Conventional Financing Chapter 9 Conventional Financing

I. Conventional Loans

Conventional Loans A CONVENTIONAL LOAN is any loan not insured or guaranteed by a government agency.

A. AMORTIZED LOANS Conventional loans made over the past several decades have generally been long-term, fixed rate, fully amortizing loans. An AMORTIZED LOAN is one that provides for repayment within an agreed period (term) by means of regular level payments (usually monthly), which include a portion for principal and a portion for interest. As each payment is received, the appropriate amount of principal is deducted from the debt and the remainder of the payment, which represents the interest, is retained by the lender as earnings or profit.

Figure 9-1

B. 15-YEAR, FIXED RATE MORTGAGE The 15-year, fixed rate mortgage has gained increasing popularity over the last few years. Before the advent of the Federal Housing Administration in 1934, most 15-year loans involved partial or no amortization with balloon payments at the conclusion of their terms. In the past two decades, there has been increased use of fixed rate mortgages that are amortized over a 15-year period.

1. Advantages of 15-Year Mortgages A 15-year mortgage saves money. One advantage is that lenders will frequently offer lower fixed interest rates because the shorter term means less risk for the lender.

Figure 9-2

2. Disadvantages of 15-Year Mortgages A 15-year mortgage requires higher monthly payments. Larger down payments are often required to reduce the monthly payments. In addition, the homeowner loses the tax deduction on the interest payments sooner because homeownership is attained sooner. Lastly, because borrowers usually have the option of making extra payments on a 30-year mortgage, they can choose to retire the debt early, without being legally obligated to make the higher payments.

C. CONFORMING VS. NONCONFORMING LOANS The particulars of the conventional loan programs detailed in this chapter reflect the criteria established by the national secondary market investors. But when a loan does not meet secondary market criteria, it’s considered NONCONFORMING and is not salable on the secondary market. JUMBO LOANS Today the trend is almost exclusively towards CONFORMING LOANS, that is, loans that meet secondary market standards.

D. 80% CONVENTIONAL LOAN For many years now, the standard conventional loan-to-value ratio (LTV) has been 80% of the appraised value or the sales price, whichever is less. With this type of loan the buyer makes a 20% down payment and obtains a 30-year, fixed rate conventional loan for the balance of the purchase price. If a buyer does not have enough money for a 20% down payment but still wants a conventional loan, he or she has a number of options, including: 1. A 90% conventional loan with a 10% down payment. 2. A 95% conventional loan with a 5% down payment. 3. A down payment of 10% with a conventional loan for up to 75% and the seller carrying a second mortgage for the remaining portion of the purchase. Example:$120,000 sales price $90,000 75% first mortgage $18,000 15% second mortgage (seller’s) $12,000 10% down payment $120,000

E. LOAN ORIGINATION FEE To cover the administrative costs of making a real estate loan, the lender will always charge a LOAN ORIGINATION FEE, also called a “loan fee” or “loan service fee.” The loan fee is a percentage of the loan amount, not the sales price. On conventional loans it will range from 1-3% or more. Example: $120,000 sales price x .80 80% loan-to-value ratio $96,000 loan amount x .022% loan fee $1,920 loan fee

F. SECONDARY FINANCING When a purchaser borrows money from any source to pay a portion of the required down payment or settlement costs, it is called SECONDARY FINANCING. Conventional lenders allow secondary financing, provided the following requirements are met. The borrower must make a 10% down payment. Term not to exceed 30 years or to be less than five years. No prepayment penalty permitted. Scheduled payments must be due on a regular basis. No negative amortization. The buyer must be able to afford the payments on both the first and second mortgages.

1. Fully Amortized Second Mortgage A five-year, $9,000 fully amortized second mortgage bearing 9.25% interest will cost the borrower approximately $190.12 per month. When underwriting the loan, the lender will include this amount in the borrower’s monthly housing expense. Example: $632.00 payment on 10%, 30-year, and $60,000 first mortgage (includes principle, interest, real estate taxes, and insurance) +$190.12 payment on 9.75%, five-year, $9,000 second mortgage (fully amortized) $822.12 total housing expense

2. Partially Amortized Second Mortgage with Balloon Payment If a second mortgage is fully amortized, the monthly payments will be larger than if it is only partially amortized over the same period. The thinking behind the partially amortized mortgage is that the smaller monthly payments make the total housing expense less burdensome for the borrower, and thus easier to qualify for the loan. Example: $632.00 payment on 10%, 30-year, $60,000 first mortgage (includes taxes and insurance) +$77.32 payment on 9.75%, five-year, $9,000 second (partially amortized, based on 30-year repayment schedule) $709.32 When compared to the example for the fully amortized second mortgage, it’s clear the partially amortized second mortgage eases the qualifying burden somewhat.

