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

© 2012 Rockwell Publishing Introduction This lesson will cover: conforming and nonconforming loans characteristics of conventional loans qualifying standards making conventional loans more affordable

© 2012 Rockwell Publishing Introduction Loans made by mortgage lenders can be divided into two main categories: conventional loans government-sponsored loans

© 2012 Rockwell Publishing Introduction Conventional loan: any institutional loan that isn’t insured or guaranteed by government agency.

© 2012 Rockwell Publishing Conforming & Nonconforming Loans Most conventional loans comply with underwriting guidelines set by Fannie Mae and Freddie Mac. Conforming loan: complies with those guidelines. Nonconforming loan: doesn’t comply.

© 2012 Rockwell Publishing Conventional Loan Characteristics Fannie Mae/Freddie Mac underwriting guidelines: widely followed in mortgage industry lenders want to be able to sell loans on secondary market many of the rules covered here are based on Fannie/Freddie guidelines

© 2012 Rockwell Publishing Topics: property types and owner-occupancy loan amounts repayment periods and amortization loan-to-value ratios risk-based loan fees private mortgage insurance secondary financing Conventional Loan Characteristics

© 2012 Rockwell Publishing Fannie Mae and Freddie Mac buy loans secured by residential property, including: detached site-built houses townhouses condominium units cooperative units manufactured homes Property types and owner-occupancy Conventional Loan Characteristics

© 2012 Rockwell Publishing Borrowers may intend to occupy property as: principal residence second home Fannie Mae/Freddie Mac also willing to purchase investor loan: borrower purchasing property doesn’t intend to occupy it. Property types and owner-occupancy Conventional Loan Characteristics

© 2012 Rockwell Publishing Conventional loan may be secured by: Principal residence Up to 4 dwelling units Second home No more than 1 dwelling unit Investment property Up to 4 dwelling units Property types and owner-occupancy Conventional Loan Characteristics

© 2012 Rockwell Publishing Conforming loan limits: set annually by Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac. Agencies won’t buy loan that exceeds limits. Loan limits vary based on area median home prices, and whether loan is for one-, two-, three-, or four-unit dwelling. Loan amounts Conventional Loan Characteristics

© 2012 Rockwell Publishing 2011 conforming loan limits for one-unit dwellings: in most areas: $417,000 in high-cost areas: based on area median house price, up to a maximum of $625,500 higher limits for Alaska, Hawaii, Guam, and Virgin Islands Loan amounts Conventional Loan Characteristics

© 2012 Rockwell Publishing Jumbo loan: exceeds conforming loan limit. Have higher interest rates and loan fees than conforming loans. Underwritten using stricter standards. Loan amounts Conventional Loan Characteristics

© 2012 Rockwell Publishing Repayment periods can range from 10 to 40 years. 30-year loans are standard. 15-year loans also popular. Repayment periods Conventional Loan Characteristics

© 2012 Rockwell Publishing Standard conventional loan is fully amortized. Partially amortized and interest-only loans also available. Amortization Conventional Loan Characteristics

© 2012 Rockwell Publishing Traditional standard conventional LTV: 80%. Loans with LTVs up to 95% also available. During subprime boom, higher LTVs were available: 97% or even 100%. Now uncommon. Loans with LTVs of 90% or 95% also harder to get. Loan-to-value ratios Conventional Loan Characteristics

© 2012 Rockwell Publishing Conventional loans may be categorized by LTV ratio. Different underwriting rules applied to each category. Fannie Mae and Freddie Mac: LTV over 80% must have private mortgage insurance. Loan-to-value ratios Conventional Loan Characteristics

© 2012 Rockwell Publishing High-LTV loans also usually have: higher interest rates and fees, and stricter underwriting rules. Loan-to-value ratios Conventional Loan Characteristics

© 2012 Rockwell Publishing If there are other mortgages against property, lender will be concerned with the combined loan-to-value ratio (CLTV). Should not exceed usual LTV limit, but in some cases a higher CLTV allowed. Combined loan-to-value ratios Conventional Loan Characteristics

