Nontraditional Mortgage Products

Chapter 8

Nontraditional Mortgage Products

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Overview • Nontraditional is defined by SAFE Act as anything other than a 30-year fixed rate mortgage • Financing options for buyers who require assistance • Help buyers achieve goals: – Qualifying for a loan – Getting a lower interest rate – Buying a bigger house – Or having a lower monthly payment. • Most popular financing tools: – Buydowns (discounts) – ARMs Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Overview • Other financing products include: –Subprime loans –Structured mortgages –Homebuyer assistance programs –Seller financing (including land contracts) • Other resourceful programs: –Lease/options –Lease/purchases –Equity exchanges –Participation plans Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Nontraditional Mortgage Products Chapter 8 covers: • Ways lenders and brokers make money on loans • Calculating points on a mortgage loan • Advantages and disadvantages of buydown plans • Elements that make up an ARM • Factors that define a subprime loan • Agency guidelines on lending and subprime loans • Various types of alternative financing

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Chapter 8: Nontraditional Mortgage Products

Key Terms • Adjustable Rate Mortgage (ARM) • Buydown • Caps • Discount Points • Equity Exchange

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

• • • • •

Estoppel Letter Index Land Contract Lease/Option Lease/Purchase

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Chapter 8: Nontraditional Mortgage Products

Key Terms • • • • •

Lender’s Yield Margin Option Participation Plan Points

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

• Rate Adjustment Period • Reverse Mortgage • Subprime Loan • Teaser Rate • Yield Spread Premium

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Chapter 8: Nontraditional Mortgage Products

Nontraditional Mortgage Products

• Achieve lower interest rate or lower payments through: – Additional payments to lender at beginning of loan – Loan structured to defer higher interest rates or payments until later in loan • Both types of financing tools fall under general category of buydowns, which involve discounts and payment of points to lender Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Adjustable Rate Mortgage (ARM) • Borrower can decrease initial interest rate if he assumes part of the lender's interest rate risk: – Borrower can allow lender to change interest rate as cost of money changes – Lender not locked into rate for 30 years, so will give borrower a lower rate

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Chapter 8: Nontraditional Mortgage Products

Subprime Loan • A borrower with less-than-perfect credit or other risk factor that prevents him from qualifying for a conventional loan • Borrower allows lender to charge an interest rate above that for typical conventional mortgages to achieve goal of home ownership

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Chapter 8: Nontraditional Mortgage Products

Lender’s Return • Also known as lender’s yield • The total amount of money a lender can earn from a loan in relation to the amount invested • Most often as a result of fees collected

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Chapter 8: Nontraditional Mortgage Products

Discount Points • •

• •

A point is 1% of the loan amount Additional funds paid to a lender at the beginning of a loan to lower interest rate that would otherwise be offered Allows borrower to lower monthly payments Allows lender to make up required rate of return lost by lower interest rate

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Chapter 8: Nontraditional Mortgage Products

Discount Points • Seller may be willing to pay discount points as a way of reducing the interest rate paid by the buyer to make seller’s property more marketable • It’s far easier to sell property if interest rate to be paid is lower and more buyers can qualify • Borrowers should determine how long they need to keep a loan for the savings from the lower interest rate to equal the extra money paid up front in discount points

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Chapter 8: Nontraditional Mortgage Products

Loan Origination Fees • Cover lender’s administrative costs in processing a loan • Also called loan fees, service fees, or administrative fees • While these are sometimes called points, loan fees are not discount points

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Chapter 8: Nontraditional Mortgage Products

Loan Origination Fees • Base loan fees on actual costs and also on what the market will bear • A mortgage broker must set the fees to offset the actual costs and expenses incurred in the origination of the loan • If not, they can be fined for upcharging the borrower – profiting from a third party or lender fee

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Chapter 8: Nontraditional Mortgage Products

Loan Origination Fees • Lender considers sale of the loan on the secondary market • In a competitive environment, some of those fees may even be waived

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Chapter 8: Nontraditional Mortgage Products

Yield Spread Premium • Tool that lowers the upfront closing costs for a borrower • Allows borrower to accept slightly higher interest rate in exchange for lowering fees

• YSP must be disclosed on GFE within 3 business days of application • Shows as a credit to the borrower on the GFE

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Chapter 8: Nontraditional Mortgage Products

Yield Spread Premium YSP paid to a mortgage broker is not considered to be a violation of RESPA’s Section 8 anti-kickback provisions as long as: • The broker is providing a service to the borrower, • The fees charged are reasonable, and • The YSP is disclosed to the borrower on the Good Faith Estimate (GFE) within three days of applying for the loan and on the HUD-1 Settlement Statement at closing.

