for specific neighborhoods where properties may still be highly desirable • Some may simply refuse to offer PMI in these markets or may raise the premiums for PMI Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Secondary Financing • When a buyer borrows money from another source (other than primary lender) to pay part of the purchase price or closing costs − Another way buyer can get a conventional loan without a 20% down payment
• Often seller "carries" the extra financing Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Combined Loan to Value • The percentage of property value borrowed through a combination of more than one loan • When borrower chooses to subordinate a junior lean, this loan amount would also be included in the CLTV • Calculated by adding all loan amounts and dividing by the home’s appraised value or purchase price, whichever is lower
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Combined Loan to Value • Example: Buyer purchases property valued at $100,000, taking out 2 loans: $80,000 + $10,000 ------------------------- = 90% CLTV $100,000 • Remember: LTV ratio considers only that first mortgage and would therefore be just 80% ($80,000 ÷ $100,000) • Both LTV and CLTV can be used to determine the amount of home equity a borrower has Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conditions •Down Payment – Borrower must make a 5% down payment – For owner-occupied property, CLTV must not exceed 95% of appraised value or sale price, whichever is less
• Loan Terms – Term of second loan cannot exceed 30 years, or be less than 5 years
•Interest Rate – Can be fixed or adjustable – First and second mortgages cannot both have adjustable rate Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conditions • No Prepayment Penalty – 2nd mortgage must be payable in full or in part at any time, without penalty for paying debt early
• Regularly Scheduled Payments – Payments must be due on regular basis, although not necessarily monthly – Payments can fully or partially amortize debt, or pay interest only Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conditions • No Negative Amortization – Payments on second mortgage must, at least, equal the interest on the loan – Loan balances cannot grow due to deferred interest • Ability to Qualify – Buyer must afford payments on 1st and 2nd mortgages • Subordination Clause – Insures primary lender’s lien will take priority, even if 2nd mortgage is recorded first
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Lender First and Lender Second
• It’s not always the seller that carries a 2nd mortgage – Can be carried by any lender, investor, or financial institution
• Sometimes the same lender may finance the 1st and 2nd mortgage – Allows lender to charge a higher interest rate on 2nd mortgage
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Lender First and Lender Second
• Some lenders offer conventional 80-20 loans, which can be sold to Fannie Mae and Freddie Mac if the loans meet all standards and criteria • When upper portion of loan represented by the 2nd mortgage is paid off, the risk is gone and borrower still has a 1st mortgage at a good interest rate • Repayment plan is a matter of agreement between borrower and lender
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Repayment Methods on Second Mortgages
• As with any loan, there are various ways to repay a 2nd mortgage: – Fully amortized – Partially amortized – Interest only
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Repayment Methods on Second Mortgages
• A house costs $66,667 • Buyer makes $6,667 (10%) down payment and gets a: − $50,000 (75%) 1st mortgage for 30 years at 6% − $10,000 (15%) 2nd mortgage for 5 years at 7 7/8%
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Fully Amortized Second Mortgage
• One with the total payments over the life of a loan paying off the entire balance of principal and interest due at the end of the term • The shorter the term, the higher the payments $299.78 + $202.17 $501.95
Payment on 1st Mortgage Payment on 2nd Mortgage Total housing expense
• After 5 years, 2nd mortgage paid in full Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Partially Amortized Second Mortgage
• Payments applied to principal and interest, but the payments do not retire the debt when the agreed upon loan term expires – Thus, a balloon payment is required as a final payment at the end of the loan term
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Partially Amortized Second Mortgage
• To keep payments low, lender and borrower calculate monthly payment as if borrower were going to pay off entire debt over a longer period of time – For example, payments may be calculated as if 2nd mortgage would be repaid over 30 years, but borrower agrees to make a balloon payment of the loan balance after 5 years
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Partially Amortized Second Mortgage
$ 299.78 + $ 72.51 $372.56
Payment on 1st mortgage Payment on 2nd mortgage Total housing expense
• Smaller monthly payment makes total housing expense less—easier for borrower to qualify • Risk is that borrower can’t deliver loan balance of 2nd mortgage (or can’t refinance) after 5 years • If 2nd mortgage is to be paid at the time, there will be a substantial balloon payment due (or refinance) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Interest Only Second Mortgage • One with scheduled payment that pay only accrued interest, and not any portion of principal • Reduces monthly payments even more – With interest only loans, no amortization is used
• Payment can be determined: – Monthly interest rate: Loan amount multiplied by interest rate then divided by 12 months – Daily interest rate: Loan amount multiplied by interest rate, divided by 360 or 365, then multiplied by number of days in the month Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Interest Only Second Mortgage $299.78 + $ 65.63 $365.41
Payment on 1st mortgage Payment on 2nd mortgage Total housing expense
• Interest only gives borrower the lowest housing expense • If no principal is paid, the balloon payment will be the original amount borrowed Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Assumption of Conventional Loans
• Assumption: One party (buyer) takes over primary liability for the loan of another party (seller), usually implying no change in loan terms • When a buyer assumes seller’s mortgage, seller remains secondarily liable unless lender provides a release • Loan assumption is not always an option today – A new loan allows a lender to change interest rates, charge fees, or change loan terms for a new party Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Assumption of Conventional Loans
Lender has several options in response to an assumption request: • Accept assumption and leave loan terms intact • Accept assumption, but charge an assumption fee and/or increase loan’s interest rate • Allow assumption, but keep original holder (seller) secondarily liable if new owner defaults • Not allow assumption and exercise a call provision − This would need to be stated in the note or mortgage
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Prepayment Penalties • Fees that a lender charges the borrower for paying off a loan early • Time periods and amount of penalty may vary • Fannie Mae and Freddie Mac do not enforce prepayment penalties • Lenders who sell loans to Fannie and Freddie cannot keep prepayment penalties • Prepayment penalties are prohibited in FHA and VA loans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-1 A potential borrower is applying for a conventional loan to purchase a primary residence. Currently he pays $500 in rent, $420 for an auto loan, $170 toward his VISA bill, and $300 on a student loan each month. His gross monthly income totals $4,900, and his take-home pay after taxes is $3,700.
