Conventional Financing

1
Lesson 10

• Conventional Financing

2
Introduction

• In this lesson we will cover
• conforming and nonconforming loans,
• characteristics of a conventional loan,
• qualifying standards for conventional loans, and
• special programs and payment plans.

3
Introduction

• Loans made by lenders can be divided into two
  main categories
• conventional loans
• government-sponsored loans

4
Introduction

• Conventional loan
• Any institutional loan that isnt insured or
  guaranteed by a government agency.

5
Conforming Nonconforming Loans

• Most conventional loans comply with underwriting
  guidelines of Fannie Mae and Freddie Mac.

6
Conforming Nonconforming Loans

• Most conventional loans comply with underwriting
  guidelines of Fannie Mae and Freddie Mac.
• Conforming loan complies with Fannie
  Mae/Freddie Mac guidelines.
• Nonconforming loan doesnt comply with Fannie
  Mae/Freddie Mac guidelines.

7
Conforming Nonconforming Loans

• Most conventional loans comply with underwriting
  guidelines of Fannie Mae and Freddie Mac.
• Conforming loan complies with Fannie
  Mae/Freddie Mac guidelines.
• Nonconforming loan doesnt comply with Fannie
  Mae/Freddie Mac guidelines.
• majority of nonconforming loans are subprime
  loans

8
Conventional Loan Characteristics

• Lenders want to be able to sell their loans on
  secondary market.
• As a result, Fannie Mae and Freddie Mac
  underwriting guidelines are widely followed and
  very influential in mortgage industry.

9
Conventional Loan Characteristics
Property types/owner-occupancy rules

• Conventional loan may be secured by
• principal residence,
• (up to 4 dwelling units)

10
Conventional Loan Characteristics
Property types/owner-occupancy rules

• Conventional loan may be secured by
• principal residence,
• (up to 4 dwelling units)
• second home,
• (no more than 1 dwelling unit)

11
Conventional Loan Characteristics
Property types/owner-occupancy rules

• Conventional loan may be secured by
• principal residence,
• (up to 4 dwelling units)
• second home,
• (no more than 1 dwelling unit)
• investment property,
• (borrower doesnt intend to occupy property).

12
Conventional Loan Characteristics
Loan amounts

• Conforming loan limits are set annually by Fannie
  Mae and Freddie Mac.
• Agencies wont purchase loan if it exceeds limit.
• Different loan limits for different parts of U.S.

13
Conventional Loan Characteristics
Loan amounts

• Jumbo loan
• Loan that exceeds conforming loan limits.
  Extra-large loans are sometimes called super
  jumbos.
• About half of jumbo loans are ARMs.

14
Conventional Loan Characteristics
Loan amounts

• Jumbo loan
• Loan that exceeds conforming loan limits.
  Extra-large loans are sometimes called super
  jumbos.
• About half of jumbo loans are ARMs.
• Higher interest rates.

15
Conventional Loan Characteristics
Repayment periods

• Repayment periods can range from 10-40 years.
• 30-year loans still standard.
• 15-year loans gaining popularity.

16
Conventional Loan Characteristics
Amortization

• Majority of conventional loans are fully
  amortized.
• Partially and interest-only loans also available.

17
Conventional Loan Characteristics
Loan-to-value ratios

• Common conventional LTVs
• 80
• 90
• 95

18
Conventional Loan Characteristics
Loan-to-value ratios

• Less common conventional LTVs
• 97
• 100

19
Conventional Loan Characteristics
Loan-to-value ratios

• Conventional loans are often categorized by LTV
  ratio, with different underwriting rules applied
  to each category.

20
Conventional Loan Characteristics
Loan-to-value ratios

• Fannie Mae and Freddie Mac require private
  mortgage insurance for any conventional loan
  purchased with LTV over 80.

21
Conventional Loan Characteristics
Loan-to-value ratios

• High-LTV loans also have
• higher interest rates and fees, and
• stricter underwriting rules.

22
Conventional Loan Characteristics
ARM LTV ratios

• At one time, Fannie Mae and Freddie Mac didnt
  buy ARM mortgages with LTVs over 90.

23
Conventional Loan Characteristics
ARM LTV ratios

• At one time, Fannie Mae and Freddie Mac didnt
  buy ARM mortgages with LTVs over 90.
• Now, both are willing to buy ARMs with LTVs up to
  95 if certain conditions are met.

24
Conventional Loan Characteristics
Private mortgage insurance

• Private mortgage insurance (PMI) is designed to
  protect lenders from risk of high-LTV loans.
• Makes up for reduced borrower equity.

