1. Financing Residential Real Estate Lesson 10: Conventional Financing

2. Introduction In this lesson we will cover: conforming and nonconforming loans, characteristics of conventional loans, qualifying standards for conventional loans, and special programs and payment plans.

3. Introduction Loans made by mortgage lenders can be divided into two main categories:  conventional loans  government-sponsored loans

4. Introduction Conventional loan Any institutional loan that isn’t insured or guaranteed by a government agency.

5. 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.

6. Conventional Loan Characteristics Fannie Mae/Freddie Mac underwriting guidelines are widely followed in the mortgage industry because lenders want to be able to sell their loans on secondary market. Many of the rules covered here are based on their guidelines.

7. Conventional Loan Characteristics Topics:  Property types and owner-occupancy  Loan amounts  Repayment periods  Amortization  Loan-to-value ratios  Risk-based loan fees  Private mortgage insurance  Secondary financing

8. Conventional Loan Characteristics Fannie Mae and Freddie Mac buy loans secured by residential property:  detached site-built houses  townhouses  condominium units  cooperative units  manufactured homes Property types and owner-occupancy

9. Conventional Loan Characteristics Fannie Mae and Freddie Mac don’t require owner- occupancy, but different (generally stricter) underwriting rules apply to investor loans. Investor loan: Borrower purchasing property doesn’t intend to occupy it. Property types and owner-occupancy

10. Conventional Loan Characteristics 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

11. Conventional Loan Characteristics Conforming loan limits are set annually by Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac.  If loan amount exceeds applicable limit, the agencies won’t purchase the loan.  Different loan limits for different areas, based on area median home prices.  Different limits for one-, two-, three-, and four-unit dwellings. Loan amounts

12. Conventional Loan Characteristics 2009 conforming loan limits for one-unit dwellings In most areas: $417,000 In high-cost areas: 125% of area median house price, up to a maximum of $729,750. Higher limits for Alaska, Hawaii, Guam, and Virgin Islands. Loan amounts

13. Conventional Loan Characteristics Loan that exceeds conforming loan limit is called a jumbo loan. Typically, jumbo loans:  have higher interest rates and loan fees than conforming loans, and  are underwritten using stricter standards. For example, lower maximum LTV, higher credit score requirements. Loan amounts

14. Conventional Loan Characteristics Repayment periods can range from 10 to 40 years.  30-year loans are standard.  15-year loans also popular. Repayment periods

15. Conventional Loan Characteristics Standard conventional loan is fully amortized.  Partially amortized and interest-only loans also available. Amortization

16. Conventional Loan Characteristics 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.  Also, loans with LTVs of 90% or 95% are less easily obtained than they were a few years ago. Loan-to-value ratios

17. Conventional Loan Characteristics Conventional loans may be categorized by LTV ratio, with different underwriting rules applied to each category. Fannie Mae and Freddie Mac require any conventional loan with LTV over 80% to have private mortgage insurance. Loan-to-value ratios

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

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

20. Conventional Loan Characteristics Fannie Mae and Freddie Mac require most borrowers to pay risk-based loan fees called loan-level price adjustments (LLPAs). Risk-based loan fees

21. Conventional Loan Characteristics Loan-level price adjustments shift some of the risk (cost) of mortgage defaults onto borrowers. Generally, the riskier the loan, the more the borrower will have to pay in LLPAs. Risk-based loan fees

22. Conventional Loan Characteristics Nearly all loans sold to Fannie Mae and Freddie Mac are subject to an LLPA that varies based on borrower’s credit score and loan-to-value ratio. Example: Borrower with 650 credit score and 80% LTV might be charged LLPA of 2.75% of loan amount. But borrower with 710 credit score and 90% LTV might be charged only 0.5%. Risk-based loan fees

23. Conventional Loan Characteristics One or more additional LLPAs may be charged because loan is ARM, investor loan, interest-only loan, or some other relatively risky type of loan. Fannie Mae and Freddie Mac also levy a flat fee called an adverse market delivery charge on every borrower to help agencies recover losses caused by poor market conditions. Risk-based loan fees

24. Conventional Loan Characteristics Private mortgage insurance (PMI) helps protect lenders from risk of high-LTV loans. Required for convention loans if LTV over 80%. Makes up for reduced borrower equity. Private mortgage insurance

