California Real Estate Practice Chapter 10 Rockwell Slides

Primary Financing: Wraparound financing

(All-inclusive trust deed) A wraparound loan (also called an all-inclusive trust deed) involves a first mortgage and a second mortgage. The first mortgage, called the underlying mortgage, is the seller's mortgage. With wraparound financing, the buyer takes title subject to the seller's existing mortgage and then makes payments to the seller. The seller continues to make payments on the existing mortgage and keeps the remainder of the payments. The seller doesn't pay off this underlying mortgage at closing, nor does the buyer assume the mortgage. Instead, the buyer takes the property "subject to" the underlying mortgage. This means the seller remains primarily responsible for making the payments on the underlying mortgage. The buyer gives the seller a downpayment, and the seller finances all the rest of the purchase price, securing this financing with another mortgage—the wraparound mortgage. Each month, the buyer makes a payment on the wraparound mortgage to the seller, and the seller then uses part of the buyer's payment to make the monthly payment on the underlying mortgage. The seller keeps the remainder of the buyer's payment. Let's return to our previous example. Wallace owes $110,000 on his $200,000 house. The mortgage payment is $1,000. Wallace sells his house to Ellen for $200,000. Ellen pays Wallace a $10,000 downpayment, and Wallace finances the remaining $190,000 of the purchase price at 8% interest. Ellen's monthly payment to Wallace is $1,400. Wallace uses part of that $1,400 to make the $1,000 payment on the underlying mortgage, and keeps the remaining $400 for himself. Ex. $110,000 Seller owes $200,000 Sell to buyer $10,000 Downpayment =$190,000 Seller Finance @ 8% = $1,400 Per month - $1,000 Underlying mortgage =$400 Seller profit For wraparound financing to work, the underlying loan cannot have a due-on-sale clause. If there is a due-on-sale clause, the lender will probably require the seller to pay off the loan, or else arrange for an assumption when he sells the property to the buyer. To avoid triggering the due-on-sale clause, a buyer and seller may occasionally try to do a "silent wrap" by keeping the lender in the dark about the sale, but this can easily backfire. Real estate agents should NEVER get involved in silent wraps. The buyer is a wraparound situation needs a little extra protection. If the seller failed to make the payment on the underlying loan, the lender could foreclose, and the buyer would lose the property, as well as all the monthly payments he had already made. The best way to protect the buyer is to set up an escrow account for the loan payments. An independent third party in charge of the escrow account will use part of the buyer's monthly payment to make the payment on the underlying loan, and then send the remainder to the seller. The underlying loan payments are always made on time, safeguarding the buyer's interest in the property. The buyer can also be required to deposit property tax and homeowner's insurance payments into the same account, which protects the seller's security interest in the property as well. *Escrow Account -Buyer's monthly paymet into escrow pay for underlying mortgage, taxes, and insurance -Surplus is paid to seller

Loan-level price adjustment

(LLPA) If the loan is going to be sold to one of the secondary market agencies. The amount of this charge depends on the borrower's credit score and LTV. The riskier the loan, the larger the LLPA. Here's an example. Marjorie's credit score is 650 and her loan's LTV is 80%. At closing, Marjorie is charged an LLPA of 2.5%. Marco, on the other hand, has a credit score of 710 and his loan's LTV is 90%. Marco is only charged an LLPA of 1%.

Basic Loan Features: Repayment period

(Loan term) 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. For a long time, the standard repayment period for a home purchase loan has been 30 years. While 30 years is still the standard term, 15-year mortgages are also very popular, but requires a significantly higher monthly payment, and will save the borrower a large amount in interest. Loan terms as short as 10 years or as long as 40 years may also be available.

Loan Fees: Origination fees

(Service fee) (Administrative charge) (Loan fee) Origination fees help cover the administrative costs of making loans. An origination fee is charged in virtually every mortgage loan transaction. It may be called a service fee, administrative charge, or simply a loan fee. The origination fee is ordinarily paid by the BORROWER.