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-1 1.
What is the maximum house payment—including principle, interest, taxes, and insurance—for which the borrower will qualify?
The borrower’s monthly debt is $890 (auto loan + VISA + student loan); rent does not count as debt since he will no longer pay that once he’s in his house. Conventional qualifying guidelines allow a total housing expense ratio of 28% and a total debt service ratio of 36%, based on gross monthly income. Under the first ratio, the borrower would qualify for $1,372 ($4,900 x .28). Under the second ratio, the borrower would qualify for $874 ($4,900 x .36 = $1,764; $1,764 - $890 = $874). Remember that you must accept whichever ratio is lower. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 A borrower is seeking a fixed rate, conventional loan to purchase a home. The sale price is $189,500 and the property has been appraised at $191,500. The buyer will make a 10% down payment and finance the balance with a 75% conventional first mortgage at 6% interest for 30 years and a 15% second mortgage. The second mortgage bears interest at 11% and calls for a balloon payment after five years (amortized on the basis of a 30-year schedule). There will be a 1.5% loan fee on the first mortgage. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 •
What will the loan amounts for the first and second loans be? What are the LTV and the CLTV?
1st loan amount: $189,500 (purchase price) x 0.75 (% of 1st loan) = $142,125
2nd loan amount: $189,500 x 0.15 (% of 2nd loan) = $28,425 LTV = 75% Combined LTV = 90% (75% 1st loan + 15% 2nd loan) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 2. How much will the buyer pay at closing for down payment and loan fees?
Down Payment: $189,500 (purchase price) x 0.10 (10% down) = $18,950
Loan Origination Fee: $142,125 (loan amount) x 0.015 (fee %) = $2,131.88
Total Due at Closing: $18,950 (down) + $2,131.88 (origination fee) = $21,081.88 Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 3. What is the monthly payment on the first mortgage, including principal and interest? Monthly Principal and Interest on 1st Loan: ($142,125 ÷ 1,000) x 6.00 payment rate = $852.75 (This solution uses the Payment Rate Chart found in the Appendix. Note that the numbers there are rounded to the nearest cent. For a more precise total, you can use a financial calculator.) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 4. What is the total monthly payment for both loans?
2nd Loan: $189,500 (purchase price) x 0.15 = $28,425 Interest on 2nd Loan: ($28,425 ÷ 1,000) x 9.53 payment rate) = $270.89
(This solution uses the Payment Rate Chart found in the Appendix. Note that the numbers there are rounded to the nearest cent. For a more precise total, you can use a financial calculator.) Total Monthly Principal and Interest Payment:
$852.75 + $270.89 = $1,123.64 Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 5. The review appraisal just came back at $185,000. What happens now?
You must use the lower of the appraised value or the purchase price. The buyer would either need to bring an additional $4,500 to closing, or the purchase price—and therefore the loan amounts— would need to be adjusted accordingly.
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Summary 1. Conventional loans are not insured or guaranteed by a government entity. Traditional conventional loans are long-term, fully amortized, and have a fixed rate. An amortized loan has payments applied to principal and interest; fully amortized loans have total payments over the life of the loan that pay all principal and interest due. Conventional loans may be 15- or 30-year, conforming or nonconforming. A 15-year loan retires sooner and saves interest, but requires higher payments and, sometimes, a higher down payment. Conforming loans meet Fannie Mae/Freddie Mac standards and can be sold on the secondary market. Qualifying standards are 28% and 36%. Nonconforming loans do not meet these standards and cannot be sold to Fannie Mae/Freddie Mac, but can be sold on the secondary market to other buyers. Nonconforming can be due to credit quality or loan size (jumbo loans exceed Fannie Mae/Freddie Mac maximum loan amount).
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Chapter 6: Conventional Financing
Summary 2. Conventional loan programs include 80%, 90%, 95%, and some loans for special needs. An 80% conventional loan means the loan-to-value ratio (LTV) is 80% of the appraised value or sale price of property, whichever is less. For an 80% loan, buyer must make a 20% down payment; for a 90% loan, buyer must make a 10% down payment with 5% from personal cash reserves (no gifts, loans, etc.); for a 95% loan, buyer must make a 5% down payment, all from personal monies. For these loans, interest rates and fees may be higher on higher LTVs, and PMI is always higher. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Summary 3.