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Chapter 8: Nontraditional Mortgage Products

Yield Spread Premium • Changes to RESPA reclassified YSP income earned by mortgage bankers who use their own funds as a service release premium (SRP) • SRP allows mortgage bankers to recognize value for the servicing of mortgage loan • When that loan is transferred (sold), the acquiring lender will pay this premium Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Buydown Plans • When discount points are paid to buy down the interest rate and lower mortgage payments • Could make it easier for borrower to qualify • Two main advantages to a buydown plan: 1. Buyer's monthly payment is lower than normal 2. Lender evaluates and lets buyer qualify for the loan on basis of reduced payment after the buydown Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Buydown Plans • Even with the lower interest rate from the buydown, payments would increase because of the increased amount of money financed • Seller could also pay discount points to buy down the interest rate for the buyer

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Chapter 8: Nontraditional Mortgage Products

Permanent Buydown • When points paid to lender reduce interest rate and loan payments for entire life of the loan – When buyer's interest rate is permanently bought down for life of loan, lender will write that interest rate into the promissory note • Nominal rate (or coupon rate) stated in the note will be the actual reduced interest rate Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Temporary Buydown • Points paid to lender reduce interest rate (prepay interest) early in a loan • Reduces loan payments early in the loan • Interest rates/payments rise at a predetermined point in loan term • Popular when interest rates are high • Plans can take two forms: 1. Level payment 2. Graduated payment

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Chapter 8: Nontraditional Mortgage Products

Level Payment Buydown • A plan with interest rate reduction constant throughout the buydown period – Constant interest rate keeps payments the same during buydown period

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Chapter 8: Nontraditional Mortgage Products

Graduated Payment Buydown • Has payment subsidies in early years that keep payments low – Payments go up each year until they're sufficient to fully amortize the loan

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Chapter 8: Nontraditional Mortgage Products

Graduated Payment Buydown Plans

Two most common types are often referred to as: – 2-1 buydowns – 3-2-1 buydowns

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Chapter 8: Nontraditional Mortgage Products

Limits on Seller-Paid Points and Other Considerations

• Fannie Mae/Freddie Mac guidelines impose limits on: – Discounts – Buydowns – Other forms of seller contributions to help buyers get into homes

• Other contributions include: – Finance costs, such as prepaid interest – Escrows for property taxes, hazard insurance, and mortgage insurance Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

FHA and VA • FHA guidelines also impose limits • FHA allows a maximum seller contribution of 6% • If the contribution is more than 6%, the FHA, like Fannie Mae and Freddie Mac, deducts the excess from the maximum loan amount

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Chapter 8: Nontraditional Mortgage Products

Adjustable Rate Mortgages (ARMS) • Permit lender to periodically adjust interest rates to reflect fluctuations in the cost of money • Made primarily by banks and mortgage companies • S & Ls make a similar type of loan called an adjustable mortgage loan (AML)

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Chapter 8: Nontraditional Mortgage Products

Elements of an ARM 1. 2. 3. 4. 5. 6. 7. 8.

Index Margin Rate adjustment period Mortgage payment adjustment period Interest rate cap (if any) Mortgage Payment cap (if any) Negative amortization cap (if any) Conversion option (if any)

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Chapter 8: Nontraditional Mortgage Products

How ARMs Work • Borrower’s interest rate determined initially by cost of money when the loan is made • Once initial interest rate for loan is set, rate of loan is tied to a widely recognized and published index • Future interest rate adjustments for ARM loans are based on the up and down movements of the index

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Chapter 8: Nontraditional Mortgage Products

Prime Rate and Margin • Prime rate is the lowest rate banks charge their best commercial customers • A margin is the difference between the index value and the interest rate charged on an ARM – Also known as spread

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Chapter 8: Nontraditional Mortgage Products

Index • At the time a loan is made, the index preferred by the lender is selected • Thereafter the loan interest rate will rise and fall with the rates reported by that index

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Chapter 8: Nontraditional Mortgage Products

Commonly Used Indexes for ARMs 1. Average One-Year Treasury Constant Maturity Index (TCM) 2. Cost of Funds Index (COFI) 3. London Interbank Offering Rate (LIBOR)

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Chapter 8: Nontraditional Mortgage Products

Margin • Lender adds a margin to the index to ensure sufficient income for administrative expenses and profit • Lender’s margin generally remains fixed for the duration of the loan • Not impacted by the movement of interest rates or other factors in the financial markets

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Chapter 8: Nontraditional Mortgage Products

Rate Adjustment Period • Interval at which a borrower's interest rate changes with ARMs – Can range from a few months up to 7 years – Most common rate adjustment periods are every 6 months or 1 year – After checking movement in the selected index, lender will notify borrower, in writing, of any increase or decrease in the rate

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Chapter 8: Nontraditional Mortgage Products

Mortgage Payment Adjustment Period • The interval at which a borrower’s mortgage payment changes with ARMs • Borrower’s actual principal and interest payments are changed • Like the rate adjustment period, this payment adjustment interval can range from a period of months up to 7 years

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Chapter 8: Nontraditional Mortgage Products

Handling Rate and Payment Adjustments 1. Lender can adjust rate periodically, as called for in loan agreement, and then adjust mortgage payment to reflect rate change 2. Lender can adjust rate more frequently than the mortgage payment is adjusted

