Financing Residential Real Estate Lesson 7: The Financing Process

Introduction In this lesson we will cover the stages of the financing process, including: 1.shopping for a loan, 2.applying for a loan, 3.application processing, and 4.closing.

Shopping for a Loan For home buyers, shopping for a mortgage loan involves:  assessing wants, needs, and finances;  choosing a lender;  comparing rates and fees; and  evaluating financing options.

Shopping for a Loan Buyers should get a realistic idea of what they can afford before they start house hunting. To establish a price range, they need to find out how much financing they can qualify for. Assessing the buyers’ circumstances

Shopping for a Loan Buyers should get a realistic idea of what they can afford before they start house hunting. To establish a price range, they need to find out how much financing they can qualify for. Two ways of doing that:  Prequalifying  Preapproval Assessing the buyers’ circumstances

Assessing Buyers’ Circumstances Prequalifying Informal process that can be done by real estate agent or using online mortgage calculator Prequalifying vs. preapproval

Assessing Buyers’ Circumstances Prequalifying Informal process that can be done by real estate agent or using online mortgage calculator Rough estimate of maximum loan amount Prequalifying vs. preapproval

Assessing Buyers’ Circumstances Prequalifying Informal process that can be done by real estate agent or using online mortgage calculator Rough estimate of maximum loan amount Preapproval Formal process that can be done only by lender (through loan officer or mortgage broker) Prequalifying vs. preapproval

Assessing Buyers’ Circumstances Prequalifying Informal process that can be done by real estate agent or using online mortgage calculator Rough estimate of maximum loan amount Preapproval Formal process that can be done only by lender (through loan officer or mortgage broker) Specific maximum loan amount Prequalifying vs. preapproval

Assessing Buyers’ Circumstances For preapproval, buyers must:  complete a loan application, and  provide documentation of income, assets, debts, and credit history. Prequalifying vs. preapproval

Assessing Buyers’ Circumstances For preapproval, buyers must:  complete a loan application, and  provide documentation of income, assets, debts, and credit history. Lender gives buyers a preapproval letter, agreeing to loan up to a specified amount. Prequalifying vs. preapproval

Assessing Buyers’ Circumstances Advantages of preapproval:  Tool in negotiations with sellers  Streamlines closing process Preapproval now widely used. In active market, seller might not even consider offers from buyers who aren’t preapproved. Prequalifying vs. preapproval

Assessing Buyers’ Circumstances Before preapproval became common, prequalifying was standard practice of real estate agents. Prequalifying is still useful for buyers who aren’t ready to apply for preapproval.  May want to get idea of what’s available and what they can afford. Knowing how to prequalify a buyer can also help agent understand underwriting process. Prequalifying vs. preapproval

Assessing Buyers’ Circumstances Basic steps in prequalifying: 1.Apply income ratios to monthly income to find maximum monthly payment.  Must cover principal, interest, taxes, and insurance (PITI). How to prequalify buyers

Assessing Buyers’ Circumstances Basic steps in prequalifying: 1.Apply income ratios to monthly income to find maximum monthly payment.  Must cover principal, interest, taxes, and insurance (PITI). 2.Subtract percentage (representing property taxes and insurance) from PITI figure to find maximum principal and interest payment. How to prequalify buyers

Assessing Buyers’ Circumstances 3.Use current market interest rate to calculate maximum loan amount based on maximum principal and interest payment. How to prequalify buyers

Assessing Buyers’ Circumstances 3.Use current market interest rate to calculate maximum loan amount based on maximum principal and interest payment. 4.Divide maximum loan amount by LTV ratio to determine ceiling of price range. How to prequalify buyers

Assessing Buyers’ Circumstances While prequalifying can be useful, buyers should be encouraged to get preapproved as soon as possible. Apply to lender or to mortgage broker. Getting preapproved

Assessing Buyers’ Circumstances While prequalifying can be useful, buyers should be encouraged to get preapproved as soon as possible. Apply to lender or to mortgage broker. Ask mortgage broker to obtain preapproval letter issued directly by lender.  Preapproval letter issued by mortgage broker doesn’t actually commit lender. Getting preapproved

Assessing Buyers’ Circumstances Preapproval letter valid only for limited period (such as 30 days). To get preapproval extended, buyers’ information will have to be verified again. Getting preapproved

Summary Preapproval and Choosing a Lender  Prequalifying  Preapproval  Preapproval letter  PITI  Loan originator  Loan officer  Mortgage broker  Referral  Good faith estimate of costs

Loan Costs Primary consideration for most buyers in choosing lender is how much loan will cost.