© 2012 Rockwell Publishing Loan-level price adjustments (LLPAs): risk- based loan fees. Required by Fannie Mae and Freddie Mac of most borrowers. Shift some of risk (cost) of mortgage defaults onto borrowers. Riskier loans usually equal higher LLPAs. Risk-based loan fees Conventional Loan Characteristics

© 2012 Rockwell Publishing LLPA varies based on borrower’s credit score and LTV ratio. Borrower with 650 credit score and 80% LTV might be charged 3% LLPA. But borrower with 710 credit score and 90% LTV might be charged only 1%. Additional LLPAs may be charged if loan is riskier (ARM, investor loan, interest-only loan) Risk-based loan fees Conventional Loan Characteristics

© 2012 Rockwell Publishing Adverse market delivery charge:* flat fee levied by Fannie Mae and Freddie Mac on every borrower. Purpose: help agencies recover losses caused by poor market conditions. *Called market condition delivery fee by Freddie Mac. Risk-based loan fees Conventional Loan Characteristics

© 2012 Rockwell Publishing Private mortgage insurance (PMI): helps protect lenders from risk of high-LTV loans. Required for conventional loans if LTV over 80%. Makes up for reduced borrower equity. Private mortgage insurance Conventional Loan Characteristics

© 2012 Rockwell Publishing Private Mortgage Insurance Private mortgage insurance company assumes only portion of risk of default and foreclosure loss. PMI covers upper portion of loan. Typically 25% to 30% of loan amount. How PMI works

© 2012 Rockwell Publishing Private Mortgage Insurance In event of default and foreclosure, lender, at insurer’s option, will either: sell property and make claim for reimbursement of losses up to policy amount, or relinquish property to insurer, and make claim for actual losses. How PMI works

© 2012 Rockwell Publishing Private Mortgage Insurance Insurers have own underwriting standards, which have been influential in mortgage industry. How PMI works

© 2012 Rockwell Publishing Private Mortgage Insurance Mortgage insurance company charges risk- based premiums for coverage. Variety of payment plans include: flat monthly premium initial premium at closing, plus renewal premiums financed one-time premium PMI premiums

© 2012 Rockwell Publishing Private Mortgage Insurance PMI premiums are currently tax-deductible. No deduction if family income is over $109,000. Deductibility set to expire end of Deductibility of PMI premiums

© 2012 Rockwell Publishing Private Mortgage Insurance Under Federal Homeowners Protection Act, lenders must cancel loan’s PMI when: loan has been paid down to 80% of property’s original value (upon borrower request); or loan reaches 78% of property’s original value (automatic cancellation). Applies only to loans on single-family dwellings occupied as primary residence. Cancellation of PMI

© 2012 Rockwell Publishing Secondary Financing Lenders generally allow secondary financing in conjunction with conventional loan. Most impose some restrictions to minimize increased risk of default on primary loan.

© 2012 Rockwell Publishing Secondary Financing Examples of restrictions lenders may impose: Borrower must qualify for payments on both first and second mortgages. Borrower must make 5% downpayment. Scheduled payments due on regular basis. Restrictions

© 2012 Rockwell Publishing Secondary Financing Restrictions Second mortgage can’t require balloon payment less than 5 years after closing. If first mortgage has variable payments, second mortgage must have fixed payments. No negative amortization. No prepayment penalty.

© 2012 Rockwell Publishing Secondary Financing Secondary financing is sometimes referred to as a piggyback loan, especially when it is used to either: avoid paying private mortgage insurance, or avoid jumbo loan treatment. Piggyback loans

© 2012 Rockwell Publishing Secondary Financing With piggyback loan, LTV of primary loan isn’t over 80%. So PMI requirement doesn’t apply. With piggyback loan, loan amount for primary loan doesn’t exceed conforming loan limit. So higher costs and stricter rules for jumbo loans don’t apply. Piggyback loans

© 2012 Rockwell Publishing Secondary Financing Popular during subprime boom, no longer widely used. Advantages of piggybacking reduced by: tax deductibility of PMI premiums loan-level price adjustments imposed on secondary financing Piggyback loans