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Chapter 8: Nontraditional Mortgage Products

Handling Rate and Payment Adjustments • When this happens, the difference in the amount of interest due is subtracted from or added to the loan balance • A loan balance increases, rather than decreases, because deferred interest creates negative amortization

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Chapter 8: Nontraditional Mortgage Products

Interest Rate Cap • Lenders typically offer a lower initial interest rate (start rate) to make ARMs more attractive to borrowers • ARMs with lower start rates usually will have a larger margin, and therefore, a much higher first payment adjustment • Interest rate caps are used with ARMs

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Chapter 8: Nontraditional Mortgage Products

Interest Rate Cap • Discounted rates and teaser rates required to have caps; as do most ARMs • The government has imposed regulations on interest rate disclosure and the true costs of ARMs

• Usually shown as two numbers, e.g., 2/6 – 2=maximum amount the interest rate can increase in one year – 6=maximum amount the interest rate can increase during the life of the loan Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Interest Rate Caps • Fannie Mae and Freddie Mac Interest Rate Caps: – Fannie Mae limit rate increases to 2% per year and 6% over the life of the loan (2/6) – Freddie Mac limit rate increases to 2% per year and 5% over the life of the loan (2/5) • FHA Interest Rate Caps – Limited to 1% per year and 5% over the life of the loan (1/5)

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Chapter 8: Nontraditional Mortgage Products

Mortgage Payment Cap • Used ARMs to protect a borrower from large payment increases • Without limits on the amount mortgage payments can be increased, borrowers are vulnerable to extreme changes in the cost of money • Lenders usually set the cap at about 7 1/2% annually Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Negative Amortization Cap • When a loan balance grows from deferred interest, because payments don’t cover the interest on the loan • Negative amortization caps limit the growth of a loan balance beyond a predetermined LTV • Caps do not stop negative amortization • Note usually calls for lender to adjust the monthly payment at some point to prevent further negative amortization Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Periodic Payment Readjustment • Some ARMs provide for regularly scheduled, periodic readjustment of payment • This can be instead of, or in addition to, any negative amortization caps, payment caps, or rate caps • Payment caps are usually not taken into account when a loan payments are readjusted • Readjustment reduces the chance of large build-up of debt 44

Chapter 8: Nontraditional Mortgage Products

Conversion Option • Gives the borrower the right to convert from an adjustable rate loan to a fixed rate loan • ARMs with a conversion option normally include: – Higher interest rate – Limited time to convert – Conversion fee

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Chapter 8: Nontraditional Mortgage Products

ARM Standardization • Estimation: More than 200 different adjustable rate plans • Sharp criticism from confused customers: – Threats of government regulation – Increased dangers of foreclosure – Refusal of secondary markets to buy ARMs • Led lenders to standardize most ARM programs • Now, lenders usually follow secondary market guidelines so they can sell ARMs just as they do fixed rate loans

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Chapter 8: Nontraditional Mortgage Products

Loan-to-Value Ratios • 80%, 90%, and 95% are available • Loan-to-value ratios may not exceed 95% for ARMs purchased by Fannie Mae and Freddie Mac • Requirements are based on the potential risk from higher payments when the interest rate is adjusted • Fannie Mae and Freddie Mac also require owner occupancy for all ARMs Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Appraisals on ARM Properties • Appraisal guidelines followed more strictly by lenders when underwriting ARM loans • Lender concerned about validity of appraisal • Lenders insist that appraisal report accurately reflects an estimate of true value of the property • Terms of the sale must be clearly communicated to appraiser • Terms must be clearly identified—preferably in the appraisal report Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Underwriting ARMs • Underwriter will: – Carefully review the appraisal report to determine if the appraiser has performed this analysis satisfactorily • If not found to be performed satisfactorily: – Appraisal will be considered deficient because underwriters try to subtract the value of any favorable financing from the appraised value in determining the maximum loan for a given LTV

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Chapter 8: Nontraditional Mortgage Products

ARM Qualifying • Lenders are often stricter in qualifying borrowers to be sure they have sufficient income in the event their payments increase – They take the income that a borrower has and multiply it by certain percentages to determine how much debt the borrower should be able to afford • Certain ARMs have features that increase the likelihood of mortgage payments increasing to dangerous levels after the first rate adjustment

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Chapter 8: Nontraditional Mortgage Products

Freddie Mac Guidelines Freddie Mac recommends borrowers be allowed to qualify: • For a mortgage payment up to 25% of their gross monthly income for total housing expense ratio (as opposed to 28%) • With total payments for all debts (including mortgage payment) up to 33% of their gross monthly income as a total debt service expense ratio (as opposed to 36%)

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Chapter 8: Nontraditional Mortgage Products

Freddie Mac Guidelines These recommendations are for ARM loans with any of the following features: • Rate or payment cap outside Freddie Mac guidelines (2% per year, 5% per loan), or no caps • Discounts or buydowns that exceed 2% • Rate cap over 1% or payment cap over 7 1/2 % • Difference between rate and payment adjustment periods exceeds three years • Payment cap does not meet Freddie Mac guidelines

