financing residential real estate lesson 10: conventional financing

Financing Residential Real Estate

Lesson 10:

Conventional Financing

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.

Introduction

Loans made by mortgage lenders can be divided into two main categories:

conventional loans

government-sponsored loans

Introduction

Conventional loan

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

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.

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.


Topics:

Property types and owner-occupancyLoan amountsRepayment periodsAmortizationLoan-to-value ratiosRisk-based loan feesPrivate mortgage insuranceSecondary financing


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


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.



Conventional loan may be secured by:

Principal residenceUp to 4 dwelling units

Second homeNo more than 1 dwelling unit

Investment propertyUp to 4 dwelling units



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


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


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


Repayment periods can range from 10 to 40 years.

30-year loans are standard.

15-year loans also popular.

Repayment periods


Standard conventional loan is fully amortized.

Partially amortized and interest-only loans also available.

Amortization


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


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.



High-LTV loans also usually have:

higher interest rates and fees, and

stricter underwriting rules.



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


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

Risk-based loan fees


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.



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%.



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.



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

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


Upon default and foreclosure, lender makes claim for reimbursement of actual losses.

Or may relinquish property to insurer.

How PMI works


Insurers have own underwriting standards, which have been influential in mortgage industry.

How PMI works


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


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


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


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


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

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.

Secondary Financing

Examples of restrictions lenders may impose:

1. Borrower must qualify for payments on both first and second mortgages.

Restrictions

Secondary Financing



2. Borrower must make 5% downpayment.

Restrictions

Secondary Financing



2. Borrower must make 5% downpayment.

3. Scheduled payments must be due on regular basis.

Restrictions

Secondary FinancingRestrictions

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.




6. No negative amortization.

7. No prepayment penalty.

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

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

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

Summary


Conventional loan Conforming loan Nonconforming loan Conforming loan limits Jumbo loan Loan-level price adjustment (LLPA) Adverse market delivery charge PMI Piggyback loan

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


Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors.

Two primary risk factors:

applicant’s credit reputation, and

the loan-to-value ratio.



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.



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.



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.



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.



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


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


When two people apply for a loan together, lowest representative credit score (not an average) is used for underwriting.

Credit reputation


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

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

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

Income Analysis

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

Compensating factors

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


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


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.


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

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

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


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

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

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

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

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


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.



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.



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


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

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

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

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


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


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


Other low-downpayment programs are offered to specific groups such as:

teachers,

police officers, and

firefighters.

Affordable housing programs

Summary

Low Downpayment & Accelerated Plans

Low-downpayment programs Affordable housing programs Alternative sources of funds Accelerated payment plans Bi-weekly mortgages Growing equity mortgages

financing residential real estate lesson 10: conventional financing

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