3. Setting Up a Partial Amortization Schedule The above example states that the payments for the partially amortized mortgage are based on a 30-year repayment (amortization) plan. This means the payments were scheduled as though the debt would be paid in full over a 30-year period, even though the entire balance would be due and payable after five years. (BALOON PAYMENT)

4. Interest-Only Second Mortgage The second mortgage can call for “interest only,” which will reduce the amount of the monthly payments still more. Of course, if no principal is paid during the term of the loan, the balloon payment will be the original amount. Monthly interest-only payments are computed by multiplying the mortgage debt by the stipulated interest and dividing that figure by 12 (months). Example: $9,000 x .0975 = $877.50 $877.50 ÷ 12 = $73.13 monthly interest payment

5. Lender First and Lender Second Mortgage The seller does not necessarily have to carry the second mortgage when secondary financing is included. The lender, for example, can make a normal 80% loan and a 10% second loan. The buyer makes a 10% down payment. A typical lender second under these circumstances might have payments based on 30-year amortization with a five-year CALL PROVISION (balloon payment in five years), or it might be a fully amortized ten-year loan.

G. PRIVATE MORTGAGE INSURANCE (PMI) When borrowers begin making down payments of less than 20% of the sales price, lenders regard the loan as more risky. Under these circumstances, the lender will require the borrower to pay for private mortgage insurance as protection against loss. The presence of mortgage insurance reduces the lender’s risk of loss in the event of a borrower default. Needless to say, the smaller down payment requirement of the 90% loan made it very popular with buyers, sellers, and real estate agents. Mortgage insurance is sometimes available for loans with up to 95% LTV.

1. How Mortgage Insurance Works When insuring a loan, the mortgage insurance company shares the lender’s risk, but actually assumes only the primary element of risk. This is to say the insurer does not insure the entire loan amount, but rather the upper portion of the loan. The amount of coverage can vary, but typically it’s 20% to 25% of the loan amount. Example: 20% coverage $200,000 sales price x.90 LTV $180,000 90% loan x.20 amount of coverage $36,000 amount of policy

Figure 9-4 The chart is intended to serve only as a general example and not as a current price guide.

2. One-Time PMI Premium Some private mortgage insurance companies offer one-time premium programs as an alternative to the traditional program of an initial premium plus renewal premiums. Under this alternative, the initial premium and renewal premiums are combined into a single, one-time premium. The one-time premium is financed over the loan term rather than paid as a lump sum; the premium amount is simply added to the mortgage amount before calculating the monthly payment.

3. Cancellation Once the increased risk of borrower default is eliminated, usually when the loan balance has been reduced to 80% or less of the home’s present value, the mortgage insurance has fulfilled its purpose. The mortgage insurance policy is a contract between the insurer and the lender—not the borrower—so only the lender can cancel it. In many cases, the lender either did not cancel the policy, or cancelled it without passing the savings on to the borrower. FHLMC revised its mortgage insurance cancellation rule in 1985 to prevent this (Loaded Couponing) and other practices.

4. Rising Mortgage Delinquency In the early 1980s, 1990s, and 2000s the amount of past-due mortgages and foreclosures began to rise dramatically. These increases in loan delinquencies and foreclosures prompted the mortgage insurance industry to raise its premiums and to institute new underwriting guidelines. Most loan defaults occur between the third and fifth year of the life of the loan. High inflation rates in the 1975 to 1985 period almost always ensured that the selling price of the home would exceed the original mortgage balance. When inflation levels lowered and the economy became depressed, the values of the homes declined drastically, and homeowners were unable, in many cases, to sell their homes for enough money to cover the amount that had been loaned on them. (happening now 2008-2009) As a result of this experience, mortgage insurance companies began to exert considerable effort to increase the quality of the loans they insure in an attempt to avoid future losses. These efforts resulted in both new policies, procedures, and new products.