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Chapter 8: Nontraditional Mortgage Products

FHA Guidelines • Borrowers who are utilizing the one-year ARM with an LTV of 95% or higher must qualify at the initial rate plus 1% – Which is the anticipated maximum 2nd year rate • FHA Hybrid ARMs are underwritten at the initial interest rate

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Chapter 8: Nontraditional Mortgage Products

ARM Discounts and Buydowns • ARMs with discounts or buydowns almost always have payment increases after the first adjustment period • If the index goes up during the first period, the payment shock would be even greater

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Chapter 8: Nontraditional Mortgage Products

ARM Discounts and Buydowns • Potential problem—initial rate discounts and buydowns often make ARMs more attractive for borrowers who have trouble qualifying for financing at higher rates – These loans inherently riskier than most other loans – Lenders are beginning to underwrite them more conservatively

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Chapter 8: Nontraditional Mortgage Products

ARM Disclosures • Lenders offering residential financing must comply with federal guidelines under Regulation Z of the Truth-in-Lending Act • Disclosures must be provided to the borrower when the loan application is made or before payment of any non-refundable fee

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Chapter 8: Nontraditional Mortgage Products

ARM Disclosures The following disclosures must be made, if appropriate: • Index used to determine the interest rate • Location where the borrower may find the index • Explanation of how the interest rate and payment are determined • Suggestion that the borrower asks the lender about the current margin and interest rate

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Chapter 8: Nontraditional Mortgage Products

ARM Disclosures • Disclosure of the fact that the initial rate is discounted and a suggestion that the borrower inquire as to the amount of the discount • Rate and payment adjustment periods • Rate and payment caps • Statement that rate or payment caps may result in negative amortization • Statement that the loan has a demand or call provision Continued on next slide 

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Chapter 8: Nontraditional Mortgage Products

ARM Disclosures • Description of the information that will be contained in the adjustment notice and when such notices will be provided • Statement that disclosure forms are available for lender’s other ARM loans • Maximum interest rate and payment • Initial interest rate and payment • Conversion option details

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Chapter 8: Nontraditional Mortgage Products

ARM Disclosures • Lender must give borrower advance notice of: – Any change in payment – Interest rate – Index – Loan balance • Such disclosures must be given at least 25 days, but not more than 120, before a new payment level takes effect Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Annual Percentage Rate (APR)

• The relationship between the cost of borrowing money and the total amount financed, represented as a percentage • Cannot be made based solely on an ARM’s initial rate • The disclosure of the APR in the federal box on the Truth-in-Lending Statement (TIL) must be based on the lender’s margin • Composite annual percentage rate

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Chapter 8: Nontraditional Mortgage Products

Payment Option ARMs The options typically include: – A traditional payment of principal and interest – An interest-only payment – A minimum (or limited) payment

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Chapter 8: Nontraditional Mortgage Products

Hybrid ARMs • May be used as a “band-aid” • Get borrowers into a home at a lower rate and payment upfront – Once a borrower has had a chance to establish more credit or repair their credit, they can look into qualifying for a mortgage with a better fixed rate • 2/28 adjustable rate mortgage • 3/27 adjustable rate mortgage

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Chapter 8: Nontraditional Mortgage Products

Subprime Loans • Prime loans are ones made to borrowers with good credit • Subprime loans have more risks – AKA B-C loans or B-C credit – Allow those with less than perfect credit to own a home • To underwrite a subprime loan, lender examines where the borrower belongs on the risk scale • Credit scoring helpful in making this determination Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Subprime Loans • Regulation C of the Home Mortgage Disclosure Act (HMDA) • Lenders willing to make these riskier loans because they can get: – Higher interest rates – Fees

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Chapter 8: Nontraditional Mortgage Products

Assessing Risk • Subprime borrower matched to a series of risk profiles • Sometimes larger down payments or secondary financing are required by lenders • Many subprime lenders offer borrowers a chance to refinance their loans at lower interest rates after they pay their mortgage on time for a given period of time

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Chapter 8: Nontraditional Mortgage Products

Interagency Guidelines Jointly published by: • The Office of the Comptroller of the Currency (OCC) • The Board of Governors of the Federal Reserve System (Board) • The Federal Deposit Insurance Corporation (FDIC) • The Office of Thrift Supervision (OTS) • The National Credit Union Administration (NCUA) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 8: Nontraditional Mortgage Products

Guidance on Nontraditional Mortgage Products

• Interagency Guidance on Nontraditional Mortgage Products • The Guidance applies to nontraditional mortgage products (NMPs) – Defined as mortgage products that allow borrowers to defer principal and, sometimes, interest

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Chapter 8: Nontraditional Mortgage Products

Qualification Standards • • • • •

Collateral-dependent loans Risk layering Reduced documentation Simultaneous second lien loans Introductory interest rates

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Chapter 8: Nontraditional Mortgage Products