FHA-Insured Loans: Underwriting standards

-Income -Net Worth -Credit Reputation As with any other type of loan, the lender will examine the credit reputation, net worth, and income of an FHA loan applicant, as well as the value of the property she wants to purchase. FHA qualifying standards are less stringent than conventional standards. An FHA loan applicant's fixed payment to income ratio should not exceed 43%, and his housing expense to income ratio should not exceed 31%. Ordinarily, no cash reserves are required, and gift funds or secondary financing from close family members may be used to help close the transaction. However, the FHA's underwriting standards are not as strict as the standards used for conventional loans. This makes it easier for low- and middle-income buyers to qualify for a mortgage.

#8. Seller Financing

-Institutional lenders -Sellers Banks, savings and loans, and mortgage companies aren't the only sources of residential financing. In some cases, home sellers can provide financing. When a seller extends financing to the buyer, it's called seller financing.

VA-Guaranteed Loans: Characteristics of VA loans

-No downpayment -Underwriting standards -No income limits -Loan term -Loan costs -Funding fee -Repayment plans

Cal-Vet Loans: Characteristics: Occupancy

A Cal-Vet borrower must occupy the home within 60 days after the loan is funded. The property may not be transferred, encumbered, or leased without the permission of the California Department of Veterans Affairs.

Cal-Vet Loans: Characteristics: Assumption

A Cal-Vet loan may not be assumed.

VA-Guaranteed Loans: Secondary financing

A VA borrower can use secondary financing to cover the downpayment or closing costs if he does not have enough cash. However, there are a few important requirements: 1) the total of all financing may not exceed the appraised value of the property, 2)the buyer must qualify for the payments on both loans, and 3)any conditions placed on the second loan can be no more stringent than those that apply to the VA loan. The interest rate on the second loan can be higher than the rate on the VA loan, but may not be higher than the industry standard for second mortgage interest rates. Note that secondary financing cannot be used to cover a downpayment that is necessary because the sales price exceeds the appraised value of the property. VA loan rate: 6.5% Second mortgage rate: 6.75% Market rate for seller seconds: 6.8% SECONDARY FINANCING ALLOWED

VA-Guaranteed Loans: Loan amount (Loan guaranty)

A VA loan cannot exceed the appraised value of the home or the sales price, but there are no other official restrictions on the loan amount. The VA guaranty covers only a portion of the loan amount. Lenders generally require the guaranty amount to be at least 25% of the sales price. If it's less than that, the veteran will usually be required to make a downpayment. Lenders impose some unofficial restrictions, however. Lenders usually apply a rule that states that the guaranty amount must equal at least 25% of the value or sales price of the property, whichever is less. So in an area where the current maximum guaranty amount is $104,250, most lenders will not lend more than $417,000 without some kind of downpayment. A veteran can, of course, obtain a larger loan if he makes a downpayment. Typically, the total of the guaranty amount and the veteran's downpayment must together equal 25% of the sales price. This 25% rule means that the downpayment a veteran may have to make is still likely to be fairly modest. Let's look at an example. Suppose Ray wants to buy a home for $450,000. In his county, the maximum guaranty amount is $104,250, which means that the largest no-downpayment loan his lender is willing to make is $417,000. Ray can make a downpayment in order to purchase the home. However, because of the lender's 25% rule, he does not have to pay the difference between the sales price and $417,000 to get the loan. His downpayment only needs to equal 25% of the difference. The sales price is $450,000. The combination of the guaranty amount and Ray's downpayment must equal 25% of the sales price. 25% of $450,000 is $112,500. The guaranty is $104,250. $112,500 minus the $104,250 guaranty equals $8,250. Ray only has to make an $8,250 downpayment in order to purchase the home. $450,000 Sale price x .25 =$112,500 Downpayment - $104,250 Guaranty = $8,250 Downpayent needed A VA borrower may also have to make a downpayment if the property's sales price exceeds its appraised value. If this is the case, the borrower will need to pay the difference between the sales price and the appraised value out of his own funds.