© 2012 Rockwell Publishing Summary Conventional Loan Characteristics Conventional loan Conforming loan Nonconforming loan Conforming loan limits Jumbo loan Loan-level price adjustment (LLPA) Adverse market delivery charge PMI Piggyback loan

© 2012 Rockwell Publishing Conventional Qualifying Standards Fannie Mae and Freddie Mac have changed how they evaluate creditworthiness of applicants. Newer methods influenced by automated underwriting systems, computer analysis. Evaluating risk factors

© 2012 Rockwell Publishing Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors. Two primary risk factors: applicant’s credit reputation, and loan-to-value ratio. Based on these, loans ranked as low, moderate, or high primary risk. Evaluating risk factors Conventional Qualifying Standards

© 2012 Rockwell Publishing Contributory risk factors: other aspects of application, such as debt to income ratio and cash reserves. Factor assigned value based on whether it: satisfies basic risk tolerances increases risk decreases risk Evaluating risk factors Conventional Qualifying Standards

© 2012 Rockwell Publishing Freddie Mac’s underwriting guidelines: separate evaluation: credit reputation, income, net worth consider overall layering of risk weakness in one component can be outweighed by strength in another Evaluating risk factors Conventional Qualifying Standards

© 2012 Rockwell Publishing Fannie Mae’s approach vs. Freddie Mac’s approach: mainly difference in terminology. Both agencies consider borrower’s overall financial picture, with positive factors offsetting negative ones, and vice versa. Evaluating risk factors Conventional Qualifying Standards

© 2012 Rockwell Publishing Credit scores central factor in conventional underwriting. Excellent score can offset weaknesses in other aspects of application. Poor score may doom application. Fannie Mae and Freddie Mac won’t buy loan if borrower’s score is under 620. Credit reputation Conventional Qualifying Standards

© 2012 Rockwell Publishing Credit scores from three main credit bureaus usually vary somewhat for given borrower. Credit score used for underwriting (representative credit score) is: lower of two scores, or middle of three scores. Credit reputation Conventional Qualifying Standards

© 2012 Rockwell Publishing When two people apply for loan together: lowest representative credit score used for underwriting not average Credit reputation Conventional Qualifying Standards

© 2012 Rockwell Publishing Stable monthly income: meets lender’s tests of quality, durability. Durable income: income that is expected to continue for at least 3 years after loan is made. Income analysis Conventional Qualifying Standards

© 2012 Rockwell Publishing Income Analysis Lenders consider income adequate for conventional loan if total monthly obligations don’t exceed 36% of stable monthly income. Total monthly obligations: proposed housing expense other recurring obligations Total debt to income ratio

© 2012 Rockwell Publishing Income Analysis Housing expense includes PITI: principal interest property taxes hazard insurance special assessments, mortgage insurance, homeowners association dues (if applicable) Total debt to income ratio

© 2012 Rockwell Publishing Income Analysis Total monthly obligation includes recurring debts. Installment debts: fixed beginning, ending date (car loan). Revolving debts: open-ended line of credit with minimum monthly payments (credit cards). Other: alimony, child support. Total debt to income ratio

© 2012 Rockwell Publishing Income Analysis Housing expense to income ratio: proposed housing expense should not exceed 28% of stable monthly income less important than total debt to income ratio Fannie Mae no longer uses Housing expense to income ratio

© 2012 Rockwell Publishing Income Analysis Fannie Mae and Freddie Mac allow income ratios to exceed benchmarks if compensating factors such as: large downpayment substantial net worth demonstrated ability to incur few debts and accumulate savings Compensating factors

© 2012 Rockwell Publishing Income Analysis Even with compensating factors, income ratios shouldn’t exceed benchmarks by too much. For manually underwritten loan, Fannie Mae and Freddie Mac won’t accept total debt to income ratio over 45%. No set maximum for loan evaluated by automated underwriting system. Compensating factors