H. 90% CONVENTIONAL LOAN Ninety-percent loans became increasingly popular with the advent of private mortgage insurance. The qualifying standards for such loans tend to be more stringent and lenders adhere to those standards more strictly (even though the loan is insured). When seeking a 90% loan, the buyer must make at least a 5% down payment out of his or her own cash reserves. The rest of the down payment may be a gift from a family member, equity in other property traded to the seller, or credit for rent already paid under a lease/purchase.

I. 95% CONVENTIONAL LOAN With the 95% loan, made primarily by savings banks and mortgage companies, it’s possible to obtain conventional financing with as little as 5% cash down. Both interest rates and loan fees are generally increased for 95% loans. No secondary financing is allowed for 95% conventional loans. The buyer must make the down payment on his or her own, without resorting to secondary financing or gifts. Underwriting guidelines are extremely strict for 95% loans, more so than they have been in the past, due to the high foreclosure rate of high loan-to-value loans. Owner occupancy is required for a 95% loan.

1. Fannie Mae Guidelines for 95% Loans as an example of stricter underwriting requirements for 95% loans, Fannie Mae guidelines state that the borrower should fall into one of the following three sets of circumstances: 1. The borrower has a good mortgage payment history, good credit, sufficient financial assets, and a credit history indicating the borrower is willing and able to devote a substantial portion of his or her income to a mortgage payment. 2. The borrower has no mortgage payment history (first-time buyer), good credit, sufficient financial assets, and the borrower’s total monthly debt service-to- income ratio is 30% or less. 3. The borrower has no mortgage payment history, but has good credit, sufficient financial assets and financial reserves to carry the mortgage payment. The borrower must normally have on deposit sufficient cash, or other very liquid assets, to cover two months’ mortgage payments (principal, interest, taxes, insurance, and mortgage insurance) after the down payment and closing costs.

J. 100% OR MORE CONVENTIONAL LOAN In the late 1990s and early 2000s, some lenders were advertising loans from 100-125%. These loans were made on two assumptions. The first was that borrowers who had a good credit history were unlikely to default. The second assumption was that rapidly increasing property values would soon make up the gap between the property’s actual value at the time of the loan and the overall loan amount. Such a loan creates a situation in which a borrower is more likely to default in a severe economic downturn when property values decrease.

K. EASY DOCUMENTATION LOANS Many lenders have been willing to waive verification of employment or documentation of income if the borrower is willing to make a larger than normal down payment, usually at least 25-30%, and has good credit. In addition to the simplified, faster qualifying procedure, these low loan-to-value ratio loans are often less expensive because the lender may impose lower loan fees or slightly lower interest rates. As may be imagined, in 2008, as a result of the economic crisis, “easy doc” and “no doc” loans disappeared.

L. ASSUMING CONVENTIONAL LOANS Agents should not take chances when writing sales that call for assumption of existing conventional loans. Don’t give buyers and sellers advice on whether a loan is assumable, unless it is a certainty. Don’t discover after the sale what the lender plans or is entitled to do. Find out before creating the sale’s contract, even if it means not making the sale at all.

M. CONVENTIONAL PREPAYMENT PENALTIES Prepayment penalties discourage early payment of a loan, and this runs counter to most lenders’ objectives in today’s real estate market. Fannie Mae and FHLMC don’t have prepayment penalties in their standard promissory notes and mortgages or trust deeds. In many states, lenders are prohibited from charging prepayment penalties beyond the first five years of the life of the loan for loans on owner-occupied, one-to-four-unit dwellings.

II. CHAPTER SUMMARY The majority of conventional loans are fixed rate, fully amortized 30-year loans. However, 15-year loans have been gaining in popularity because of the significant savings in interest payments. Also, loans may be fully amortized, partially amortized, or interest-only with a balloon payment. Today, virtually all conventional loans are conforming loans, meaning they conform to Fannie Mae/FHLMC standards. Different standards apply to loans of different loan-to-value ratios: loans of not more than 80% LTV, loans of more than 80% LTV, and loans of more than 90% LTV.

Chapter Summary (cont.) Secondary financing is allowed on many conventional loans, but there are specific restrictions that must be followed. For loans over 80% LTV, private mortgage insurance is required to insure the lender for part of the loan amount. Before trying to assume a conventional loan, study the original loan papers carefully. Conventional loans may or may not include prepayment charges and/or alienation clauses