#2. Basic Loan Features: Fixed-rate loans

A mortgage loan may be a fixed-rate loan or an adjustable-rate loan. A fixed-rate loan has an interest rate that stays the same throughout the loan term, regardless of what market interest rates do. For instance, a 30-year fixed-rate loan that begins at 6.5% interest will remain at 6.5% for all 30 years of the loan term, even if market interest rates go up or down during that time.

Fixed and Adjustable Rates: Mortgage payment caps

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. Typically, payment caps limit payment increases to 7.5% annually. Many ARMs have a rate cap, but no payment cap; this helps prevent payment shock while avoiding the risk of negative amortization.

Buydowns: Permanent buydowns

A permanent buydown reduces the note rate—the interest rate stated in the buyer's promissory note. For example, if a lender is planning to charge 12% interest and the seller buys down the interest rate to 11%, the buyer will sign a note promising to repay the loan at the lower rate, 11%. Since the note rate is reduced, the monthly payments are reduced for the entire life of the loan. The cost of a permanent buydown depends on the loan amount and how much the interest rate is reduced. The greater the rate reduction, the higher the cost. For example, it might take about 6% of the loan amount (or six points) to increase a lender's yield on a 30-year loan by 1%. So a lender offering an interest rate that is 1% below market rate might charge six points to make up the difference. Let's see how this works. Suppose that Bert is buying Sheila's house for $200,000. He's applying for a 90% loan, so the loan amount will be $180,000. The current market rate for this loan is 10.5%. Bert doesn't think he can qualify for the loan at that interest rate, so Sheila offers to buy down Bert's interest rate by one percentage point. 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%. Loan amount: $180,000 Current interest rate: 10.5% $180,000 Loan amount x .06 =$10,800 Seller pays at closing 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. Note that this buydown will benefit Bert more than if Sheila simply reduced the sales price by the amount that the buydown is costing her ($10,800). If the interest rate stayed at 10.5% but the loan amount was reduced to $170,280, the monthly payment would go down by $89 per month. That would save Bert only about $32,000 over the course of the loan. Cost of buydown: $10,800 $180,000 loan for 30yrs @ 9.5% $133 less per month $48,000 total savings _______________________________ $170,280 loan for 30yrs @ 10.5% $89 less per month $32,000 total savings It's important to keep in mind that the cost of a permanent buydown varies from lender to lender. 6% of the loan amount for each percentage point deducted from the interest rate is merely an example. The cost is affected by current market conditions, including market rates and the average time loans are outstanding before they are paid off. If you need to know the exact cost of a buydown, you must ask the lender.

Conventional Loans: Prepayment penalties

A prepayment penalty is a charge imposed on the borrower if he pays off all or part of the loan's principal before it is due. Prepayment penalties are not standard in conventional loans for the purchase of residential property. When the loan agreement does provide for a prepayment penalty, it is typically charged only if the borrower pays all or part of the principal before it is due during the first few years of the loan term. However, a lender may choose to include a prepayment penalty in the loan agreement. In fact, in some cases lenders offer incentives such as reduced loan fees or a lower interest rate in exchange for the inclusion of a prepayment penalty. A borrower should consider potential long-term consequences before agreeing to a prepayment penalty, though. Form giving details about a sample loan's prepayment penalty. 30-year fixed-rate loan @ 5.5% interest rate Prepayment penalty: 1.5% of any principal prepaid during the first few years of loan term Prepayment penalties usually are charged only during the first few years of the loan term. The borrower should find out how many years the prepayment penalty will be in effect. She should also find out under what circumstances the penalty will be applied. For instance, will the penalty be charged if the loan is paid off early because the borrower is refinancing? Will it be charged if the loan is paid off early because the borrower is selling the property? Also, of course, the borrower should determine how much the penalty will be. Imposing an unreasonably heavy prepayment penalty is a predatory lending practice. California law and the federal Dodd-Frank Act place restrictions on prepayment penalties for certain types of loans.