© 2012 Rockwell Publishing Income Analysis Some applications have factors that pose increased risk to lender. Lenders may apply stricter standards to high-LTV loans. Many lenders won’t accept high total debt to income ratio if LTV over 90%. Factors that increase risk

© 2012 Rockwell Publishing Income Analysis ARMs need careful underwriting to ensure borrower can handle rate and payment increases. ARM borrower should have: strong potential for increased earnings, significant liquid assets, or demonstrated ability to manage finances. ARMs

© 2012 Rockwell Publishing General rule: conventional borrower should have at least 2 months of mortgage payments in reserve after closing smaller amount will weaken loan application Available funds – reserves Conventional Qualifying Standards

© 2012 Rockwell Publishing Available Funds Fannie Mae and Freddie Mac set limits on use of gift funds. Donor must be: borrower’s relative, fiancé, or domestic partner borrower’s employer municipality nonprofit religious or community organization Gift funds

© 2012 Rockwell Publishing Available Funds Borrower may be required to make a downpayment of at least 5% of sales price out of her own resources. Rule doesn’t apply if LTV is 80% or less. Gift funds

© 2012 Rockwell Publishing Summary Conventional Qualifying Standards Comprehensive risk assessment Primary risk factors Contributory risk factors Overall layering of risk Representative credit score Total debt to income ratio Housing expense to income ratio Compensating factors Reserves Gift funds

© 2012 Rockwell Publishing Making Loans More Affordable Variety of alternatives are available with conventional financing: buydowns loans with lower initial payments low-downpayment programs accelerated payment plans

© 2012 Rockwell Publishing Making Loans More Affordable Buydown: seller or third party pays lender lump sum at closing to lower interest rate on buyer’s loan. Increases lender’s upfront yield. Lowers buyer’s monthly payment. Lowers interest rate. Buydowns

© 2012 Rockwell Publishing Buydowns Buydown can be permanent or temporary. Permanent buydown: borrower pays lower interest rate for entire loan term. Temporary buydown: borrower pays lower interest rate for first few years of term. Buydown plans

© 2012 Rockwell Publishing Buydowns Permanent buydown: reduces note rate (rate stated in promissory note) cost calculated in terms of points (percentage of loan amount) Permanent buydowns

© 2012 Rockwell Publishing Buydowns Two types of temporary buydown plans: level payment plans graduated payment plans Temporary buydowns

© 2012 Rockwell Publishing Buydowns Level payment plan: calls for interest rate reduction that stays same throughout buydown period. Graduated payment plan: calls for largest payment reduction in first year, progressively smaller reductions each remaining year. Temporary buydowns

© 2012 Rockwell Publishing Buydowns Permanent buydown: lender qualifies buyer at bought-down interest rate. Temporary buydown: depends on program, but borrower may be qualified based on the greater of: note rate or note rate + percentage, or fully indexed rate. Buydowns and qualifying rules

© 2012 Rockwell Publishing Buydowns Fannie Mae and Freddie Mac limit amount of buydown to percentage of sales price or appraised value, whichever is less. LTV > 90%: 3% limit LTV > 75% but < 90%: 6% limit LTV ≤ 75%: 9% limit Amount over limit is deducted from sales price before calculating maximum loan amount. Limits on buydowns

© 2012 Rockwell Publishing Buydowns Limits also apply to other contributions from seller or another interested party, such as real estate agent or builder. But usually don’t apply to someone not in transaction, such as employer or family member. Limits on buydowns

© 2012 Rockwell Publishing Making Loans More Affordable Loans with lower initial payments appeal to buyers who expect income to increase steadily: two-step mortgages balloon/reset mortgages interest-only mortgages Loans with lower initial payments

© 2012 Rockwell Publishing Loans with Lower Initial Payments Characteristics of two-step mortgages: 30-year term lender can adjust interest rate once during loan term two common types: 5/25 and 7/23 Interest rate cap applies to adjustment. Two-step mortgages

© 2012 Rockwell Publishing Characteristics of balloon/reset mortgages: two types: 5/25 and 7/23 payment amounts based on 30-year amortization schedule but loan is partially amortized, with balloon payment of entire balance due at end of initial 5- or 7-year period at end of initial period, borrower may be allowed to reset loan Balloon/reset mortgages Loans with Lower Initial Payments