Private mortgage insurance (PMI) insures lenders against borrower default, compensating lenders for lower borrower equity, and shares partial risk (upper part) with the lender. PMI can be fee paid at closing and as a renewal premium, one-time PMI premium, or no PMI premium but with a higher interest rate. Federal law says that loans after July 1999 must drop PMI when LTV is 78% of original property value and the borrower is not delinquent, or if the borrower requests and the appraisal is 80% of original property value. Fannie Mae/Freddie Mac rules require a drop of PMI if LTV is 78% (or borrower-paid appraisal is 80%) of property’s current value.
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Summary 4. Secondary financing is when buyer borrows money for part of the purchase price or closing costs. To determine the combined loan-to-value ratio (CLTV) when there is more than one loan, add all loan amounts and divide by the home's appraised value or purchase price, whichever is lower. Typical conditions for secondary financing: 1. Borrower must make a 5% down payment; 2. Term of second loan must be five to 30 years; 3. No prepayment penalty; 4. Scheduled payments due on a regular basis; 5. No negative amortization; 6. Buyer must be able to afford payments on first and second mortgages; and 7. Required subordination clause. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Summary 5. A second mortgage can be fully amortized, partially amortized with balloon payment, or interest-only with a balloon to pay off the principal at end of the loan. Partial amortization is when payments are scheduled as if the loan term is longer (e.g., 30 years), but the balance is due sooner (e.g., in 5 years). Partially amortized and interest-only loans have smaller payments than fully amortized loans, so they may help a buyer qualify. One lender can provide both loans at different interest rates.
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Summary 6. Assumption means that one party (buyer) takes over primary liability for the loan of another party (seller). When trying to assume a loan: 1. Lender can accept assumption and leave loan terms in tact; 2. Lender can accept assumption and charge a fee or increase the interest rate; or 3. Lender will not allow assumption and call the note payable immediately. Prepayment penalties can be charged for paying a loan early. FHA/VA prohibit this. Always consult the original lender or a lawyer concerning assumptions. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 1. What is the term that describes a second mortgage holder agreeing to accept a second position in a refinance transaction? a. b. c. d.
alienation assumption subrogation subordination
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Chapter 6: Conventional Financing
Quiz 2. A loan that is repaid with periodic payments of both principal and interest so that the entire loan amount is paid in full at the end of the loan term is a(n) a. b. c. d.
annualized loan. conventional loan. fully amortized loan. partially amortized loan.
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Chapter 6: Conventional Financing
Quiz 3. All of the following are disadvantages of 15-year mortgages, EXCEPT a. earlier loss of interest deduction for income tax purposes. b. higher interest rates. c. higher monthly payments. d. larger down payments usually required.
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Chapter 6: Conventional Financing
Quiz 4. You are pre-qualifying a buyer for a purchase loan of $160,000. They state they do not want to pay PMI on the loan. In that case, what is the maximum loan amount they can receive? a. b. c. d.
$32,000 $128,000 $136,000 $144,000
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Quiz 5. Which type of mortgage is traditionally defined as NOT being insured or guaranteed by the government? a. b. c. d.
conventional mortgage FHA mortgage rural home mortgage VA mortgage
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Chapter 6: Conventional Financing
Quiz 6. When seeking an 80% conventional loan with the seller taking back a second mortgage, the buyer a. can expect to pay a higher interest rate than with a 90% loan. b. may choose which mortgage (first or second) will have lien priority. c. must make at least a 5% down payment from personal funds. d. must make at least a 20% down payment from personal funds. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 7. Which would likely have the highest PMI cost? a. b. c. d.
80% loan 90% loan 95% loan house purchased for cash
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Chapter 6: Conventional Financing
Quiz 8. PMI must be cancelled a. anytime the buyer requests it. b. only if the lender is satisfied that the buyer is no longer a credit risk. c. when a home has been paid down to 78% of its original value for loans made after July 1999. d. whenever a new appraisal is ordered, regardless of the value. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 9. A provision that penalizes borrowers who pay off their loans sooner than agreed is a(n) a. b. c. d.
alienation clause. assumption clause. incorporation clause. prepayment penalty clause.
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Chapter 6: Conventional Financing
Quiz 10. Lenders are often willing to charge lower interest rates for 15-year mortgages because the a. borrower is always a better risk. b. interest rate is fixed for a longer period of time. c. loan funds will be repaid more quickly. d. loan qualifications are much more stringent.
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Chapter 6: Conventional Financing
Quiz 11. You are pre-qualifying a buyer for a purchase loan of $140,000 and they stated they do not want to pay PMI. How much of down payment will they need? a. b. c. d.