Underwriting Standards •

Should address the effect of a substantial payment increase on the borrower’s capacity to repay a nontraditional mortgage loan when amortization begins

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Statement on Subprime Mortgage Lending

• Promote consumer protection standards • The statement includes guidelines for: – Defining predatory lending – Underwriting standards – Establishing control systems – Consumer protection

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Chapter 8: Nontraditional Mortgage Products

Consumer Protection Consumers should be informed of: • • • • •

Payment shock Prepayment penalties Balloon payments Cost of reduced documentation loans Responsibility for taxes and insurance

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Chapter 8: Nontraditional Mortgage Products

Predatory Lending A loan involving at least one of the following: • Making loans based mostly on the foreclosure or liquidation value of a borrower’s collateral • Inducing a borrower to repeatedly refinance a loan in order to charge high points and fees each time the loan is refinanced (known as “loan flipping” or “equity skimming”) • Engaging in fraud or deception to conceal the true nature of the mortgage loan obligation

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Chapter 8: Nontraditional Mortgage Products

Structured Mortgages • • • • • •

Variable Balance Mortgage (VBM) Bi-Weekly Mortgage Growth Equity Mortgage (GEM) Reduction Option Mortgage Reverse Mortgage Shared Appreciation Mortgage (SAM)

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Chapter 8: Nontraditional Mortgage Products

Seller Financing • When a seller extends credit to a buyer to finance the purchase of the property • Mortgage money from traditional lenders may be too costly in terms of interest rates or it may be simply unavailable • Seller must address the possibility of a due on sale clause in existing mortgage

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Chapter 8: Nontraditional Mortgage Products

Purchase Money Mortgage • A mortgage given by the buyer to the seller as partial payment of the purchase of real estate • AKA seller held mortgage • Contains all of elements and follows all rules and procedures for any type of mortgage • Central advantage of this arrangement: Sellers are not bound by institutional policies regarding: – Loan ratios – Interest rates – Qualifying standards

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Unencumbered Property • Property with the title owned free and clear • Simplest form of purchase money financing • The buyer and seller can simply negotiate the amount and terms of their financing arrangement and draw up the appropriate documents Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Encumbered Property • Has mortgages, liens, or other restrictions against it which prevent or restrict its transfer • Can complicate a seller financing deal because there are other parties whose interests must be considered

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Chapter 8: Nontraditional Mortgage Products

Assumption • One party agrees to take over payments of another party’s debt, with terms of the note staying unchanged • FHA and VA loans permit assumptions • Some conventional mortgages also allow assumptions

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Assumption and Release • Assumption might be an agreement strictly between buyer and seller • The buyer assumes responsibility for the loan, but the seller is not completely released from liability • A release is a document in which a legal right is given up

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Chapter 8: Nontraditional Mortgage Products

Alienation Clause • Gives the lender the right to exercise certain rights upon transfer of the property – Such as declare the entire loan balance immediately due and payable – Due on sale clause or acceleration clause • Designed to restrict the seller’s right to transfer the property

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Chapter 8: Nontraditional Mortgage Products

Seller-Sponsored Wraparound Financing • When seller offers the wraparound mortgage, retaining an existing loan on the property while the lender (or in this case, seller) gives the buyer another larger loan • Seller can extend the benefit of an existing loan at lower-than-market interest rates

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Purchase Money Second Mortgage • A purchase money mortgage in a second lien position • If the seller is financing only part of the purchase price, then the seller would be in a junior lien position with the institutional lender taking the first lien position

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Chapter 8: Nontraditional Mortgage Products

Land Contract • Real estate installment agreement where the buyer makes payments to the seller in exchange for the right to occupy and use the property, – No deed or title is transferred until all, or a specified portion, of the payments have been made • Equitable title is an interest in real property created with the execution of a valid sales contract

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Land Contract Subject to an Existing Mortgage • Possession of property is transferred to buyer • Seller retains liability for mortgage • If seller defaults, buyer may be forced to file suit to recover • Land contract could allow buyer to make payments directly to lender

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Contract Escrow • Ensures that a seller makes the payments on the existing mortgage • Sets up an escrow account or servicing agreement for the contract payments

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Estoppel Letter • Legal doctrine that prevents a person (or artificial person such as a lender or company) from asserting rights or facts inconsistent with earlier actions or statements, when he or she failed to object (or attempt to stop) another person’s actions

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Land Contract with Assumption of an Existing Mortgage • The mortgage must not contain any alienation clauses • Seller must get a release or remain secondarily liable • Buyer becomes personally liable for: – Payment of the mortgage debt – Making one payment to the mortgagee – Another payment to the seller for the land contract

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Other Forms of Creative Financing • Lease/Option • Lease • Option

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Option Instances in which an option might be used: • • • • • • •

Profit Speculation Investment Comparison Time to Acquire Cash Qualifying Rent Credit

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Consideration for an Option • Anything of value given to induce another to enter into a contract • Usually a sum of money (called option money), but it can be anything of value