© 2012 Rockwell Publishing Under reset option: reset loan remains in place interest rate is set at current market rate rate and payment amount are level for remaining 25 or 23 years borrower avoids refinancing charges Balloon/reset mortgages Loans with Lower Initial Payments

© 2012 Rockwell Publishing Borrower not allowed to reset if: payments aren’t current, or other liens have attached to property. Borrower will have to refinance or sell property to make balloon payment. Balloon/reset mortgages Loans with Lower Initial Payments

© 2012 Rockwell Publishing Characteristics of interest-only mortgage: 30-year loan term interest-only payments during specified period at beginning of loan term at end of interest-only period, payments fully amortized over remainder of loan term Risk of payment shock: monthly payment likely to rise sharply. Interest-only mortgages Loans with Lower Initial Payments

© 2012 Rockwell Publishing Fannie Mae and Freddie Mac: will buy fixed-rate loans with interest-only periods ranging from 10 to 15 years won’t buy interest-only ARMs unless initial fixed-rate period is three years or more won’t buy interest-only balloon/reset loans or interest-only cash-out refinance loans Interest-only mortgages Loans with Lower Initial Payments

© 2012 Rockwell Publishing Summary Buydowns & Low Initial Payment Loans Permanent buydown Temporary buydown Level payments Graduated payments Qualifying rate Contribution limits Two-step mortgages Balloon/reset mortgages Interest-only mortgages

© 2012 Rockwell Publishing Making Loans More Affordable Secondary market agencies have developed low-downpayment programs for first-time buyers and others who tend not to have much money saved. Low-downpayment programs

© 2012 Rockwell Publishing Low-Downpayment Programs Examples of low-downpayment programs: Loan with 95% LTV and: 3% downpayment from borrower’s funds 2% downpayment from alternative sources Loan with 97% LTV and: 3% downpayment from borrower’s funds 3% contribution to closing costs from alternative sources LTVs and downpayment rules

© 2012 Rockwell Publishing Low-Downpayment Programs Allowable alternative sources of funds may include gifts, grants, or unsecured loans from: relative employer public agency nonprofit organization private foundation Alternative sources of funds

© 2012 Rockwell Publishing Low-Downpayment Programs Many low-downpayment programs are targeted at low- and moderate-income buyers. Buyers qualify if stable monthly income doesn’t exceed median income of area. Debt to income ratio rules are relaxed. Income limit may be waived for buyers purchasing homes in low-income or rundown neighborhoods. Affordable housing programs

© 2012 Rockwell Publishing Low-Downpayment Programs Other low-downpayment programs are offered to specific groups such as: teachers police officers firefighters Affordable housing programs

© 2012 Rockwell Publishing Making Loans More Affordable Accelerated payment plan allows borrower to repay loan in shorter period than stated term. Pays less interest over life of loan. Builds equity faster. Accelerated payment plans

© 2012 Rockwell Publishing Making Loans More Affordable Loans with accelerated payment plans include: biweekly mortgages growing equity mortgages (GEMs) Accelerated payment plans

© 2012 Rockwell Publishing Accelerated Payment Plans Characteristics of biweekly mortgage: interest rate and payment amount fixed payments made every two weeks (26 per year) each payment equal to half of monthly payment for 30-year, fully amortized, fixed-rate loan loan paid off in years Biweekly mortgages

© 2012 Rockwell Publishing Accelerated Payment Plans Characteristics of GEM: interest rate fixed over life of loan loan must be paid off in 15 years or less first-year payments of principal and interest based on 15- or 30-year term payments increase at specified intervals for all or part of loan term 100% of payment increase goes to reduce principal balance Growing equity mortgages

© 2012 Rockwell Publishing Summary Low Downpayment & Accelerated Plans Low-downpayment programs Affordable housing programs Alternative sources of funds Accelerated payment plans Biweekly mortgages Growing equity mortgages