$7,000 $14,000 $21,000 $28,000
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Quiz 12. A buyer is paying $200,000 for a house. He makes a $30,000 down payment, gets a first mortgage for $160,000, and a second mortgage to cover the balance. What is his CLTV? a. 70% b. 80% c. 85% d. 90% Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Conventional Financing
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Chapter 6: Conventional Financing
Overview • Nearly half of all residential real estate lending is completed with conventional financing programs • This chapter discusses: – Different types of conventional loans (15year, 30-year, conforming, non-conforming) – How private mortgage insurance and secondary financing have made conventional loans easier to obtain Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Key Terms • • • • • • •
Amortization Conforming Loan Conventional Loan Declining Market Fixed Rate Loan Jumbo Loan Loan-to-Value Ratio (LTV)
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• Negative Amortization • Prepayment Penalties • Private Mortgage Insurance (PMI) • Secondary Financing • Self-Liquidating 3
Chapter 6: Conventional Financing
Conventional Loans • One that is usually made by a bank or lender that is not insured or guaranteed by a government entity or agency, such as FHA or VA • Most are guaranteed or purchased by governmentsponsored entities (GSEs) in the secondary market and must meet appropriate guidelines • Conventional loans may be conforming (meeting criteria to be sold in the secondary market) or nonconforming • Just under half of all residential mortgages are handled as conventional financing – Percentage can change depending on market conditions or consumer trends Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Traditional Conventional Loans • Typically long-term, fully amortized, fixed rate real estate loans • Type of loan with which borrowers are most familiar • Anything other than 30-year fixed is considered nontraditional
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Chapter 6: Conventional Financing
Long-Term Loan • Payments generally spread out over 25-30 years (even 40) • Before the FHA was formed in 1934, home loans were typically 5, 7, or 10 years – Payments were high, required balloon payments, and/or frequent refinancing
• Provide reasonable payment and security so borrowers can choose if, when to refinance Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Fully Amortized • Amortization: The reduction of the balance of the loan by paying back some of the principal owed on a regular basis – Payments applied to principal and interest • Fully amortized loan: Total payments over the life of a loan pay off the entire balance of principal and interest due at the end of the term – Also known as self-liquidating – Payments stay constant for the entire loan term Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Fully Amortized • Different from how things were before FHA – When loans had only partial amortization or none, resulting in negative amortization • Negative amortization: Occurs when loan balances increase rather than decrease due to deferred interest – With even larger balloon payments then due from the borrower
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Chapter 6: Conventional Financing
Fixed Rate Loans • Interest rates remain constant for the duration of the loan • Borrower can refinance if rates decrease • Lenders have a guaranteed rate of return
• Benefit borrower or lender, depending on interest rates
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Chapter 6: Conventional Financing
15-Year Mortgage Loans • Often get better interest rates from lenders because shorter term means less risk • Over life of the mortgage, its total interest paid are about one-third less than a 30-year mortgage at the same interest rate • Homebuyer can attain full ownership in half the time of a 30-year mortgage
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Chapter 6: Conventional Financing
15-Year Mortgage Loans • Disadvantages: – Higher payments – Larger down payments required – Borrower loses the income tax deduction more quickly because home is paid for sooner
• Disciplined borrower could make additional payments each month on a 30-year mortgage (if allowed) – Borrower gets benefits of a 15-year mortgage without the contractual burden of higher payments Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• Conforming loans meet Fannie Mae/Freddie Mac standards and can be sold on the secondary market • Lenders prefer these loans because the ability to sell them on the secondary market allows them to liquidate if they need more funds
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• In order to obtain a conventional loan, borrower must qualify under both of the following: – 28% total housing expense ratio – 36% total debt service ratio
• Borrower should have: – 5% of their own funds for a down payment – 2 months of reserves on deposit
• For some lenders, these guidelines may be less rigid when automated underwriting is used Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• Nonconforming loans do not meet the previous standards and cannot be sold to Fannie Mae or Freddie Mac • Some other secondary markets will purchase nonconforming loans • Lenders that have the option of keeping loans in their own portfolio (e.g., banks and S & Ls) can, within limits of the law, deviate from the standards set by the secondary market
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Chapter 6: Conventional Financing
Conforming vs. Nonconforming Loans
• The distinctions between the two loans are becoming blurred • Fannie Mae and Freddie Mac constantly implement new loan program standards to meet the needs of consumers – Conforming market follows into territory that once was domain of nonconforming market
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Chapter 6: Conventional Financing
What Makes a Loan Nonconforming
1. Size of the Loan − Jumbo loans exceed the maximum loan amount established by Fannie Mae and Freddie Mac for conforming mortgage loans
1. Credit Quality of Buyer − Doesn’t meet standards and is classified as a B or C borrower by Fannie Mae/Freddie Mac − Loans can still be offered, but they can’t be sold to Fannie Mae or Freddie Mac
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Chapter 6: Conventional Financing