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How Does a Lease/Option Work? • The seller/lessor leases the property to the buyer/tenant for a specific term • Includes provision that part of the rental payments may be applied to the purchase price if the tenant decides to buy before the lease expires

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Lease Contract Separate from the Option Contract • Problem: Too often the optionee/lessee does not exercise the right to purchase • Two problematic characteristics: 1. Prospective buyer’s minimal cash investment 2. Prospective buyer’s extended occupancy of property before commitment Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Lease/Purchases • When a seller leases property to someone for a specific term, with the tenant agreeing to buy the property at a set price during or following the lease term • Equivalent of a sale

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Lease/Purchase • Instances in which a lease/purchase might be used: – Time to Acquire Cash – Qualifying – Rent Credit • How does a lease/purchase work? – The seller/lessor leases the property to the buyer/tenant for a specific term with the provision that part of the rental payments may be applied to the purchase price Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Equity Exchanges • Value in one property being traded for value in another property • This is also called: – Tax-deferred exchange – Tax-free exchange – Like-kind exchange, or Section 1031 (from the section number of IRS law)

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Equity Exchange General Rules 1. The properties must be exchanged, or qualify as delayed exchange 2. The properties must be like-kind property (real estate for real estate) 3. The properties must be held for use in a trade or business, or held by the party as an investment

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Participation Plans • AKA equity participation mortgage • When a buyer and another investor enter into a partnership, with the buyer paying an equity share in a deal in lieu of interest (also called a shared equity plan) • Buyer enters into a form of partnership with an investor who provides cash for the purchase • The investor may be the seller, a bank, or any private investor Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Important Questions to Consider • How will the loan be applied? • How will the equity be calculated? • What percentage of the equity will the investor receive? • When will the investor be repaid? • How will improvements be handled? • Who will be responsible for payment of taxes and insurance? Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Application of the Loan • An investor may simply put up cash for the down payment • The primary lender may reduce the interest rate in exchange for a share of the equity

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Calculation of Equity • Equity is the difference between the value of the property and the outstanding indebtedness secured by the property • Buyer and investor must agree at the outset to the method of valuing the property

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Investors • Investor’s Percentage of Equity – Negotiable – Provide at least a market rate of return to investors

• Repayment of Investor – The investor may cash out his share of equity at a pre-agreed time, or when the property is sold

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Handling Improvements • Handling Improvements – The agreement should specify how improvements will be paid for – if the investor will share in any changes in equity resulting from improvements to the property

• Responsibility for Taxes and Insurance – Usually the buyer will pay the property taxes and homeowners insurance premiums – but this point may be negotiable with some private investors

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Responsibilities for Taxes and Insurance • Usually the buyer will pay the property taxes and homeowners insurance premiums • But this point may be negotiable with some private investors

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Homebuyer Assistance Programs • Can be: – Down payment assistance programs (AKA DAP programs) – Subsidized mortgage interest rates – Help with closing costs – Combination

• May be offered by: – Government or non-profit organizations – Lenders as part of their obligation under the Community Reinvestment Act Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-1 A borrower wants to buy a $150,000 home, and is going to make a $15,000 down payment. The borrower is seeking a conventional loan, but doesn’t want to pay more than 6 1/2% interest. The lender agrees to 6 1/2% interest if the loan has three discount points and the loan origination fee is 2%.

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Exercise 8-1 1. What’s the total amount of points (in dollars and percentage) that the lender will receive for making this loan? Points are based on the loan amount, in this case, $135,000 ($150,000 - $15,000 down). The lender is charging a total of 5 points, or 5% of the loan. Discount points total $4,050 ($135,000 x .03) and the loan origination fee is $2,700 ($135,000 x .02). The total the lender will receive in points is $6,750 ($4,050 + $2,700). Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-1 2. If the seller agrees to pay the discount points, how much will the seller net from the transaction? (Assume the seller pays no other costs.) The seller net is the sale price minus any seller-paid points, so the seller will net $145,950 ($150,000 - $4,050).

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Mortgage Exercises 3. What will the borrower’s note state as the interest rate on the loan? What dollar amount will the note say was borrowed? The loan note rate will be 6.500% since this is not a temporary buydown. The amount on the note equals the loan amount, not the sale price, so it’s $135,000 ($150,000 - $15,000). The note amount does not reflect the sellerpaid points. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-1 4. Can the lender sell this loan to Fannie Mae or Freddie Mac on the secondary market? Why or why not? Yes, the lender should be able to sell this loan to Fannie Mae/Freddie Mac on the secondary market because it has less than the 6% seller assistance limit that the programs allow with a 90% LTV. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-2 A borrower just received a 30-year ARM mortgage loan for $120,000. The start rate is 3.50% and the loan adjusts every 12 months for the life of the mortgage. The index used for this mortgage is the LIBOR (for this exercise, let’s say it’s currently at 5.00%). The margin on the loan is 3.00%. Rate caps are 2.00% per year, 6.00% over life of the loan with a first adjustment cap of 3.00%.