Seller Financing: How seller financing works: Purchase money loan

A purchase money loan is fundamentally different from an institutional loan. Seller financing usually takes the form of a purchase money loan, where the seller extends credit to the buyer. The buyer signs a promissory note and a mortgage or deed of trust, then makes installment payments to the seller. (Alternatively, a land contract may be used.) An institutional lender essentially gives the borrower cash, which will then be given to the seller in exchange for title to the property. A purchase money loan, however, is an extension of credit to the buyer by the seller. The buyer will pay the seller in installments, instead of paying the entire purchase amount up front.

Cal-Vet Loans: Characteristics: Loan-to-value ratios

A small downpayment is required, but loan-to-value ratios of 95% to 97% are common.

Mortgages with Lower Initial Payments: Two-step mortgages

A two-step mortgage is basically a 30-year fixed-rate loan, except that the loan's interest rate will be changed at one point during the loan term. With a two-step mortgage, the interest rate will be changed to current market rates at a set point during the loan term, usually either after 5 or 7 years, then stay the same for the remainder of the loan term. As with an adjustable-rate loan, the borrower gets a lower initial interest rate in exchange for assuming the risk of an interest rate increase. It has some of the advantages of an ARM, but less risk for the borrower. There are two popular two-step programs, known as the 5/25 program and the 7/23 program. The interest rate on a 5/25 loan is automatically adjusted after five years to the current market rate. The loan's interest rate then stays at that level for the remaining 25 years of the term. 5/25: Rate is adjusted after 5 years. Here's an example. When the Fergusons take out a 5-25 loan, the current market rate for fixed-rate loans is 8%. The Fergusons start out at a slightly lower interest rate, 7.5%. They pay 7.5% interest on their loan for the first five years of the term. At the end of the five-year period, the market rate is 9.5%. The interest rate on the Fergusons' loan is increased to 9.5%, and they will continue to pay 9.5% interest for the remainder of the loan term. A 7/23 loan works the same way, but the interest rate is automatically adjusted after 7 years, and then stays at that level for the remaining 23 years of the loan term. 7/23: Rate is adjusted after seven years As you saw in the example, two-step mortgages may be offered at a lower initial rate than ordinary fixed-rate loans, because the lender will have the opportunity to adjust the interest rate on a two-step mortgage to reflect changes in the market rate. And while the borrowers assume the risk that interest rates will increase in the next 5 or 7 years, they may get to take advantage of lower rates without refinancing if market rates are lower at the end of that 5- or 7-year period. Because the loan's interest rate changes only once, many borrowers feel more comfortable with a two-step loan than with an ARM. And if the borrowers plan on selling their home before the end of the 5- or 7-year period, they get the lower-than-fixed initial rate without having to worry about a rate increase down the line.

Seller Financing: Reasons for seller financing

Although seller financing can be complicated, there are several reasons a seller might want to offer financing. Seller financing makes the property more marketable, especially when market interest rates are high. Potential buyers may have a difficult time qualifying for a loan when rates are high, or they may simply be unwilling to take on a long-term loan at a very high interest rate. By offering seller financing at a lower-than-market interest rate, a seller can make his home more appealing. -Current market rates: 12% -Seller financing offered at 9% Seller financing can also help a buyer who wouldn't be able to get institutional financing. For one thing, it can be considerably less expensive, since the seller won't be charging a loan origination fee or discount points. And the seller might agree to accept a smaller downpayment than an institutional lender would require. This means that the buyer has to come up with less money at closing. Some buyers couldn't qualify for an institutional loan because they don't make enough money or have had credit problems in the past. A seller may be willing to extend credit to a buyer with a good credit rating and a history of stable employment, even though the house payment would be a greater share of the buyer's monthly income than an institutional lender would allow. And a seller may make allowances for past credit problems if the buyer can make a large downpayment. Because of these advantages, by offering financing a seller may be able to get a higher price for her home. For example, a buyer might only be willing to pay $100,000 for the property if he has to get a bank loan, but agree to pay $107,000 for it if the seller provides financing on attractive terms. -Buyer's offer: $100,000 -Buyer's offer: $107,000 contingent on seller financing The seller also gets tax benefits with seller financing. Since the buyer is paying the purchase price of the home in installments over several years, the federal income tax rules allow the seller's profit from the sale to be spread out over that same period. Only the portion of the profit actually received in a given year is taxed in that year. The seller can spread payment of the taxes over several years, and may be able to take advantage of a lower tax rate as a consequence.