Loan Costs Primary consideration for most buyers in choosing lender is how much loan will cost. In addition to interest rate, cost of loan may include:  loan origination fee,  discount points,  miscellaneous charges, and  mortgage broker’s fee.

Loan Costs Point = percentage point 1 point = 1% of loan amount Points

Loan Costs Point = percentage point 1 point = 1% of loan amount Usage issue:  Some lenders use “points” to refer to origination fee and discount points together.  Others use “points” to refer only to discount points. Points

Loan Costs Origination fee pays for lender’s expenses, such as staff compensation, facilities costs, and other overhead.  Charged in almost every mortgage transaction.  Typically around 1% of loan amount.  Paid at closing, usually by borrower. Loan origination fee

Loan Costs Discount points are a lump sum paid at closing to increase lender’s upfront yield (profit) on loan.  In exchange for upfront payment, lender charges borrower lower interest rate.  May save borrower money in long run, depending on how long she owns home. Discount points

Loan Costs How many discount points lenders charge varies depending on market conditions and other factors.  Might charge 4 to 6 points for 1% interest rate reduction. Discount points

Loan Costs Example: Market rate for mortgage: 5.25% Lender charges 4 points for 1% rate reduction $300,000 Loan amount x 4% 4 points $12,000 Cost of discount If lender is paid $12,000 up front, will charge borrower only 4.25% interest on loan. Discount points

Loan Costs Discount points may be paid by buyer or seller. Buydown = Paying lender discount points to “buy down” buyer’s interest rate. Discount points

Loan Costs Discount points may be paid by buyer or seller. Buydown = Paying lender discount points to “buy down” buyer’s interest rate. When buyer pays points, pays lender in cash at closing. When seller pays points, amount is withheld from loan amount and deducted from seller’s proceeds at closing. Discount points

Loan Costs In addition to an origination fee and discount points, lenders often charge borrowers other fees, such as:  application fee  document preparation fee  underwriting fee Miscellaneous fees

Loan Costs In addition to an origination fee and discount points, lenders often charge borrowers other fees, such as:  application fee  document preparation fee  underwriting fee These vary widely from one lender to another. Borrower should ask loan originator if any can be reduced or waived. Miscellaneous fees

Loan Costs Buyers working with mortgage broker are generally charged a mortgage broker’s fee. May be separate fee or included in points quote for loan. Mortgage broker’s compensation

Loan Costs Buyers working with mortgage broker are generally charged a mortgage broker’s fee. May be separate fee or included in points quote for loan. Shouldn’t make loan more expensive than one obtained without a broker’s help.  Broker gets loan at wholesale price, marks it up to retail price, keeps overage as fee. Mortgage broker’s compensation

Loan Costs Controversy over another form of mortgage broker compensation: yield spread premium (YSP). Mortgage broker’s compensation

Loan Costs Controversy over another form of mortgage broker compensation: yield spread premium (YSP). Broker persuades borrower to accept a loan at “above par” (higher-than-market) interest rate. Mortgage broker’s compensation

Loan Costs Controversy over another form of mortgage broker compensation: yield spread premium (YSP). Broker persuades borrower to accept a loan at “above par” (higher-than-market) interest rate. Lender pays broker YSP based on difference between market rate and borrower’s rate. Mortgage broker’s compensation

Loan Costs Controversy over another form of mortgage broker compensation: yield spread premium (YSP). Broker persuades borrower to accept a loan at “above par” (higher-than-market) interest rate. Lender pays broker YSP based on difference between market rate and borrower’s rate. Practice gives mortgage brokers incentive to steer borrowers to more expensive loans. Mortgage broker’s compensation

Comparing the Cost of Loans The various fees charged in addition to interest make it hard to compare loans offered by different lenders. Truth in Lending Act (TILA): federal consumer protection law that requires lenders to disclose the cost of a loan using certain figures and terminology, to make comparison easier. Truth in Lending Act

Most important TILA disclosure: annual percentage rate (APR). APR expresses relationship between all of the financing charges and the amount borrowed as a percentage. To determine which of two loans is more expensive, compare APRs, not just interest rates. Annual percentage rate

Truth in Lending Act Another key TILA disclosure: total finance charge. Total finance charge includes:  interest,  origination fee,  discount points paid by borrower,  mortgage broker’s fee,  finder’s fee,  service fee, and/or  mortgage guaranty or insurance fees. Total finance charge