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

26. Private Mortgage Insurance Upon default and foreclosure, lender makes claim for reimbursement of actual losses.  Or may relinquish property to insurer. How PMI works

27. Private Mortgage Insurance Insurers have own underwriting standards, which have been influential in mortgage industry. How PMI works

28. Private Mortgage Insurance Mortgage insurance company charges risk-based premiums for coverage. Variety of payment plans, including:  flat monthly premium;  initial premium at closing, plus renewal premiums; or  financed one-time premium. PMI premiums

29. Private Mortgage Insurance With some plans, borrower who pays off loan early is entitled to partial refund of initial premium or financed one-time premium. But plans that don’t provide for refunds are less expensive. PMI premiums

30. Private Mortgage Insurance PMI premiums are currently tax-deductible.  No deduction if family income is over $109,000. Deductibility set to expire in 2010. Deductibility of PMI premiums

31. Private Mortgage Insurance Under federal Homeowners Protection Act, lenders must cancel loan’s PMI under certain conditions: 1.once loan has been paid down to 80% of property’s original value (upon borrower request); or 2.once loan reaches 78% of property’s original value (automatic cancellation). Cancellation of PMI

32. Private Mortgage Insurance Homeowners Protection Act applies only to loans on single-family dwellings occupied as borrower’s primary residence. Depending on payment plan, cancellation of PMI may reduce monthly mortgage payment. Cancellation of PMI

33. Secondary Financing Lenders generally allow secondary financing in conjunction with a conventional loan. Most impose some restrictions to minimize increased risk that borrower will default on primary loan.

34. Secondary Financing Examples of restrictions lenders may impose: 1.Borrower must qualify for payments on both first and second mortgages. Restrictions

35. Secondary Financing Examples of restrictions lenders may impose: 1.Borrower must qualify for payments on both first and second mortgages. 2.Borrower must make 5% downpayment. Restrictions

36. Secondary Financing Examples of restrictions lenders may impose: 1.Borrower must qualify for payments on both first and second mortgages. 2.Borrower must make 5% downpayment. 3.Scheduled payments must be due on regular basis. Restrictions

37. Secondary Financing Restrictions 4.Second mortgage can’t require balloon payment less than 5 years after closing.

38. Secondary Financing Restrictions 4.Second mortgage can’t require balloon payment less than 5 years after closing. 5.If first mortgage has variable payments, second mortgage must have fixed payments.

39. Secondary Financing Restrictions 4.Second mortgage can’t require balloon payment less than 5 years after closing. 5.If first mortgage has variable payments, second mortgage must have fixed payments. 6.No negative amortization.

40. Secondary Financing Restrictions 4.Second mortgage can’t require balloon payment less than 5 years after closing. 5.If first mortgage has variable payments, second mortgage must have fixed payments. 6.No negative amortization. 7.No prepayment penalty.

41. 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

42. 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

43. Secondary Financing Piggybacking was popular during subprime boom, but is no longer widely used. Advantages of piggybacking reduced by:  tax deductibility of PMI premiums  loan-level price adjustments imposed on secondary financing Piggyback loans

44. 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

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

46. Conventional Qualifying Standards Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors. Two primary risk factors:  applicant’s credit reputation, and  the loan-to-value ratio. Evaluating risk factors

47. Conventional Qualifying Standards Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors. Two primary risk factors:  applicant’s credit reputation, and  the loan-to-value ratio. Loans ranked as low, moderate, or high primary risk. Evaluating risk factors

48. Conventional Qualifying Standards Fannie Mae treats other aspects of application, such as debt to income ratio and cash reserves, as contributory risk factors. Each factor assigned value depending on whether it:  satisfies basic risk tolerances,  increases risk, or  decreases risk. Evaluating risk factors

49. Conventional Qualifying Standards Freddie Mac’s underwriting guidelines call for separate evaluation of each component of creditworthiness: credit reputation, income, net worth. Underwriter then considers overall layering of risk.  Weakness in one component can be outweighed by strength in another. Evaluating risk factors

50. Conventional Qualifying Standards Difference between Fannie Mae’s approach and Freddie Mac’s approach is mainly a difference in terminology. Both agencies consider the borrower’s overall financial picture, with positive factors offsetting negative ones and vice versa. Evaluating risk factors