A-Minus Conventional Loans • Allow a borrower with less than perfect credit history, limited money for down payments, or higher debt service ratio to get a loan that could be sold on the secondary market • Instituted to meet increasing consumer demand and limit loss of market share to nonconforming lenders • Note: Final interest rate and fees are determined on basis of risk factors present in loan
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Chapter 6: Conventional Financing
Conventional Loan Programs • Can be classified by the percentage of down payment • Conditions and standards presented here are most typical • Remember some lenders offer high LTV loans where PMI is not necessary, but fees may be higher, or conditions and standards imposed
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Chapter 6: Conventional Financing
80% LTV Conventional Loan • LTV ratio refers to the amount of money borrowed (the loan amount of a first mortgage) compared to the value of the property • Lender will always use the lower of the appraised value or the sale price in order to protect its interest • Lower LTV = Higher borrower down payment, which means the loan is more secure Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Higher LTV Loans • If buyer wants a conventional loan but doesn’t have enough for a 20% down payment he can still try to get a: – 90% conventional with a 10% down payment – 95% conventional with a 5% down payment
• Loan with an LTV higher than 80% are possible due to PMI and secondary financing
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Chapter 6: Conventional Financing
Higher LTV Loans • Qualifying standards tend to be more stringent • Lenders adhere to those standards more strictly even if the loan is insured through PMI • May have higher interest rate, higher loan origination fees, or impose additional conditions and standards
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Chapter 6: Conventional Financing
90% Conventional Loan • At least half of the 10% payment (5%) must be made from personal cash reserves • Remainder may be gift from family member, equity in other property, or credit for rent already paid
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Chapter 6: Conventional Financing
95% Conventional Loan • Requires owner occupancy • Down payment must be made from personal cash reserves (no secondary financing or gifts)
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Chapter 6: Conventional Financing
Loans for Special Needs • For people who: – Can’t pass a stringent credit review, but have a larger down payment – Have good credit, but have a hard time proving stability of income • May be referred to as “no doc,” “low doc,” “stated income,” “no-ratio,” “NINA,” or “easy qualifier” loans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Loans for Special Needs • Lenders modify qualifying standards or loan criteria based on customers’ needs – May require same documentation, but relax qualifying standards due to increased equity borrower is putting into the home – May relax income verification standards for borrowers with good credit or down payments of at least 20%
• Current market conditions will drive the availability of such loans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Private Mortgage Insurance (PMI)
• Offered by private companies to insure lender against default on loan by a borrower • Evolved to compensate lender for reduced borrower equity, making loans easier for borrowers and safer for lenders • Both Fannie Mae and Freddie Mac require mortgage insurance on home loans with less than 20% down
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Chapter 6: Conventional Financing
How Mortgage Insurance Works • When insuring a loan, mortgage insurance company shares lender’s risk, but only part of the risk • Insurer does not insure entire loan amount – Rather the upper portion of the loan that exceeds the standard 80% LTV
• Amount of coverage is typically 20% - 25% of loan amount
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Chapter 6: Conventional Financing
How Mortgage Insurance Works • In event of default and foreclosure, insurer will take over property or allow lender to sell it • Lender can make a claim for reimbursement of actual losses (if any) up to the face amount of the policy
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Chapter 6: Conventional Financing
PMI Premiums Three ways a buyer can pay for PMI: 1. Fee at closing and renewal premium • Traditional way • One-time fee at closing when loan is made • Recurring fee 1. One-time PMI premium • Some PMI companies offer a one-time mortgage insurance premium, with no renewal fee continued on next slide Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Premiums 3. No PMI premium, but higher interest rate • Interest rate adjustment made at the time of closing in exchange for lender agreeing to “insure” home loan themselves • This allows money to be deducted as interest on a borrower's federal income tax • Higher payment will be in effect for the life of the loan—there is no cancellation
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Chapter 6: Conventional Financing
PMI Cancellation • When increased risk of borrower default is gone (LTV 80% or less), PMI has fulfilled its purpose • Homeowners Protection Act (HPA) of 1998 requires lenders to automatically cancel PMI when home has been paid down to 78% of its original value if borrower is not delinquent – Exceptions: Multi-family units, non-owner occupied homes, mortgages on second homes, and second mortgages – Law sets a minimum, market moves bar higher Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Cancellation Fannie Mae and Freddie Mac have: • Applied the 78% rule to all their mortgages – Even those closed before July 1999
• Expanded rules to cover investment properties and 2nd homes • Will consider present value of home, not just original value as required by law – Effectively cancels PMI more quickly (assuming home appreciates) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
PMI Cancellation • For loans closed after July 29, 1999, lenders must drop PMI at a borrower’s request if: – A new lender-approved appraisal shows loan has been paid down to 80% or less of home’s original value. – The borrower shows a history of repayment over the past 12 months.
