Chapter 28: Types of Loans

Sub-Prime Loans

Lenders provide loans to unqualified homebuyers - those who have poor credit and whose ability to repay the loan is risky because of their income.

Predatory Lender

One that literally "preys" on the customers who may fall into the "B, C or D" lending categories, particularly those who don't speak English, are poorly educated or are elderly.

Conforming Loan

A mortgage loan that conforms to GSE (Fannie Mae & Freddie Mac) guidelines. The most well-known guideline is the size of the loan, which as of 2016 was limited to $417,000 for single family homes in the continental US.

Origination Points

Used to compensate loan officers. Not all mortgage providers require the payment of origination points, and those that do are often willing to negotiate the fee. The origination fee is tax-deductible if it was used to obtain the mortgage and not to pay other closing costs.

Predatory Lending Practices:

1. Basing an unaffordable loan on the applicant's assets rather than his/her ability to repay the loan. 2. Encouraging a borrower to refinance a loan so that the lender can charge high points and fees for the new loan. This is called Loan Flipping. Sometimes the borrower also pays a higher interest rate than with the original loan. 3. Using fraud or deception to hide the true obligations of the loan from the borrower.

Fixed-Rate Fully Amortized Loans Distinct Features:

1. The interest rate remains fixed for the life of the loan. 2. The payments remain level for the life of the loan and are structured to repay the loan at the end of the loan term.

Amortization Plan

A borrower makes a periodic (usually monthly) payment of principal plus interest. These payments result in the loan being paid off gradually over time. Usually fixed-interest, long-term loans of 15-30 years. At the end of the loan term, the full amount of the principal and all of the interest is totally paid off and the balance is zero.

Reverse Annuity Mortgage (RAM)

The lender is making payments to the borrower. This system is particularly attractive to senior citizens who often have fixed incomes that are low. The RAM allows older property owners to receive regular monthly payments from the equity in their paid-off property without having to sell. The paid-off property is pledged to the lender as collateral. In return, the lender sends a regular monthly check (or annuity) to the borrower until a certain balance has been reached. The borrower pays interest on the loan and then the loan is repaid when the home sells or from the borrower's estate upon his or her death. To qualify for most reverse mortgages, the borrower must be at least 62 and live in the home. The proceeds of a reverse mortgage (without other features, like an annuity) are generally tax-free, and many reverse mortgages have no income restrictions.

Non-Conforming Loan

A loan that fails to meet bank criteria for funding. Reasons include the loan amount is higher than the conforming loan limit (for mortgage loans), lack of sufficient credit, the unorthodox nature of the use of funds, or the collateral backing it.

Balloon Mortgage

A loan that has one large final payment due when the loan matures. They are partially amortized loans - meaning the monthly payments are not large enough to fully amortize the loan by the end of the term, leaving the large balloon payment due. The major problem with a balloon payment loan is that the borrower has to come up with a large sum of money at the end of the term. Many borrowers believe that if they have been a good credit risk and made payments on time the lender will extend the balloon payment for another term. This could happen but lenders are not obliged to make an extension and could choose to require the full payment when the note comes due.

Adjustable-Rate Mortgage

A loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. Sometimes come with additional features such as convertibility, assumability, and prepayment penalty.

Prepayment Penalty

A prepayment penalty is a clause in a mortgage contract stating that a penalty will be assessed if the mortgage is prepaid within a certain time period. The penalty is based on a percentage of the remaining mortgage balance or a certain number of months' worth of interest.

Sale and Leasebacks

A seller leaseback, also called a seller rent back or sale-leaseback, is a transaction in which a person sells property and then leases or rents from the new property owner. The seller no longer owns the property, but lives in the property for the length of time stated in the rental agreement. The seller realizes profit from the sale of the property while the buyer is assured of rental income from the lease agreement. The sale and leaseback arrangement is typically used by commercial enterprises to free up money that has been tied up in the real estate to use as working capital in the business. The owner of the real estate sells the property and then leases it back from the buyer. The buyer becomes the owner and the former owner becomes the tenant. These arrangements are very complicated and should be undertaken only with proper and adequate legal advice.

Construction Loan (aka Interim Financing)

A type of open-end mortgage. A construction loan finances the cost of labor and materials as they are needed and used throughout a building project. Construction loans are different from other open-end loans because the collateral typically used to secure the loan has not yet been built, so only the land itself is available as collateral when the lender makes the original loan. Lenders will typically make a commitment for a loan at 75 percent of the property's total value. Construction loans are also different because the lender has to know the "story" behind the planned construction before it will be willing to lend money to the borrower.

Blanket Mortgage

Covers more than one parcel of real estate, owned by the same buyer. Developers often use a blanket loan to secure construction financing for a proposed subdivision or a condominium project. Due to the nature of land development, a builder needs a way to release single parcels of the project as they are completed. The mechanism for doing this is a release clause.