25
Private Mortgage Insurance
How PMI works

• Private mortgage insurance company assumes only a
  portion of risk of default.
• Covers upper portion of loan.
• Typically 25 to 30 of loan amount.

26
Private Mortgage Insurance
How PMI works

• Upon default and foreclosure, lender makes claim
  for reimbursement of actual losses.
• Can also relinquish property to insurer.

27
Private Mortgage Insurance
How PMI works

• Insurers have own underwriting standards, which
  have also been influential on mortgage market.

28
Private Mortgage Insurance
PMI premiums

• Mortgage insurance company charges insurance
  premiums for coverage.

29
Private Mortgage Insurance
PMI premiums

• Mortgage insurance company charges insurance
  premiums for coverage.
• Variety of payment plans, including
• initial premium at closing, plus renewal
  premiums, or
• financed one-time premium.

30
Private Mortgage Insurance
PMI premiums

• Mortgage insurance company charges insurance
  premiums for coverage.
• Variety of payment plans, including
• initial premium at closing, plus renewal
  premiums, or
• financed one-time premium.
• If borrower pays loan off early, she may be
  entitled to partial refund of premiums.

31
Private Mortgage Insurance
Cancellation of PMI

• Under federal Homeowners Protection Act, lenders
  must cancel loans PMI under certain conditions
• once loan has been paid down to 80 of propertys
  original value (upon borrower request) or
• once loan reaches 78 of propertys original
  value (automatic cancellation).

32
Private Mortgage Insurance
Cancellation of PMI

• Homeowners Protection Act only applies to loans
  on single-family dwellings occupied as borrowers
  primary residence.

33
Private Mortgage Insurance
Cancellation of PMI

• If payment plan involved initial premium and
  renewal premiums, cancellation of PMI reduces
  monthly mortgage payment.

34
Conventional Loan Characteristics

• Conforming loan
• Nonconforming loan
• Investor loan
• Jumbo loans
• Loan-to-value ratios
• PMI
• Amortization
• Repayment period

35
Secondary Financing

• Lenders generally allow secondary financing.
• Most impose some restrictions due to increased
  risk of default.

36
Secondary Financing
Restrictions

• Examples of restrictions lenders may impose
• Borrower must qualify for payments on both first
  and second mortgages.

37
Secondary Financing
Restrictions

• Examples of restrictions lenders may impose
• Borrower must qualify for payments on both first
  and second mortgages.
• Borrower must make 5 downpayment.

38
Secondary Financing
Restrictions

• Examples of restrictions lenders may impose
• Borrower must qualify for payments on both first
  and second mortgages.
• Borrower must make 5 downpayment.
• Scheduled payments must be due on regular basis.

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• Second mortgage cant require balloon payment
  less than 5 years after closing.

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• Second mortgage cant require balloon payment
  less than 5 years after closing.
• If first mortgage has variable payments, second
  mortgage must have fixed payments.

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• Second mortgage cant require balloon payment
  less than 5 years after closing.
• If first mortgage has variable payments, second
  mortgage must have fixed payments.
• No negative amortization.

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• Second mortgage cant 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.

43
Secondary Financing
Piggyback loans

• Piggyback loan is another term for secondary
  financing.
• Used to either
• avoid paying private mortgage insurance, or
• avoid jumbo loan treatment.

44
Secondary Financing
Piggyback loans

• Using secondary financing to avoid PMI can
  backfire if second loan has high interest rate
  and steep fees.

45
Qualifying Standards
Evaluating risk factors

• Fannie Mae and Freddie Mac have changed how they
  evaluate creditworthiness of applicants.
• Newer methods influenced by automated
  underwriting systems and computer analysis.

46
Qualifying Standards
Evaluating risk factors

• Fannie Mae uses comprehensive risk assessment
  to evaluate risk factors.
• Two primary risk factors
• applicants credit history, and
• the loan-to-value ratio.

47
Qualifying Standards
Evaluating risk factors

• Fannie Mae uses comprehensive risk assessment
  to evaluate risk factors.
• Two primary risk factors
• applicants credit history, and
• the loan-to-value ratio.
• Loans ranked as low, moderate, or high primary
  risk.

48
Qualifying Standards
Evaluating risk factors

• 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
• satisfied basic risk tolerances,
• increases risk, or
• decreases risk.

49
Qualifying Standards
Evaluating risk factors

• Freddie Mac evaluates each component of
  creditworthiness
• capacity to repay,
• credit reputation, and
• collateral.

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Qualifying Standards
Evaluating risk factors

• Underwriter then considers overall layering of
  risk.
• Weakness in one component can be outweighed by
  strength in another.