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Chapter 6: Conventional Financing
PMI Cancellation • Fannie Mae and Freddie Mac: – Allow borrowers to use 80% of home’s current value if no payments have been more than 30 days late in prior 12 months for fixed rate loans (24 months for ARMS) – Rules apply to all loans, but can require up to 5 years of seasoning before they apply
• When PMI is terminated, lender cancels policy and reduces monthly mortgage payment by PMI amount • Law and Fannie Mae/Freddie Mac rules do not apply to any upfront or one-time PMI premium paid Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Underwriting PMI in Declining Markets
• Many factors could go into determining whether or not a market area is declining • May seem reasonable, but label can create problems – Label may not account for specific neighborhoods where properties may still be highly desirable • Some may simply refuse to offer PMI in these markets or may raise the premiums for PMI Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Secondary Financing • When a buyer borrows money from another source (other than primary lender) to pay part of the purchase price or closing costs − Another way buyer can get a conventional loan without a 20% down payment
• Often seller "carries" the extra financing Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Combined Loan to Value • The percentage of property value borrowed through a combination of more than one loan • When borrower chooses to subordinate a junior lean, this loan amount would also be included in the CLTV • Calculated by adding all loan amounts and dividing by the home’s appraised value or purchase price, whichever is lower
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Chapter 6: Conventional Financing
Combined Loan to Value • Example: Buyer purchases property valued at $100,000, taking out 2 loans: $80,000 + $10,000 ------------------------- = 90% CLTV $100,000 • Remember: LTV ratio considers only that first mortgage and would therefore be just 80% ($80,000 ÷ $100,000) • Both LTV and CLTV can be used to determine the amount of home equity a borrower has Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conditions •Down Payment – Borrower must make a 5% down payment – For owner-occupied property, CLTV must not exceed 95% of appraised value or sale price, whichever is less
• Loan Terms – Term of second loan cannot exceed 30 years, or be less than 5 years
•Interest Rate – Can be fixed or adjustable – First and second mortgages cannot both have adjustable rate Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conditions • No Prepayment Penalty – 2nd mortgage must be payable in full or in part at any time, without penalty for paying debt early
• Regularly Scheduled Payments – Payments must be due on regular basis, although not necessarily monthly – Payments can fully or partially amortize debt, or pay interest only Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Conditions • No Negative Amortization – Payments on second mortgage must, at least, equal the interest on the loan – Loan balances cannot grow due to deferred interest • Ability to Qualify – Buyer must afford payments on 1st and 2nd mortgages • Subordination Clause – Insures primary lender’s lien will take priority, even if 2nd mortgage is recorded first
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Chapter 6: Conventional Financing
Lender First and Lender Second
• It’s not always the seller that carries a 2nd mortgage – Can be carried by any lender, investor, or financial institution
• Sometimes the same lender may finance the 1st and 2nd mortgage – Allows lender to charge a higher interest rate on 2nd mortgage
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Chapter 6: Conventional Financing
Lender First and Lender Second
• Some lenders offer conventional 80-20 loans, which can be sold to Fannie Mae and Freddie Mac if the loans meet all standards and criteria • When upper portion of loan represented by the 2nd mortgage is paid off, the risk is gone and borrower still has a 1st mortgage at a good interest rate • Repayment plan is a matter of agreement between borrower and lender
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Chapter 6: Conventional Financing
Repayment Methods on Second Mortgages
• As with any loan, there are various ways to repay a 2nd mortgage: – Fully amortized – Partially amortized – Interest only
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Chapter 6: Conventional Financing
Repayment Methods on Second Mortgages
• A house costs $66,667 • Buyer makes $6,667 (10%) down payment and gets a: − $50,000 (75%) 1st mortgage for 30 years at 6% − $10,000 (15%) 2nd mortgage for 5 years at 7 7/8%
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Chapter 6: Conventional Financing
Fully Amortized Second Mortgage
• One with the total payments over the life of a loan paying off the entire balance of principal and interest due at the end of the term • The shorter the term, the higher the payments $299.78 + $202.17 $501.95
Payment on 1st Mortgage Payment on 2nd Mortgage Total housing expense
• After 5 years, 2nd mortgage paid in full Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Partially Amortized Second Mortgage
• Payments applied to principal and interest, but the payments do not retire the debt when the agreed upon loan term expires – Thus, a balloon payment is required as a final payment at the end of the loan term
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Chapter 6: Conventional Financing
Partially Amortized Second Mortgage
• To keep payments low, lender and borrower calculate monthly payment as if borrower were going to pay off entire debt over a longer period of time – For example, payments may be calculated as if 2nd mortgage would be repaid over 30 years, but borrower agrees to make a balloon payment of the loan balance after 5 years
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Chapter 6: Conventional Financing
Partially Amortized Second Mortgage
$ 299.78 + $ 72.51 $372.56
Payment on 1st mortgage Payment on 2nd mortgage Total housing expense
• Smaller monthly payment makes total housing expense less—easier for borrower to qualify • Risk is that borrower can’t deliver loan balance of 2nd mortgage (or can’t refinance) after 5 years • If 2nd mortgage is to be paid at the time, there will be a substantial balloon payment due (or refinance) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Interest Only Second Mortgage • One with scheduled payment that pay only accrued interest, and not any portion of principal • Reduces monthly payments even more – With interest only loans, no amortization is used
• Payment can be determined: – Monthly interest rate: Loan amount multiplied by interest rate then divided by 12 months – Daily interest rate: Loan amount multiplied by interest rate, divided by 360 or 365, then multiplied by number of days in the month Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Interest Only Second Mortgage $299.78 + $ 65.63 $365.41
Payment on 1st mortgage Payment on 2nd mortgage Total housing expense
• Interest only gives borrower the lowest housing expense • If no principal is paid, the balloon payment will be the original amount borrowed Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Assumption of Conventional Loans
• Assumption: One party (buyer) takes over primary liability for the loan of another party (seller), usually implying no change in loan terms • When a buyer assumes seller’s mortgage, seller remains secondarily liable unless lender provides a release • Loan assumption is not always an option today – A new loan allows a lender to change interest rates, charge fees, or change loan terms for a new party Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Assumption of Conventional Loans
Lender has several options in response to an assumption request: • Accept assumption and leave loan terms intact • Accept assumption, but charge an assumption fee and/or increase loan’s interest rate • Allow assumption, but keep original holder (seller) secondarily liable if new owner defaults • Not allow assumption and exercise a call provision − This would need to be stated in the note or mortgage
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Chapter 6: Conventional Financing
Prepayment Penalties • Fees that a lender charges the borrower for paying off a loan early • Time periods and amount of penalty may vary • Fannie Mae and Freddie Mac do not enforce prepayment penalties • Lenders who sell loans to Fannie and Freddie cannot keep prepayment penalties • Prepayment penalties are prohibited in FHA and VA loans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-1 A potential borrower is applying for a conventional loan to purchase a primary residence. Currently he pays $500 in rent, $420 for an auto loan, $170 toward his VISA bill, and $300 on a student loan each month. His gross monthly income totals $4,900, and his take-home pay after taxes is $3,700.