Wraparound Loan

Allows a borrower who has an existing loan to get another loan from a second lender without paying off the first loan. The second lender issues a new larger loan to the borrower at a higher interest rate. The new loan is a combination of the first loan and the second loan. The borrower makes the new higher payments to the second lender, and then the second lender pays the first lender out of those funds. It's attractive to lenders because they can leverage a lower interest rate on the existing mortgage into a higher yield for themselves. Often used in a refinancing situation or for the purchase of a home when a buyer can't prepay the existing mortgage, either because of a lock-in clause or a high prepayment penalty.

Release or Partial Release Clause

Allows for parcels/units to be sold from a blanket mortgage. If a release clause isn't included in the mortgage document, the developer would be required to pay off the entire loan balance before he/she could sell any of the individual parcels.

Land Contract

An agreement between a buyer and seller of property in which the buyer makes payments toward full ownership, but in a land contract, the title or deed is held by the owner until the full payment is made. With an installment land sales contract, also called a contract for deed, the buyer does not receive legal title until the final payment is made. The seller keeps legal title until the debt is paid in full. The buyer receives equitable title until the debt is fully paid. The buyer agrees to give the seller a down payment and to make regular payments of principal and interest for some agreed-upon number of years. The buyer also agrees to pay real estate taxes and insurance premiums and to maintain the repairs and upkeep of the property. Many installments contracts contain a provision that allows the seller to cancel the contract, keep all payments, and evict the buyer if the buyer defaults.

Open-End Loan (aka Mortgage or Deed of Trust for Future Advances)

An expandable loan in which the lender gives the borrower a limit up to which he/she may borrow. Each advance the borrower takes is secured by the same mortgage. Often the money that the lender advances is principal already paid. This type of loan can save the borrower the time and expense of refinancing the property at some future date. The borrower repays the advanced funds either through an extension of the loan term or through an increase in the monthly payments. It's also possible for the lender to adjust the interest rate to assist the repayment. Borrowers can use the funds advanced by an open-end loan to purchase personal property. The lender adds the advanced amount to the principal and adjusts the borrower's payment to account for the new balance. If that personal property later becomes part of the collateral for the loan, the loan would be converted to a package mortgage, which we will discuss on an upcoming page. An open-end loan usually has more favorable terms than a home improvement loan, which usually has a higher interest rate and must be repaid in a shorter period of time.

Package Loan

Finances the purchase of a home along with the purchase of personal items, such as a washer, dryer, refrigerator, air conditioner, carpeting, and furniture. The financing instrument describes the real property and then states that the named personal items are fixtures, and therefore part of the mortgaged property. The monthly payments on the loan include the principal, interest and some pro-rated payment for the appliances. Some lenders like to use package mortgages because they believe they will have less risk of default. Borrowers like package loans because they can pay for personal items over the extended period of the loan, rather than have to make outright purchases. Also, most consumer loans for furniture and appliances carry much higher interest rates and must be paid back within a much shorter term than the mortgage loan. Another incentive to use this kind of loan package is the interest on the home loan is tax-deductible, while the interest on a consumer loan is not. This type of loan is popular in the sale of new subdivision homes and furnished condos.

Home Equity Loan

Owners have the ability to borrow against the equity they have built up in their home. Homeowners can use a home equity loan for: 1. Purchasing high dollar items 2. Taking a vacation 3. Consolidating other loans or credit card debt 4. Paying medical expenses 5. Paying college tuition 6. Making home improvements A home equity loan is an alternative to refinancing. It can be given as a fixed amount or it can be a line of credit that the home owner can borrow against as he or she needs.

Novation

More of a hybrid of mortgage assumption and mortgage assignment. Similar to the concept of assignment, but there are fundamental differences between the two. 1. Assignment can't transfer the mortgage obligation, but novation can transfer both rights and obligations. 2. Assignment doesn't always require the consent of the party that benefits from the transfer; novation does. 3. Assignment doesn't extinguish the original contract, but novation does. Legally is equals a new obligation, but with the same terms, including interest rate, of the former mortgage loan. Few contemporary mortgage loan notes permit this form of assumption and assignment.

Purchase Money Loan

Most commonly a technique in which the buyer borrows from the seller in addition to the lender. The purchase money mortgage is created at the time of the purchase and delivered at the time the property is transferred as part of the sale transaction. This is sometimes done when a buyer cannot qualify for a bank loan for the full amount, so the seller "takes back" a portion of the purchase price as a second or junior mortgage. A purchase money loan can also be a senior or first loan.

Interest on Fixed-Rate Loans

Most conventional loans have traditionally been designed as fixed-rate loans. With this common type of mortgage program, the monthly payments for interest and principal never change. Property taxes and homeowners insurance may increase, but generally the monthly payments will be very stable. Fixed rate mortgages are available for a number of different loan terms. There are also "biweekly" mortgages, which shorten the loan by calling for half the monthly payment every two weeks. (Since there are 52 weeks in a year, the borrower makes 26 payments, or 13 "months" worth, every year.) During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal. The most common fixed-rate loans are 30-year mortgages, because the payment is stable and there is always the opportunity to pay the balance down or to refinance for a better rate at a later date. Recently, 15-year mortgages have become popular as borrowers realize that the interest savings is significant over the 30-year loan.