51. Conventional Qualifying Standards Credit scores have become a central factor in conventional underwriting. Excellent score can offset weaknesses in other aspects of application. Poor score may doom application.  For instance, Fannie Mae won’t buy a loan if borrower’s score is under 580. Credit reputation

52. Conventional Qualifying Standards Credit scores from the three main credit bureaus usually vary somewhat for a given borrower. Under Fannie Mae and Freddie Mac rules, credit score used for underwriting (representative credit score) is:  lower of two scores, or  middle of three scores. Credit reputation

53. Conventional Qualifying Standards When two people apply for a loan together, lowest representative credit score (not an average) is used for underwriting. Credit reputation

54. Conventional Qualifying Standards Fannie Mae and Freddie Mac consider income durable if it is expected to continue for at least 3 years after loan is made. Income analysis

55. Income Analysis For a conventional loan, applicant’s stable monthly income is generally considered adequate if they don’t exceed these benchmarks: Total debt to income ratio: 36% Housing expense to income ratio: 28% Income ratios

56. Income Analysis Housing expense ratio is less important than total debt to income ratio.  Fannie Mae no longer applies a housing expense to income ratio. Income ratios

57. Income Analysis Fannie Mae and Freddie Mac allow income ratios to exceed benchmarks if there are compensating factors. Compensating factors

58. Income Analysis Possible compensating factors include:  large downpayment  substantial net worth  demonstrated ability to incur few debts and accumulate savings  education, job training, or employment history indicating potential for increased earnings Compensating factors

59. Income Analysis (Possible compensating factors, cont.)  short-term income that doesn’t count as stable monthly income  demonstrated ability to devote large portion of income to basic needs, such as housing expense  significant energy-efficient features in home being purchased Compensating factors

60. Income Analysis Even if there are 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

61. Income Analysis Some applications have factors that pose increased risk to lender. If so, higher-than-benchmark income ratios usually won’t be accepted. Factors that increase risk

62. Income Analysis For example, some lenders apply stricter standards to high-LTV loans. Many lenders won’t accept a high total debt to income ratio if LTV exceeds 90%. Factors that increase risk

63. Income Analysis ARMs should be underwritten carefully to make sure that borrower will be able to handle rate and payment increases. ARM borrower should have:  strong potential for increased earnings,  significant liquid assets, or  demonstrated ability to manage finances. ARMs

64. Conventional Qualifying Standards As a general rule, conventional borrower should have at least 2 months of mortgage payments in reserve after closing. Not an absolute requirement, but having a smaller amount in reserve will weaken loan application. Available funds – reserves

65. Available Funds Both 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; or  nonprofit religious or community organization. Gift funds

66. Available Funds Borrower required to make 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

67. 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

68. Loans with Lower Initial Payments 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

69. Loans with Lower Initial Payments Under reset option:  Reset loan remains in place.  Interest rate is set at current market rate (again, interest rate cap may apply).  Rate and payment amount are level for remaining 25 or 23 years. Borrower avoids refinancing charges. Balloon/reset mortgages

70. Loans with Lower Initial Payments Borrower not allowed to reset if: payments aren’t current, or other liens have attached to property. In that case, borrower will have to refinance or sell property to make balloon payment on balloon/reset mortgage. Balloon/reset mortgages

71. Loans with Lower Initial Payments Characteristics of typical 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

72. Loans with Lower Initial Payments Fannie Mae and Freddie Mac: will buy loans with interest-only periods ranging from under 3 years to over 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. Interest-only mortgages

73. 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

74. 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

75. Low-Downpayment Programs Examples of low-downpayment programs: Loan with 95% LTV and:  3% of downpayment from borrower’s funds  2% of 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

76. Low-Downpayment Programs Allowable alternative sources of funds may include gifts, grants, or unsecured loans. Funds may come from:  relative,  employer,  public agency,  nonprofit organization, or  private foundation. Alternative sources of funds

77. 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

78. Low-Downpayment Programs Other low-downpayment programs are offered to specific groups such as:  teachers,  police officers, and  firefighters. Affordable housing programs

79. Summary Low Downpayment & Accelerated Plans  Low-downpayment programs  Affordable housing programs  Alternative sources of funds  Accelerated payment plans  Bi-weekly mortgages  Growing equity mortgages