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Chapter 6: Conventional Financing
Exercise 6-1 1.
What is the maximum house payment—including principle, interest, taxes, and insurance—for which the borrower will qualify?
The borrower’s monthly debt is $890 (auto loan + VISA + student loan); rent does not count as debt since he will no longer pay that once he’s in his house. Conventional qualifying guidelines allow a total housing expense ratio of 28% and a total debt service ratio of 36%, based on gross monthly income. Under the first ratio, the borrower would qualify for $1,372 ($4,900 x .28). Under the second ratio, the borrower would qualify for $874 ($4,900 x .36 = $1,764; $1,764 - $890 = $874). Remember that you must accept whichever ratio is lower. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 A borrower is seeking a fixed rate, conventional loan to purchase a home. The sale price is $189,500 and the property has been appraised at $191,500. The buyer will make a 10% down payment and finance the balance with a 75% conventional first mortgage at 6% interest for 30 years and a 15% second mortgage. The second mortgage bears interest at 11% and calls for a balloon payment after five years (amortized on the basis of a 30-year schedule). There will be a 1.5% loan fee on the first mortgage. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 •
What will the loan amounts for the first and second loans be? What are the LTV and the CLTV?
1st loan amount: $189,500 (purchase price) x 0.75 (% of 1st loan) = $142,125
2nd loan amount: $189,500 x 0.15 (% of 2nd loan) = $28,425 LTV = 75% Combined LTV = 90% (75% 1st loan + 15% 2nd loan) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 2. How much will the buyer pay at closing for down payment and loan fees?
Down Payment: $189,500 (purchase price) x 0.10 (10% down) = $18,950
Loan Origination Fee: $142,125 (loan amount) x 0.015 (fee %) = $2,131.88
Total Due at Closing: $18,950 (down) + $2,131.88 (origination fee) = $21,081.88 Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 3. What is the monthly payment on the first mortgage, including principal and interest? Monthly Principal and Interest on 1st Loan: ($142,125 ÷ 1,000) x 6.00 payment rate = $852.75 (This solution uses the Payment Rate Chart found in the Appendix. Note that the numbers there are rounded to the nearest cent. For a more precise total, you can use a financial calculator.) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 4. What is the total monthly payment for both loans?
2nd Loan: $189,500 (purchase price) x 0.15 = $28,425 Interest on 2nd Loan: ($28,425 ÷ 1,000) x 9.53 payment rate) = $270.89
(This solution uses the Payment Rate Chart found in the Appendix. Note that the numbers there are rounded to the nearest cent. For a more precise total, you can use a financial calculator.) Total Monthly Principal and Interest Payment:
$852.75 + $270.89 = $1,123.64 Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Exercise 6-2 5. The review appraisal just came back at $185,000. What happens now?
You must use the lower of the appraised value or the purchase price. The buyer would either need to bring an additional $4,500 to closing, or the purchase price—and therefore the loan amounts— would need to be adjusted accordingly.
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Chapter 6: Conventional Financing
Summary 1. Conventional loans are not insured or guaranteed by a government entity. Traditional conventional loans are long-term, fully amortized, and have a fixed rate. An amortized loan has payments applied to principal and interest; fully amortized loans have total payments over the life of the loan that pay all principal and interest due. Conventional loans may be 15- or 30-year, conforming or nonconforming. A 15-year loan retires sooner and saves interest, but requires higher payments and, sometimes, a higher down payment. Conforming loans meet Fannie Mae/Freddie Mac standards and can be sold on the secondary market. Qualifying standards are 28% and 36%. Nonconforming loans do not meet these standards and cannot be sold to Fannie Mae/Freddie Mac, but can be sold on the secondary market to other buyers. Nonconforming can be due to credit quality or loan size (jumbo loans exceed Fannie Mae/Freddie Mac maximum loan amount).
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Chapter 6: Conventional Financing
Summary 2. Conventional loan programs include 80%, 90%, 95%, and some loans for special needs. An 80% conventional loan means the loan-to-value ratio (LTV) is 80% of the appraised value or sale price of property, whichever is less. For an 80% loan, buyer must make a 20% down payment; for a 90% loan, buyer must make a 10% down payment with 5% from personal cash reserves (no gifts, loans, etc.); for a 95% loan, buyer must make a 5% down payment, all from personal monies. For these loans, interest rates and fees may be higher on higher LTVs, and PMI is always higher. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Summary 3.