Cal-Vet Loans: Characteristics: Origination fee

Although the borrower may originate the loan with a mortgage broker or directly through the California Department of Veterans Affairs, in either case the borrower will pay a 1% origination fee. No discount points are paid, however.

Basic Loan Features: Amortization

Amortization refers to how the principal and interest on a loan are paid during the repayment period. Most mortgage loans are fully amortized. A fully amortized loan is repaid within a set period of time with regular monthly payments. Amortization is the repayment of a debt through installment payments that include both principal and interest. A fully amortized loan is paid off by the end of its term with regular payments, whereas a partially amortized loan requires a balloon payment. With an interest-only loan, no principal payments are required until the end of the loan term or the end of a specified period. Each monthly payment is for the same amount, and includes both a principal portion and an interest portion. Ex. January payment: $1,780 Principal: $179 Interest: $1,605 February payment: $1,780 Principal: $177 Interst: $1,603 As each payment is made, the principal amount of the debt is reduced, and the interest is recalculated on the remaining principal balance. Although the total amount of the monthly payment remains the same, with each successive payment, a slightly smaller portion is devoted to interest and a slightly larger portion is applied to the principal. The final monthly payment pays off the loan completely. No further principal or interest is owed. In the early years of a fully amortized loan, the principal portion of each payment is quite small. For example, with a 30-year $90,000 loan at 8% interest, only $60 of the first $660 monthly payment goes toward principal. The rest of the payment, $600, is interest. Because the principal is reduced so slowly at first, it takes several years for the borrower's equity in the property to increase significantly by debt reduction. However, toward the end of the loan period, the increase in equity speeds up considerably. By the 20th year of that same $90,000 loan, $295 of the $660 payment is applied to the principal. And by the end of the 30-year term, almost all of the final payment is for principal. $656 out of $660 goes toward principal.

FHA-Insured Loans: Minimum cash investment

An FHA borrower must make a minimum cash investment of at least 3.5% of the sales price or the appraisal price, whichever is less. This means that FHA loan borrowers can have a loan-to-value ratio as high as 96.5%. Borrower-paid closing costs and discount points do not count toward this required minimum cash investment. Neither do "prepaid expenses," which include interim interest on the loan and impounds for property taxes and hazard insurance. In this way, the minimum cash investment is essentially the required downpayment for an FHA loan.

FHA-Insured Loans: Secondary financing

An FHA borrower ordinariy may not use secondary financing to pay the required minimum cash investment. For instance, a borrower could not use a second mortgage from a seller, another interested party, or an institutional lender in order to come up with the required 3.5% investment. This applies whether the secondary financing would cover the downpayment, the closing costs, or any other expenses. NOT ALLOWED: $160,000 Purchase price $154,400 FHA insured loan from First Bank $5,600 Second mortgage from seller However, there is one notable exception to this rule about secondary financing. Secondary financing may be used to cover the minimum cash investment if it comes from the borrower's family (parent, child, or grandparent) or a governmental or nonprofit agency. In this situation, the total financing cannot exceed the property's value or sales price plus the closing costs, prepaid expenses, and discount points. In addition, the borrower must be able to afford the monthly payments on both loans, and the borrower cannot be required to make a balloon payment within five years of closing. -Total financing can't exceed property's value plus closing costs -Borrower must be able to afford payment on both loans -No balloon payment in five years after closing It is also permissible to use a second mortgage (from any lender, not necessarily a family member or agency), combined with an FHA-insured first mortgage. Before that type of secondary financing can be used, several conditions must be met, so your buyer should check with a lender if he wants to use secondary financing.