Truth in Lending Act Total finance charge does NOT include:  title insurance costs,  credit report charges,  appraisal fee, or  discount points paid by seller. Total finance charge

Loan Costs Some lenders offer no-fee loans or low-fee loans. No major lender charges such as origination fee or discount points. Only (or almost only) financing charge is interest. Interest rate often much higher than rate for loan with standard fees. Helpful for buyers with little cash for closing. No-fee or low-fee loans

Summary Loan Costs and Financing Options  Origination fee  Discount points  Buydown  Mortgage broker’s fee  Truth in Lending Act  APR  Total finance charge  No-fee or low-fee loan  Home buyer counseling

Applying for a Loan After buyers have chosen a lender, next step is to apply for a loan (or for preapproval). Loan interview: buyers talk with loan originator  in person, on phone, by fax, or online Loan interview

Applying for a Loan After buyers have chosen a lender, next step is to apply for a loan (or for preapproval). Loan interview: buyers talk with loan originator  in person, on phone, by fax, or online Originator helps buyers:  choose best financing option  prepare application Loan interview

Loan Interview During loan interview, originator may enter information into automated underwriting system. System provides preliminary evaluation of what buyers are likely to qualify for.  This does not guarantee preapproval. Prequalifying during interview

Loan Interview Loan originator may require buyers to make a deposit to cover certain expenses. May include:  application fee,  credit report fee, and  other preliminary charges. Deposit

Loan Interview If buyers have already signed purchase agreement, loan originator reviews contract. Main concerns:  terms of financing contingency  closing date Contract and closing date

Applying for a Loan Mortgage lenders almost always use Uniform Residential Loan Application form. Loan application form

Loan Application Form First section of form asks about:  type of loan  loan amount  loan term  interest rate  whether rate is fixed or adjustable  any special amortization arrangement Types and terms of loan

Loan Application Form Second section asks about property:  address  legal description  when house was built Property information and purpose

Loan Application Form Second section asks about property:  address  legal description  when house was built Also asks about purpose of loan:  purchase, construction, refinancing  primary residence, secondary residence, investment property Property information and purpose

Loan Application Form Second section also asks about:  how buyers will take title  source of downpayment and other funds for closing  secondary financing Property information and purpose

Loan Application Form Third section asks for this info about each applicant:  name  social security number  phone number  date of birth  years of schooling  marital status  number and age of any dependents  address or addresses during past two years Borrower/co-borrower information

Loan Application Form Legal for lender to ask about marital status and dependents.  Illegal for lender to use this information in a discriminatory way. Borrower/co-borrower information

Loan Application Form Each applicant must also provide:  name and address of employer  number of years employed at this job  number of years in this line of work  position held and title  type of business  business phone number Employment information

Loan Application Form This section asks about:  primary employment income  overtime, bonuses, or commissions  dividends and interest  net rental income  other sources of income  current rent or mortgage payment Income and monthly housing expense

Loan Application Form Assets may include:  good faith deposit  money in bank  investments  life insurance policy  retirement account  automobile  personal property  real property Assets and liabilities

Loan Application Form Liabilities may include:  student loan  car loan  real estate loan  other installment loan  charge accounts  credit cards  alimony/child support  job-related expenses Assets and liabilities

Loan Application Form Application also asks for information about transaction, including:  purchase price  cost of alterations/improvements  cost of land  prepaid expenses  closing costs Details of transaction

Loan Application Form Applicants must answer questions about:  outstanding judgments  bankruptcies  foreclosures or deeds in lieu  lawsuits  alimony/child support  citizenship Declarations

Loan Application Form Applicants also must state:  whether any portion of downpayment was borrowed  whether property is to be primary residence  whether they have owned any other property in last three years Declarations

Loan Application Form Applicants agree to several provisions regarding application and loan by signing and dating form.  For example, they agree to correct or update information on application if necessary. Acknowledgement and agreement

Loan Application Form Form also has optional questions regarding applicants’ ethnicity, race, and sex. Used by federal government to assess lender’s compliance with fair lending laws. Information for government monitoring

Loan Application Form Last page of application form is for applicants to use if they need more room to answer any of form’s questions. Continuation sheet

Loan Application Form Real estate agent should let buyers know what information they need to collect for loan application. Application checklist

Applying for a Loan Two federal laws require lenders to disclose information to loan applicants: Federal disclosure requirements