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Exercise 8-2 1. What is the initial rate and what is the interest rate after the first year? The initial and start rate are the same, 3.50%. The rate after the first year based on the current LIBOR is 5.00% + margin of 3.00% = 8.00%. BUT, the maximum rates caps have to taken in consideration also. In this mortgage, the maximum rate increase the first year is 3.00% (2.00% in all other years). So 3.50% + 3.00% = 6.50%, which will be the interest rate after the first adjustment. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-2 2. What is the fully indexed rate? Is this a teaser rate? The fully indexed rate is 8.00%: Current LIBOR Rate (5.00%) + Margin (3.00%) When you subtract the start rate of 3.50% from the fully indexed rate of 8.00%, you find a difference of 4.50%, or 450 basis points. Since the rate spread is more than 300 basis points (or 3%) this is a teaser rate. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-2 3. What is the interest rate after the second year using the information provided?

The current LIBOR of 5.00% + the margin of 3.00% is 8.000%. The rate after the first adjustment period is 6.50%. Adding the maximum adjustment cap of 2.00% = 8.50%. Using the lower of the two interest rates makes the actual rate 8.00% after the second adjustment. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Exercise 8-2 4. What is the maximum interest rate this loan could have? What would the LIBOR have to be to obtain that interest rate? The maximum interest rate equals the start rate of 3.50% + the life of the loan maximum of 6.00%, so the maximum interest rate this loan could have is 9.50%. In order for this loan to get to that rate, however, the LIBOR would have to increase 1.50% from its current rate of 5.00%: 9.50% (Maximum Lifetime Rate) – 3.00% (Margin) = 6.50% (LIBOR) Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Summary 1. Nontraditional mortgage products could include real estate that is financed with terms or concessions other than those typical for conventional loans. Such products can help buyers qualify for larger loans, or help them reach other financial goals. The most popular alternative financing tools are buydowns and adjustable rate mortgages (ARMs). Other types include structured mortgages, subprime loans, and homebuyer assistance programs. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Summary 2. Lender’s yield is the total amount a lender or broker makes on a loan. This can come from loan fees, discount points, or yield spread premium. Points: 1% of loan amount; increase lender’s yield and are paid for many reasons.

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Summary 3.

Buydowns are additional money (points) paid to the lender at the start of a loan to lower interest rate and payments. Discount points are paid to the lender to make up the difference between the market interest rate and the rate a buyer gets in the note. Buydowns may be paid by a seller or builder. A permanent buydown (for life of loan) has a reduced rate stated in the note. A temporary buydown (early in loan) can be level payment or graduated payment (3-2-1, 2-1). With buydowns, the lowest a buyer can qualify is 2% below market rate. The limit on seller paid points: Fannie Mae and Freddie Mac—90% or higher LTV = 3 points, between 90% and 75% LTV = 6 points, 75% or lower LTV = 9 points; FHA = 6 points. FHA requires buyers to qualify at the note rate, not the buydown rate.

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Summary 4.

Adjustable rate mortgages (ARMs) let lenders adjust interest rates. Lenders pick an index (statistical report reflecting cost of money), add a margin (profit margin), and this is the rate paid on the loan. Loan documents must state: Rate, index, margin, and payment adjustment period; caps (if any) on rate, payments or negative amortization; conversion option (if any). The rate and payment may not adjust at same time. Rates that change more frequently than payments create negative amortization (loan balance grows from deferred interest). Caps keep loans from growing out of control. Rate caps: Fannie Mae = 2%/year, 6%/life of loan; Freddie Mac = 2%/year, 5%/life of loan; FHA = 1%/year, 5%/life of loan. Payment caps are 7 1/2% to 15% a year. Negative amortization caps are based on LTV: 110 to 125% of loan or 100% of appraised value. If loan grows too large, re-amortization occurs. Periodic re-amortization is when payments are recalculated based on the loan balance at specific interval. Conversion options allow buyers to convert to fixed rate (limited).

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Summary 5. Other limits on ARMs: Fannie Mae and Freddie Mac LTVs are limited to 95%, appraisals are more strict, if there are no (or high) caps, then income ratios are reduced to 25% and 33%. Freddie Mac requires buyer to qualify 2% above initial rate. ARM rules under Regulation Z of Truth in Lending Act include: CHARM booklet must be given to the buyer, specific disclosures are made, annual percentage rate (APR) is disclosed. APR is a composite rate that reflects the lower rate for certain number of years and the higher rate for later years. Lenders cannot disclose only initial low rates. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Summary 6. Structured mortgages help borrowers reach other financial goals. Variable balance: Variable rate, constant payments so balance adjusts. Biweekly: Payments every two weeks so balance is paid faster, saves interest. Growth equity: Fixed rate, but payments increase to pay off faster. Reduction option: Buyer can reduce rate one time, with fewer refinancing costs. Reverse: People over 62 can get a monthly check from lender. Shared appreciation: Lender shares equity in commercial project. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Summary 7. Subprime loans (B-C loans, B-C credit) have more risk than what is allowed by the conventional market. Borrower risk factors determine interest rate and terms.