51
Qualifying Standards
Income analysis

• Fannie Mae and Freddie Mac consider income
  durable if it is expected to continue for at
  least 3 years after loan is made.

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Income Analysis
Obligations to income ratio

• Once lender finds amount of stable monthly
  income, next step is to determine if it is enough
  to support monthly payment.

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Income Analysis
Obligations to income ratio

• Income is adequate if total monthly obligations
  dont exceed 36 of stable monthly income.

54
Income Analysis
Obligations to income ratio

• Income is adequate if the total monthly
  obligations dont exceed 36 of stable monthly
  income.
• Total monthly obligations includes applicants
  recurring obligations and proposed housing
  expense.

55
Income Analysis
Obligations to income ratio

• Income is adequate if the total monthly
  obligations dont exceed 36 of stable monthly
  income.
• Total monthly obligations includes applicants
  recurring obligations and proposed housing
  expense.
• Recurring obligations installment debts,
  revolving debts, and other obligations.

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Income Analysis
Obligations to income ratio

• Installment debts have a fixed beginning and
  ending date.
• Example a car loan.

57
Income Analysis
Obligations to income ratio

• Revolving debts involve open-ended line of
  credit, with minimum monthly payments.
• Example credit card or department store charge
  account.

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Income Analysis
Obligations to income ratio

• Other category of obligations alimony, child
  support, and similar ongoing financial
  obligations.
• Fannie Mae and Freddie Mac dont consider child
  care expenses part of recurring obligations.

59
Income Analysis
Housing expense to income ratio

• Proposed housing expense (PITI) should not exceed
  28 of loan applicants stable monthly income.

60
Income Analysis
Applying the ratios

• How to apply ratios
• Add monthly obligations together to get total.
• 425 250 675 monthly obligations

61
Income Analysis
Applying the ratios

• How to apply ratios
• Add monthly obligations together to get total.
• 425 250 675 monthly obligations
• Multiply stable monthly income by obligations to
  income ratio.
• 6,100 36 2,196

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• Subtract monthly obligations from that figure to
  get maximum mortgage payment.
• 2,196 675 1,521

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• Subtract monthly obligations from that figure to
  get maximum mortgage payment.
• 2,196 675 1,521
• OR
• Multiply stable monthly income by housing expense
  to income ratio to find maximum mortgage payment.
• 6,100 28 1,708

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Income Analysis
Applying the ratios

• Housing expense ratio is less important than
  total obligations ratio.
• Fannie Mae no longer applies a housing expense to
  income ratio.

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Income Analysis
Debt-to-housing gap ratio

• Freddie Mac requires lenders to calculate a
  debt-to-housing gap ratio.
• Calculated by
• Subtracting housing expense ratio from total
  obligations ratio.

66
Income Analysis
Higher ratios and compensating factors

• If compensating factors exist, Fannie Mae and
  Freddie Mac will consider income ratios that
  exceed benchmarks.

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Income Analysis
Higher ratios and compensating factors

• 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

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• short-term income that doesnt count as stable
  monthly income
• demonstrated ability to devote large portion of
  income to basic needs, such as housing expense
  or
• significant energy-efficient features in home
  being purchased.

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Income Analysis
Factors that increase risk

• Some applications have factors that are
  considered an increased risk to lender.
• May include
• mediocre credit score, or
• unsettled work history.

70
Income Analysis
95 loans

• Some lenders apply stricter standards for
  high-LTV loans.
• Fannie Mae and Freddie Mac are willing to buy 95
  loans if they have been evaluated very carefully.

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Income Analysis
95 loans

• Lender must pay special attention to applicants
• credit history,
• reserves,
• ability to accumulate savings, and
• potential for increased earnings.

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Income Analysis
ARMs

• ARMs must be underwritten more carefully than
  fixed-rate loans.

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Income Analysis
ARMs

• ARMs must be underwritten more carefully than
  fixed-rate loans.
• ARM borrower should either have
• strong potential for increased earnings,
• significant liquid assets, or
• demonstrated ability to manage finances.

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Income Analysis
ARMs

• ARMs are commonly offered at much lower interest
  rate than fixed-rate loans.
• May be easier to qualify with lower monthly
  payments.
• Subject to greater application scrutiny.

75
Net Worth
Gift funds

• Both Fannie Mae and Freddie Mac set limits on use
  of gift funds. Donor must be
• borrowers relative, fiancé, or domestic partner
• borrowers employer
• municipality or
• nonprofit religious or community organization.