Applying for a Loan Two federal laws require lenders to disclose information to loan applicants: Truth in Lending Act (TILA)  APR, total finance charge, lender’s charges Federal disclosure requirements

Applying for a Loan Two federal laws require lenders to disclose information to loan applicants: Truth in Lending Act (TILA)  APR, total finance charge, lender’s charges Real Estate Settlement Procedures Act (RESPA)  Good faith estimate of closing costs  Booklet about closing process  Mortgage servicing disclosure Federal disclosure requirements

Applying for a Loan Lenders must provide all of these within three business days after loan application is submitted.  Disclosures not required if application rejected before three-day deadline.  If any costs change, new disclosures must be made before closing. Federal disclosure requirements

Applying for a Loan Buyers should ask loan originator about locking in the interest rate. Lock-in = lender guarantees certain interest rate for specified period. Float = interest rate will move up or down with market interest rates until closing. Locking in the interest rate

Applying for a Loan If interest rate not locked in, sharp increase in rates might increase monthly payment so much that buyers no longer qualify. Locking in the interest rate

Applying for a Loan If interest rate not locked in, sharp increase in rates might increase monthly payment so much that buyers no longer qualify. Terms of lock-in agreement should be in writing. Locking in the interest rate

Locking in the Interest Rate Lock-in agreement should state how long the rate will be locked in. Lock-in period should extend beyond expected loan processing time. Some lenders provide free automatic extension if closing delayed. Lock-in period

Locking in the Interest Rate Lender may charge fee to lock in rate. If loan approved, fee usually applied to closing costs. If application rejected, fee usually refunded. Lock-in fee

Locking in the Interest Rate If market interest rates are more likely to go down than up, doesn’t make sense to lock rate. Lender can usually charge locked-in rate even if market rates have gone down. Rate decreases

Summary Applying for a Loan  Uniform Residential Loan Application form  Real Estate Settlement Procedures Act  Good faith estimate of closing costs  Rate lock-in  Float

Application Processing After application form filled out: verification forms sent to applicants’ employers and banks; credit reports and credit scores obtained; and if buyers have entered into a purchase agreement:  appraisal ordered  title report ordered

Application Processing After verification forms returned and reports received, loan processor puts together loan package and sends it to underwriting department.

The Underwriting Decision Underwriter carefully reviews loan package and applies appropriate qualifying standards to buyers.  May use automated underwriting system to perform these steps.

The Underwriting Decision Underwriter carefully reviews loan package and applies appropriate qualifying standards to buyers.  May use automated underwriting system to perform these steps.  Loan is:  approved,  rejected, or  approved subject to conditions.

The Underwriting Decision If loan denied, lender must provide explanation.  Written statement within 30 days. Rejection

The Underwriting Decision If loan denied, lender must provide explanation.  Written statement within 30 days. Buyers may want to:  apply to different lender  apply for different type of loan  wait and take steps to improve finances Rejection

The Underwriting Decision Conditional commitment commits lender to making loan if buyers:  fulfill specified conditions, and/or  submit additional documentation. Conditional commitment

The Underwriting Decision Preapproval is a form of conditional commitment. Approval contingent on:  satisfactory appraisal  satisfactory title report Preapproval letter

The Underwriting Decision Preapproval letter states that lender will loan buyers up to a specified amount to buy a house.  Expires at end of specified period.  Lender may agree to extension if buyers’ information reverified. Preapproval letter

The Underwriting Decision When all conditions for approval are satisfied, lender issues final commitment letter.  Confirms loan terms.  Has expiration date. Final commitment

Closing the Loan Last stage of financing process coordinated with closing of property sale. In many areas, closings are handled through escrow. Escrow: neutral third party holds money and documents for buyer and seller until transaction ready to close. Escrow

Closing the Loan Closing agent (escrow agent): makes sure all requirements are taken care of before closing date, and disburses purchase price and delivers deed when conditions in purchase agreement are satisfied. Closing agent

Closing the Loan Closing agent may be:  independent escrow agent  employee of lender  title company  lawyer  real estate broker Closing agent

Closing the Loan  Clearing and insuring title  Inspections and repairs  Loan documents issued and signed  Funding the loan  Preparing settlement statements  Recording documents  Disbursing funds Steps in closing process

Steps in Closing Process Any liens that would have higher priority than new mortgage or deed of trust must be removed.  Doesn’t include property tax or special assessment liens. Clearing and insuring title