Negative Amortization

Negatively amortizes when scheduled payments are made that are less than the interest charge due on the loan at the time. When a payment is made that is less than the interest charge due, deferred interest is created and added to the loan's principal balance, creating negative amortization. A negative amortization limit states that the principal balance of a loan cannot exceed a certain amount, usually designated as a percentage of the original loan balance.

Discount Points

Prepaid interest. The purchase of each point generally lowers the interest rate on your mortgage by 0.25%. Most lenders provide the opportunity to purchase anywhere from 0 to 3 discount points. The more points you pay, the lower the interest rate on the loan.

Mortgage Assumption

The act of acquiring title to a property that already has an existing mortgage and agreeing to be personally liable for the terms and conditions of the mortgage, including the payments. There is little reason for a lender to relieve the original seller from liability on an assumed note. Lenders usually prefer to have both the buyer and the seller remain liable. However, in some cases the lender will agree to release the original seller from liability. This usually happens only after the lender has renegotiated the terms of the loan with the new mortgagor, raised the interest rate and charged an assumption fee.

Fully Amortized Loan

The borrower has the same payment amount every month. Payment goes first to the interest and then to the principal. Over the life of the loan, the amount going toward interest decreases, while the amount going to principal increases. In the early years of the loan, the principal payment is very small, so it takes several years for the borrowers to increase their equity in the property. However, closer to the end of the repayment period, the borrowers' equity increases much more quickly.

Straight Amortized Loan

The borrower pays a different amount with each payment. A fixed amount goes to the principal with each payment. The interest amount changes as the pricinpal balance declines.

Interest

The charge for the privilege of borrowing money, typically expressed as annual percentage rate.

Adjustable Rate Mortgage (ARM)

The interest rate is linked to an economic index. The loan starts at one rate of interest, but then it fluctuates up or down over the life of the loan as the index changes. The loan agreement describes how the interest rate will change and when. There are many possible ARM indexes. Each one has distinct market characteristics and fluctuates differently. The interest rate the borrower pays is usually the index rate plus a margin. The margin is the lender's "mark-up." It represents the lender's cost of doing business. The margin is added to the index at every adjustment period.

Annual Percentage Rate

The term annual percentage rate of charge (APR) describes the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a mortgage loan. It is a finance charge expressed as an annual rate. Banks are required to disclose the "cost" of borrowing in some standardized way as a form of consumer protection. APR is intended to make it easier to compare lenders and loan options.

Mortgage Points

They come in two varieties - origination points and discount points. In both cases, each point is equal to 1% of the total amount mortgaged.

Convertibility

This feature gives the borrower the option to convert to a fixed-rate mortgage. Convertible ARMs are marketed as a way to avoid rising interest rates and usually include specific conditions. The financial institution often charges a fee to switch the ARM to a fixed-rate mortgage.

Paid in Arrears

This means that when you make a payment on the first of a month (most contemporary mortgage loans are written as of the first of the month) you are paying the previous month's interest. Over the long-term, this difference means little. However, at the beginning or the end of the mortgage, it may be significant.

Mortgage Assignment

Usually involving a mortgage lender, is very different from mortgage assumption, involving a homebuyer. Occur when the original lender transfers the mortgage loan to a third party. Lenders who sell mortgages, which is most of them, assign their mortgages to others, who become the owners of the loans. As we discussed on the previous page, mortgage assumption happens when a homebuyer assumes the home seller's existing loan, making all future payments.

Fixed Rate Mortgage v. Adjustable Rate Mortgage

When borrowers make fixed extra payments to principal on a fixed rate mortgage, they shorten the term but don't change the payment. When they make fixed extra payments to principal on an ARM, they reduce the payment on rate adjustment dates, but don't change the term. This makes ARMs attractive to those who want to reduce their payments, and FRMs attractive to those who want to shorten their term.

Straight Loan (aka Interest-Only Loan)

With a straight or term mortgage, the monthly payments are allocated only to interest. No principal is paid off. At the end of the term, the borrower must be able to pay off the entire principal amount or get another loan. Payments are typically lower than with other loan types.

Property Pledged

With a traditional mortgage, the house alone is used as collateral for the loan. Typically, lenders require a 20% down payment so buyers do not end up owing more than their home's value. Without the down payment, the buyer pays a monthly fee for private mortgage insurance (PMI) and a potentially higher interest rate. In contrast, borrowers with a pledged-asset mortgage may avoid paying PMI or being charged a higher interest rate by providing securities and the home as collateral. The two most common types of pledged mortgages are package loans and blanket mortgages.

Assumability

With an assumable mortgage, a new home buyer has the ability to take over the existing mortgage of the seller as long as the lender of that mortgage approves. One unique risk for this type of mortgage can exist for the seller of the home. An assumable mortgage can hold the seller liable for the loan itself even after the assumption takes place.