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Net Worth
Gift funds

• Borrower required to make downpayment of at least
  5 of sales price out of her own resources.
• Rule doesnt apply if LTV is 80 or less.

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Net Worth
Reserves

• Conventional borrower may be required to have 2
  months worth of mortgage payments left in reserve
  after downpayment and closing costs.

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Net Worth
Credit reputation

• Credit scores have become central factor in
  conventional underwriting.
• Excellent score can offset weaknesses in other
  aspects of application.

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Net Worth
Credit reputation

• When two people apply for loan together,
  underwriter uses lowest credit score, not average.

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Secondary Financing Qualifying

• Secondary financing
• Piggyback loans
• Primary risk factors
• Contributory risk factors
• Income analysis
• Total obligations to income ratio
• Housing expense to income ratio
• Recurring obligations
• Net worth

81
Special Programs Payment Plans

• Variety of alternatives are available with
  conventional financing.

82
Special Programs Payment Plans
Buydown plans

• In buydown, seller or third party pays lender a
  lump sum at closing to lower interest rate on
  buyers loan.

83
Special Programs Payment Plans
Buydown plans

• In buydown, seller or third party pays lender a
  lump sum at closing to lower interest rate on
  buyers loan.
• Increases lenders yield.
• Lowers buyers monthly payment.
• Lower interest rate.

84
Buydowns
Buydown plans

• Buydown can be permanent or temporary.
• Permanent buydown borrower pays
  lower interest rate for entire loan term.
• Temporary buydown interest rate and monthly
  payment reduced during first years of loan
  term.

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Buydowns
Permanent buydowns

• Permanent buydown reduces note rate (rate stated
  in promissory note).
• Cost of buydown calculated in terms of points of
  loan amount.

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Buydowns
Permanent buydowns

• Permanent buydown rule of thumb
• It takes about 6 points to increase lenders
  yield on 30-year loan by 1.

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Buydowns
Temporary buydowns

• Two types of temporary buydown plans
• level payment plans, and
• graduated payment plans.

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Buydowns
Temporary buydowns

• Level payments
• Calls for interest reduction that stays same
  throughout buydown period.

89
Buydowns
Temporary buydowns

• Graduated payments
• Calls for largest payment reduction in first
  year, with progressively smaller reductions in
  each remaining year of buydown period.
• 3-2-1 buydown interest rate bought down 3
  the first year, 2 the second year, and 1 the
  third year.

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Buydowns
Temporary buydowns

• To find cost of temporary buydown
• Calculate buyers monthly principal and interest
  payment without buydown, at full interest rate.
• Calculate buyers monthly payment with
  bought-down interest rate.

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• Subtract bought-down payment from actual payment
  and multiply by twelve for annual buydown amount.
• For level payment, multiply annual buydown amount
  by number of years in buydown plan.

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Buydowns
Temporary buydowns

• Graduated payment buydown is calculated in same
  way, except each years buydown must be
  calculated separately and then added together.

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Buydowns
Buydowns and qualifying rules

• Permanent buydown
• Lender qualifies buyer at bought-down interest
  rate.
• Temporary buydown
• Lender may qualify buyer at bought-down rate,
  note rate, or an intermediate rate.

94
Buydowns
Buydowns and qualifying rules

• Fannie Mae allows lender to use bought-down rate
  if
• loan is fixed-rate, or
• ARM with a 3-year initial period.

95
Buydowns
Buydowns and qualifying rules

• Freddie Mac has its own rules for temporary
  buydowns.
• Bought-down rate can usually be used to qualify
  buyer.
• 3-2-1 buydowns with LTV of 80 requires
  qualifying with second year interest rate.

96
Buydowns
Limits on buydowns

• Fannie Mae and Freddie Mac limit amount of
  buydown to percentage of
• sales price, or
• appraised value (whichever is less).

97
Buydowns
Limits on buydowns

• Fannie Mae and Freddie Mac limit amount of
  buydown to percentage of
• sales price, or
• appraised value (whichever is less).
• Also applies to other contributions accepted from
  seller or another interested party.

98
Buydowns
Limits on buydowns

• Fannie Mae and Freddie Mac limit amount of
  buydown to percentage of
• sales price, or
• appraised value (whichever is less).
• Also applies to other contributions accepted from
  seller or another interested party.
• Doesnt include parties not participating in
  transaction.

99
Buydowns
Limits on buydowns

• Excess contributions are deducted from sales
  price before finding maximum loan amount.