Steps in Closing Process Any liens that would have higher priority than new mortgage or deed of trust must be removed.  Doesn’t include property tax or special assessment liens. To remove lien: seller pays amount owed release obtained and recorded Clearing and insuring title

Steps in Closing Process Lender will require extended coverage title insurance policy to protect lien priority.  Usually paid for by buyer. Clearing and insuring title

Steps in Closing Process Lender may require inspections or tests, such as:  pest control inspection  soil percolation test  flood hazard inspection Inspections and repairs

Steps in Closing Process Lender may require inspections or tests, such as:  pest control inspection  soil percolation test  flood hazard inspection Based on inspection report, lender decides whether to require repairs or other corrective steps.  May or may not have to be completed by closing date. Inspections and repairs

Steps in Closing Process Once loan has been approved, lender forwards loan documents to closing agent. Buyer: deposits funds required for closing (such as downpayment, closing costs) into escrow, and signs loan documents. Loan documents and buyer’s funds

Steps in Closing Process Lender often requires buyer to make a deposit into an impound account at closing. Impound account

Steps in Closing Process Lender often requires buyer to make a deposit into an impound account at closing. Impound account ensures taxes and insurance will be paid on time.  Portion of buyer’s monthly payment goes into impound account.  Lender pays taxes and insurance out of account when due. Impound account

Steps in Closing Process Lender often requires buyer to make a deposit into an impound account at closing. Impound account ensures taxes and insurance will be paid on time.  Portion of buyer’s monthly payment goes into impound account.  Lender pays taxes and insurance out of account when due. Illegal to require deposit of more than two months of impounds at closing. Impound account

Steps in Closing Process Buyer will also pay interim interest (prepaid interest) at closing. Interim interest

Steps in Closing Process Buyer will also pay interim interest (prepaid interest) at closing. Interim interest necessary because: 1. Buyer’s first payment is not due on first day of month immediately after closing.  Instead, due first day of month after that. Interim interest

Steps in Closing Process Buyer will also pay interim interest (prepaid interest) at closing. Interim interest necessary because: 1. Buyer’s first payment is not due on first day of month immediately after closing.  Instead, due first day of month after that. 2. Mortgage interest paid in arrears, after it accrues.  Monthly payment includes the interest that accrued during previous month. Interim interest

Steps in Closing Process Example: Closing date is January 23. First mortgage payment will be due March 1.  No mortgage payment due February 1. Interim interest

Steps in Closing Process Example: Closing date is January 23. First mortgage payment will be due March 1.  No mortgage payment due February 1. But interest begins accruing on closing date. Interim interest

Steps in Closing Process Example: Closing date is January 23. First mortgage payment will be due March 1.  No mortgage payment due February 1. But interest begins accruing on closing date.  March 1 payment will cover interest that accrues during February. Interim interest

Steps in Closing Process Example: Closing date is January 23. First mortgage payment will be due March 1.  No mortgage payment due February 1. But interest begins accruing on closing date.  March 1 payment will cover interest that accrues during February.  But won’t cover interest accruing from January 23 to January 31. Interim interest

Steps in Closing Process Example: Closing date is January 23. First mortgage payment will be due March 1.  No mortgage payment due February 1. But interest begins accruing on closing date.  March 1 payment will cover interest that accrues during February.  But won’t cover interest accruing from January 23 to January 31. Interim interest payment at closing covers those 9 days. Interim interest

Steps in Closing Process Funding the loan: When lender releases buyer’s loan funds to closing agent. Loan funded only after:  buyer signs loan documents,  lender reverifies buyer’s employment and other information, and  any other conditions imposed by lender have been satisfied. Funding the loan

Steps in Closing Process Closing agent prepares final settlement statements for buyer and seller.  Itemizes charges and credits for each party. Settlement statements

Steps in Closing Process Closing agent prepares final settlement statements for buyer and seller.  Itemizes charges and credits for each party. To comply with RESPA, closing agent must:  use Uniform Settlement Statement form, and  allow buyer to review statement at least one day before closing, if buyer asks to. Settlement statements

Steps in Closing Process Closing agent:  records deed, mortgage or deed of trust, lien releases, and other documents;  disburses funds to appropriate parties. Title company issues policies. Lender gives buyer copy of loan documents in final form. Buyer gives lender copy of hazard insurance policy. Final steps

Summary Application Processing and Closing  Loan package  Rejection  Conditional commitment  Preapproval letter  Final commitment  Closing agent  Escrow  Interim interest  Impound account  Funding the loan