FHA-Insured Loans: Characteristics: Small downpayment

An FHA loan requires a comparatively small downpayment, and the loan fees and other charges may be lower than they would be for a typical conventional loan.

Fixed and Adjustable Rates: Index

An index is a published report on changes in the cost of money. The lender will use a specified index to determine whether the interest rate on an ARM should be changed. 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.

Mortgages with Lower Initial Payments: Interest-only mortgages

An interest-only mortgage enables the borrower to make lower payments in the early years of the loan term, because the borrower is paying only interest at first. Then the borrower must begin repaying the principal, with interest, amortized over the remainder of the loan term. For example, an interest-only loan might have a 30-year term with a 15-year interest-only period. The interest rate will remain fixed throughout the 30 years, but the borrower will pay only interest during the initial 15 years. In the sixteenth year, the borrower will begin repaying the principal in addition to the remaining interest. The entire loan amount will be amortized over the remainder of the loan term. This may cause the monthly payment to rise significantly. However, borrowers are usually allowed to make prepayments of principal during the initial interest-only period. This will reduce the size of the monthly payments they have to make once the interest-only phase ends. Ex. Loan amount: $200,000 @ 8% interest -Year 15, Month 11 payment: Principal $0 Interest $1,333 -Year 16 Month 1 payment: Principal $578 Interest $1,333 -Year 16, Month 2 payment: Principal $580 Interest $1,331

Private Mortgage Insurance: Canceling PMI

As a loan is paid off, the principal balance will get smaller. Assuming that the value of the property does not also fall, the balance will eventually drop below 80% of the value of the property. At that point, private mortgage insurance is no longer necessary, and the borrower may request to have the policy canceled. PMI no longer necessary A federal law called the Homeowners Protection Act requires lenders to cancel the PMI on a loan and refund any unearned premium to the borrower once certain conditions are met. The lender must automatically cancel the PMI when the loan's principal balance is scheduled to reach 78% of the home's original value (the appraised value of the home when it was purchased), unless the borrower is delinquent on payments. The borrower may request that the lender cancel PMI when the principal balance is scheduled to reach 80% of the home's original value. If the borrower's payment history is good, the value of the property has not decreased, and the borrower has not taken out additional loans against the property, then the request must be granted. ANNUAL NOTICE: Right to cancel PMI Note that these requirements do not apply to loans closed before July 29, 1999, nor do they apply to certain high-risk or non-standard loans. Nevertheless, most lenders will typically allow PMI to be canceled on older loans once the loan-to-value ratio has been reduced to a specified level. In addition, the Homeowners Protection Act requires that all lenders send an annual notice informing borrowers of their PMI cancellation rights, regardless of when the loan was originated.

Seller Financing: The agent's role

As a real estate agent involved in a seller-financed transaction, you should make sure that both parties understand all the ramifications of the financing arrangement. Some of the concerns discussed earlier—such as lien priority, protection of the seller's security interest, and the importance of an escrow account—must be made clear. A real estate agent should never prepare the documents used in a seller-financed transaction, and should always strongly recommend that both the buyer and the seller get competent advice from their attorneys or CPAs (or both).