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Summary 8. Seller financing is when seller extends credit to buyer to finance the purchase of property. Seller can extend all or partial credit. This can help a buyer who doesn’t have enough cash to buy a property, can’t qualify for a conventional loan, or wants or needs a lower-than-market interest rate. Seller gets the benefit of a home that’s easier to sell, and often a better price by offering terms, as well as a tax deferment on the gain from the home’s sale. A purchase money mortgage or sellerheld mortgage is given by buyer to the seller to secure part or all of the money borrowed to purchase property. Unencumbered property with no liens is best for this transaction; encumbered property with liens needs assumption or wraparound. Assumption has the buyer take responsibility for the mortgage, but the seller must get a release from the lender. (An alienation clause can stop this.) A wraparound mortgage has the seller retain existing mortgage (the buyer makes one larger payment; the seller pays the lender and keeps difference, making good yield.)

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Summary 9. A land contract is an installment contract where a buyer pays a seller for possession of property, but the seller keeps title until all (or some) payments are made. If seller doesn’t own the property free and clear, the buyer may take a land contract subject to the existing mortgage or assume the mortgage. An estoppel letter gives the lender’s written consent to the deal. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Summary 10. A lease/option has the seller lease to a tenant who has the right (but not the obligation) to buy the property at a set price within a certain time. An option can be used for profit, speculation, investment, comparison, or to give buyer time to acquire cash, to qualify, or credit rent toward purchase price. A lease/purchase combines a lease with a purchase contract. An equity exchange (tax-deferred exchange, Section 1031) is property traded for value in other property. Properties must be exchanged (or delayed exchange), like kind, and held for trade, business, or investment. Capital gains tax is deferred, but boot (unlike property added to balance value) is taxed. Tax-free exchanges are not available for residential property. Participation plans have investors share equity instead of receiving interest.

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Summary 11. Homebuyer assistance programs can be down payment assistance programs (DAP), subsidized mortgage interest rates, help with closing costs, or combination. Programs can be offered by government or non-profit groups, or by lenders as obligated under the Community Reinvestment Act.

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Quiz 1. Which is NOT a way for lenders or brokers to make money at the beginning of a loan? a. b. c. d.

discount points loan fees prepayment penalties yield spread premium

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Quiz 2. On an $80,000 loan, six points equals a. b. c. d.

$800. $2,400. $3,400. $4,800.

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Quiz 3. In VA transactions, points are a. allowed and can be paid by buyer, seller, or a third party. b. allowed, but must be paid by the buyer. c. allowed, but must be paid by the seller. d. not allowed.

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Quiz 4. A buydown plan can reduce the borrower's payments a. early in the loan or for the entire life of the loan. b. early in the loan only, but then requires a large balloon payment. c. for the life of a loan, but with automatic prepayment penalty. d. through gradual payment decreases throughout the life of the loan.

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Quiz 5. Which statement is true about interest rate buydowns on FHA loans? a. Borrowers may qualify at the buydown rate. b. Borrowers must qualify at the note rate. c. FHA does not allow builder-paid buydowns. d. FHA does not allow seller-paid buydowns.

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Quiz 6. Which of the following is NOT an element of an ARM? a. b. c. d.

index margin positive amortization cap rate

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Quiz 7. What is the adjustable number used to compute the interest rate on an ARM called? a. b. c. d.

cap index margin prepayment

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Quiz 8. With an ARM, the margin is added to the ______ to determine the _________ . a. b. c. d.

APR / cost of funds index home value / amount borrowed index / interest rate charged qualifying ratio / maximum monthly mortgage

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Quiz 9. Negative amortization occurs when a.a borrower suffers payment shock. b.mortgage payments are adjusted more frequently than interest rates. c.the loan balance grows from deferred interest. d.all of the above.

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Quiz 10. What is the LTV limit that Fannie Mae and Freddie Mac require for ARMs they purchase? a. b. c. d.

80% 85% 90% 95%

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Quiz 11. How are subprime loans different from conforming loans? a. b. c. d.

They allow for lower interest rates. They allow for more risk. They are only offered by banks. They are sold in the secondary market.

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Quiz 12. According to HMDA, a first mortgage will be considered a subprime loan when the difference between the annual percentage rate and the rate spread is greater than a. b. c. d.

2 percentage points. 3 percentage points. 5 percentage points. 6 percentage points.

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Quiz 13. If Bob takes over Sue’s mortgage, becoming personally liable for the debt, and he will pay the balance of the purchase price to Sue under a contract, they have a. an assumption and release. b. encumbered property cash out. c. a land contract subject to an existing mortgage. d. a land contract with assumption of an existing mortgage. Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Quiz 14. An equity exchange is treated as a taxfree exchange when property is a. b. c. d.

for profit and of like kind. held for sale by a dealer only. owner-occupied. rental only.

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