Chapter 10: Financing programs

Mortgage payment cap

A mortgage payment cap serves the same purpose as a rate cap: limiting how much the borrower's monthly mortgage payment can increase. A payment cap directly limits how much the lender can raise the monthly mortgage payment, regardless of what is happening to the interest rate on the loan. For example, a payment cap might limit payment increases to 7.5% annually.

There are two types of buydowns: permanent and temporary.

A permanent buydown lowers the buyer's interest rate and monthly payments for the entire loan term. A temporary buydown lowers the rate and monthly payments for only the first few years of the loan.

Amortization

Amortization refers to how the principal and interest on a loan are paid during the repayment period.

RAP

Depending on the loan, the rate adjustment period might be six months or three years or some other time period. The most common rate adjustment period is one year. An ARM with a one-year rate adjustment period is called a one-year ARM.

Margin

Every ARM has a margin. The margin is the difference between the index rate and the interest rate the lender charges the borrower. The margin is essentially the lender's income from the loan, providing the lender with a profit. A typical margin is two to three percentage points. ** At the end of each year, the lender checks the index. If the index rate has increased, the lender can increase the borrower's interest rate. If the index rate has decreased, the lender must decrease the borrower's interest rate.

Owner occupancy

FHA borrowers must intend to occupy the property they're financing with an FHA loan as their primary residence. FHA loans are not available to investors, and so they cannot be used to finance rental properties. An FHA loan can be used for the purchase of a property with up to four dwelling units.

Underwriting conventional loans

Fannie Mae treats an applicant's credit score as one of two primary risk factors. The other risk factor is the size of the applicant's cash investment, as measured by the proposed loan-to-value ratio. Based on these two factors, a lender will assess a borrower as posing a low, moderate, or high primary risk, which will determine the level of scrutiny that will be applied to the rest of the application. Other factors, such as the total debt to income ratio and net worth, are considered contributory risk factors that may increase or decrease the level of risk.

A level payment buydown involves an interest reduction that stays the same during the buydown period.

For instance, a level payment buydown might reduce the buyer's interest rate by 2% during the first two years of the loan; the buyer would then pay the note interest rate for the remainder of the loan term.

Loan to value ratio

For instance, if the buyers put down $10,000 on a home valued at $100,000, the loan amount would be $90,000, and the loan-to-value ratio would be 90%.

Freddie Mac

Freddie Mac takes a slightly different approach. First, the main components of the applicant's creditworthiness—his credit reputation, ability to repay (income and net worth), and collateral (the property's value)—are evaluated. Then the underwriter considers the "overall layering of risk." Weakness in one area may be balanced by strength in the other areas. But if the overall risk seems excessive, the loan will be denied.

To estimate how much this buydown would cost Sheila, take the loan amount, $180,000, and multiply it by 6%. $180,000 times .06 equals $10,800. Sheila will have to pay the lender $10,800 at closing to reduce Bert's interest rate to 9.5%.

If Bert obtains a 30-year loan at 9.5% instead of 10.5%, this 1% buydown reduces Bert's monthly payment by about $133 per month. This will save Bert almost $48,000 over the term of the loan.

Loan fees

In addition to an origination fee, an FHA borrower may have to pay discount points as well, depending on the policy of the individual lender.

Its insurance program, the Mutual Mortgage Insurance Plan, is funded with premiums paid by FHA borrowers. If a lender making an FHA-insured loan suffers a loss because of a loan default, the FHA will compensate the lender for that loss.

In exchange for insuring the loan, the FHA regulates many of the loan's terms and conditions

FHA-insured loan

Let's start with FHA-insured loans. The FHA-insured loan program is administered by the Federal Housing Administration, and the characteristics of FHA loans are established by the federal government.

Partially amortized loans

Loans where payments are applied to principal and interest, but the payments do not retire the debt when the agreed upon loan term expires, thus requiring a balloon payment at the end of the loan term.

Loan term

Most FHA loans have 30-year terms, although 15-year loans are also available. And all FHA loans must have a first lien position—that is, they must have priority over all other mortgage liens.

Negative Amortization

Negative amortization occurs when unpaid interest is added to the loan's principal balance. Usually, a loan's principal balance declines steadily over the loan term. But negative amortization makes the loan balance go up instead of down. The borrower can end up owing the lender more money than the original loan amount.

Secondary Market

Some lenders make conventional loans to keep in their own portfolios instead of selling them on the secondary market. These are known as "portfolio loans," and, within certain limits, they can be made according to the lender's own internal standards.

The index

The ARM's index is the statistical report the lender has chosen to use as a measure of changes in the cost of money, so that the interest rate on the loan can be adjusted accordingly. The lender may use any of several available indexes, such as the weekly auction rate of Treasury bills, or the Eleventh District cost of funds index.

Conventional loan characteristics

The characteristics of conventional loans are determined by rules concerning loan amounts, loan-to-value ratios, private mortgage insurance, risk-based loan fees, secondary financing, prepayment penalties, and assumption.

A mortgage loan's repayment period is the number of years the borrower has in which to repay the loan. The repayment period is also called the loan term.

The length of the repayment period affects both the amount of the monthly payment and the total amount of interest paid over the life of the loan.

Fannie Mae and Freddie Mac limit the amount a seller or other interested party (such as a real estate agent) may contribute to help the buyer purchase the property.

These limits apply to buydowns as well as any payment of closing costs ordinarily paid by the buyer. The amount of the limit varies depending on the loan program.

Benchmark ratio

To qualify for a conventional loan, the loan applicant's total monthly obligations (including the proposed mortgage payment) generally must not exceed 36% of her stable monthly income. In other words, the maximum acceptable total debt to income ratio is 36%. This is sometimes called the "benchmark" total debt to income ratio for conventional loans.

Rate Adjustment Period

While an ARM enables the lender to adjust the borrower's interest rate to reflect current market rates, the lender isn't allowed to change the borrower's rate whenever there's any change in market rates. The rate adjustment period limits how often the lender has the right to make an adjustment.

With a graduated payment buydown, the reduced interest rate increases in steps, usually each year.

common graduated payment plan is the 3-2-1 buydown, which calls for a 3% reduction in the interest rate in the first year of the loan, a 2% reduction in the second year, and a 1% reduction in the third year. In the fourth year of the loan, the buyer will begin paying the note rate.

The role of credit scores has become very significant in conventional lending. Both Fannie Mae and Freddie Mac encourage lenders to use credit scoring as a key tool in assessing a loan applicant's likelihood of default.

credit scores are used in determining the risk-based fees (loan-level price adjustments) that borrowers will be charged.

Conventional loans

real estate loans that are not insured by the FHA or guaranteed by the VA