100
Special Programs Payment Plans
Loans with lower initial payments

• Many first-time buyers are just starting their
  careers and expect their incomes to increase
  steadily.
• Loans with lower initial payments include
• Hybrid ARMs
• Two-step mortgages
• Balloon/reset mortgages
• Interest first mortgages

101
Loans with lower initial payments
Two-step mortgages

• Characteristics of two-step mortgages
• 30-year term.
• Lender can adjust interest rate once during loan
  term.
• Offered at lower initial rate than fixed-rate
  loans.
• Two common types 5/25 and 7/23.

102
Loans with lower initial payments
Two-step mortgages

• 5/25 loan is automatically adjusted after 5
  years, to the current market rate.
• 7/23 loan is automatically adjusted after 7
  years, to the current market rate.

103
Loans with lower initial payments
Balloon/reset mortgages

• Characteristics of balloon/reset mortgages
• Two types 5/25 and 7/23.
• At end of initial 5- or 7-year period, entire
  loan balance is due.
• Payment amounts based on 30-year amortization
  schedule.

104
Loans with lower initial payments
Balloon/reset mortgages

• At end of initial period, borrowers may either
• refinance,
• pay off loan balance, or
• reset loan.

105
Loans with lower initial payments
Balloon/reset mortgages

• By resetting loan, loan remains in place and
  interest rate is set at current market rate.
• Avoids refinancing charges.
• Borrowers cant be delinquent on payments.
• No other liens may exist on property.

106
Loans with lower initial payments
Interest first mortgages

• Characteristics of interest first mortgages
• 30-year loan term.
• Interest only payments during first part of loan
  term (10-15 years).
• Payments fully amortized for remainder of loan
  term.

107
Buydowns Low Initial Payment Loans

• Permanent buydown
• Temporary buydown
• Level payments
• Graduated payments
• Two-step mortgages
• Balloon/reset mortgages
• Interest first mortgages

108
Special Programs Payment Plans
Low downpayment programs

• Secondary market agencies have developed some
  conventional loan programs to make home ownership
  more affordable.

109

• Examples of conventional alternatives
• Loan with 95 LTV with 3 downpayment from
  borrowers funds, and 2 from alternative
  sources.
• Loan with 97 LTV with 3 downpayment from
  borrowers funds, and 3 contribution to closing
  costs from alternative sources.
• Loan with 100 LTV with no downpayment from
  borrowers funds, and 3 contribution to closing
  costs from alternative sources.

110
Special Programs Payment Plans
Low downpayment programs

• Allowable alternative sources of funds may
  include gifts, grants, or unsecured loans.

111
Special Programs Payment Plans
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.

112
Low Downpayment Programs
Affordable housing programs

• Many conventional loan programs are targeted at
  low- and moderate-income buyers.

113
Low Downpayment Programs
Affordable housing programs

• Many conventional loan programs are targeted at
  low- and moderate-income buyers.
• Buyers qualify if stable monthly income doesnt
  exceed median income of area.
• Cash requirements reduced.
• Eligibility based on income or property location.

114
Low Downpayment Programs
Affordable housing programs

• Some programs waive income limits for buyers
  purchasing homes in low-income or rundown
  neighborhoods.
• Buyers with income above area median can still
  qualify.

115
Low Downpayment Programs
Affordable housing programs

• Other programs are offered to specific groups
  such as
• teachers,
• police officers, and
• firefighters.

116
Accelerated Payment Plans
Bi-weekly mortgages

• Characteristics of a bi-weekly 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 20-22 years.

117
Accelerated Payment Plans
Bi-weekly mortgages

• Disadvantages for lenders
• More work to service 26 payments instead of 12.
• Less of a profit in interest.

118
Accelerated Payment Plans
Growing equity mortgages

• Characteristics of growing equity mortgage (GEM)
• Interest rate is fixed over life of loan.
• First-year payments of principal and interest
  based on 15- or 30-year loan.
• Payments increased at specified intervals for all
  or part of loan term.
• 100 of annual payment increase used to reduce
  principal balance.

119
Accelerated Payment Plans
Growing equity mortgages

• Annual payment adjustments usually increased by
  fixed percentage, such as 3 or 5 per year.

120
Accelerated Payment Plans
Growing equity mortgages

• Equity builds up quickly with GEM and actual
  repayment period depends on interest rate and
  magnitude of annual payment increases.
• Most GEMs with 30-year stated terms pay off in 11
  to 17 years.

121
Accelerated Payment Plans
Growing equity mortgages

• Advantages of GEM
• Reduced interest costs
• Lower interest rate
• Payments are predictable

122
Low Downpayment Accelerated Plans

• Affordable housing programs
• Conventional low-downpayment financing
• Accelerated payment plans
• Bi-weekly mortgages
• Growing equity mortgages