Private mortgage insurance (PMI) insures lenders against borrower default, compensating lenders for lower borrower equity, and shares partial risk (upper part) with the lender. PMI can be fee paid at closing and as a renewal premium, one-time PMI premium, or no PMI premium but with a higher interest rate. Federal law says that loans after July 1999 must drop PMI when LTV is 78% of original property value and the borrower is not delinquent, or if the borrower requests and the appraisal is 80% of original property value. Fannie Mae/Freddie Mac rules require a drop of PMI if LTV is 78% (or borrower-paid appraisal is 80%) of property’s current value.
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Chapter 6: Conventional Financing
Summary 4. Secondary financing is when buyer borrows money for part of the purchase price or closing costs. To determine the combined loan-to-value ratio (CLTV) when there is more than one loan, add all loan amounts and divide by the home's appraised value or purchase price, whichever is lower. Typical conditions for secondary financing: 1. Borrower must make a 5% down payment; 2. Term of second loan must be five to 30 years; 3. No prepayment penalty; 4. Scheduled payments due on a regular basis; 5. No negative amortization; 6. Buyer must be able to afford payments on first and second mortgages; and 7. Required subordination clause. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Summary 5. A second mortgage can be fully amortized, partially amortized with balloon payment, or interest-only with a balloon to pay off the principal at end of the loan. Partial amortization is when payments are scheduled as if the loan term is longer (e.g., 30 years), but the balance is due sooner (e.g., in 5 years). Partially amortized and interest-only loans have smaller payments than fully amortized loans, so they may help a buyer qualify. One lender can provide both loans at different interest rates.
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Chapter 6: Conventional Financing
Summary 6. Assumption means that one party (buyer) takes over primary liability for the loan of another party (seller). When trying to assume a loan: 1. Lender can accept assumption and leave loan terms in tact; 2. Lender can accept assumption and charge a fee or increase the interest rate; or 3. Lender will not allow assumption and call the note payable immediately. Prepayment penalties can be charged for paying a loan early. FHA/VA prohibit this. Always consult the original lender or a lawyer concerning assumptions. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Quiz 1. What is the term that describes a second mortgage holder agreeing to accept a second position in a refinance transaction? a. b. c. d.
alienation assumption subrogation subordination
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Chapter 6: Conventional Financing
Quiz 2. A loan that is repaid with periodic payments of both principal and interest so that the entire loan amount is paid in full at the end of the loan term is a(n) a. b. c. d.
annualized loan. conventional loan. fully amortized loan. partially amortized loan.
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Chapter 6: Conventional Financing
Quiz 3. All of the following are disadvantages of 15-year mortgages, EXCEPT a. earlier loss of interest deduction for income tax purposes. b. higher interest rates. c. higher monthly payments. d. larger down payments usually required.
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 4. You are pre-qualifying a buyer for a purchase loan of $160,000. They state they do not want to pay PMI on the loan. In that case, what is the maximum loan amount they can receive? a. b. c. d.
$32,000 $128,000 $136,000 $144,000
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 5. Which type of mortgage is traditionally defined as NOT being insured or guaranteed by the government? a. b. c. d.
conventional mortgage FHA mortgage rural home mortgage VA mortgage
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 6. When seeking an 80% conventional loan with the seller taking back a second mortgage, the buyer a. can expect to pay a higher interest rate than with a 90% loan. b. may choose which mortgage (first or second) will have lien priority. c. must make at least a 5% down payment from personal funds. d. must make at least a 20% down payment from personal funds. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 7. Which would likely have the highest PMI cost? a. b. c. d.
80% loan 90% loan 95% loan house purchased for cash
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 8. PMI must be cancelled a. anytime the buyer requests it. b. only if the lender is satisfied that the buyer is no longer a credit risk. c. when a home has been paid down to 78% of its original value for loans made after July 1999. d. whenever a new appraisal is ordered, regardless of the value. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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Chapter 6: Conventional Financing
Quiz 9. A provision that penalizes borrowers who pay off their loans sooner than agreed is a(n) a. b. c. d.
alienation clause. assumption clause. incorporation clause. prepayment penalty clause.
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Chapter 6: Conventional Financing
Quiz 10. Lenders are often willing to charge lower interest rates for 15-year mortgages because the a. borrower is always a better risk. b. interest rate is fixed for a longer period of time. c. loan funds will be repaid more quickly. d. loan qualifications are much more stringent.
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Chapter 6: Conventional Financing
Quiz 11. You are pre-qualifying a buyer for a purchase loan of $140,000 and they stated they do not want to pay PMI. How much of down payment will they need? a. b. c. d.
$7,000 $14,000 $21,000 $28,000
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Chapter 6: Conventional Financing
Quiz 12. A buyer is paying $200,000 for a house. He makes a $30,000 down payment, gets a first mortgage for $160,000, and a second mortgage to cover the balance. What is his CLTV? a. 70% b. 80% c. 85% d. 90% Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009
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