FHA-Insured Loans: Insurance premiums

As we stated earlier, all FHA loans require mortgage insurance. An FHA borrower pays both a one-time premium and annual premiums. The one-time premium can be financed over the loan term. The annual premium is paid in monthly installments, and may be canceled after 11 years if the original LTV was 90% or less. The mortgage insurance premiums for FHA loans are called the MIP. For most programs, FHA borrowers pay both a one-time premium and annual premiums. The one-time premium is sometimes called the "upfront premium." Either the borrower or the seller can pay the one-time MIP in cash at closing. Currently, the upfront insurance premium is 1.75% of the loan amount. One-time premium for $100,000 loan at 6% interest: -Pay $1,750 @ closing, or -Add $11 per month to mortage payment for 30 years The borrower also has the option of financing the one-time MIP over the loan term. When the one-time MIP is financed, it is simply added to the base loan amount. The monthly payments are then set to pay off both the base loan and the one-time MIP by the end of the loan term. When the upfront premium is financed in this way, the total loan amount (the base loan amount plus the upfront premium) can't exceed 100% of the property's appraised value. In addition to the one-time MIP, an annual premium is also required for most FHA programs. The annual premium ranges from .45% to 1.55% of the loan balance, depending on the base loan amount, loan term, and LTV. The annual premium is paid in monthly installments: one-twelfth of the annual premium is added to each monthly payment. For loans with an original LTV over 90%, the annual MIP must be paid for the entire loan term. For loans with an original LTV of 90% or less, however, the annual MIP will be canceled after 11 years. Annual MIP -Ranges from .45% to 1.55% -LTV over 90% : paid for entire loan term -LTV under 90%: cancelled afte 11 years

Underwriting Conventional Loans: Income analysis

As with any type of loan, the first step in the income analysis for a conventional loan is to calculate the applicant's stable monthly income. The next step is to apply the appropriate income ratios. Traditionally, two income ratios are used in underwriting conventional loans: the total debt to income ratio and the housing expense to income ratio.

Fixed and Adjustable Rates: Conversion option

As you can see, ARMs do pose some risks for the borrower. Over the long haul, interest rate increases and decreases tend to balance each other out, but borrowers can be faced with large payment increases. Many borrowers are uncomfortable with this risk. One feature that can alleviate that discomfort is a conversion option. A conversion option allows the borrower to convert the ARM to a fixed-rate loan under certain circumstances (for example, during the first 5 years of the loan). Conversion is usually less expensive than refinancing.

Types of Seller Financing: Seller seconds

As you know, when a buyer supplements a first loan with additional financing, it is called secondary financing. A buyer may be able to obtain secondary financing from an institutional lender, but in many cases it's the seller who provides secondary financing. The most common type of seller financing is a seller second. The buyer obtains an institutional loan for the majority of the purchase price and the seller finances part of the buyer's downpayment. This is often called taking back or carrying back a second mortgage. This kind of secondary financing is called a seller second, and it's one of the most common forms of seller financing. With a seller second, the buyer pays most of the purchase price with an institutional loan, and the seller finances some of what would normally be the buyer's downpayment with a second mortgage. *Seller Second: -Primary financing from bank -Secondary financing from sellers Here's an example. The O'Haras are buying a house from the Bernards for $300,000. The O'Haras are getting a 90% conventional loan from an institutional lender. The loan amount is $270,000, so the O'Haras must still come up with a downpayment of $30,000. They only have $15,000 available, so to enable the sale to go through, the Bernards agree to take back a second mortgage for $15,000. A seller second can help a buyer make a smaller downpayment than would otherwise be necessary, and can even help a marginal applicant qualify for an institutional loan. But remember that institutional lenders have certain rules that must be followed when the buyer is going to use secondary financing. Unless the buyer and seller follow these rules, the institutional lender will not agree to the transaction.

Seller Financing: How seller financing works: Home purchase loan

As you'll remember, institutional lenders providing home purchase loans have the borrower sign both a promissory note and a mortgage or deed of trust. The promissory note is evidence of the debt, and the mortgage or deed of trust makes the property collateral for the loan. These same documents may also be used in seller financing. The buyer signs a promissory note, promising to pay the seller the amount of the debt, and then signs a mortgage or deed of trust that gives the seller a security interest in the home being sold. This kind of seller financing arrangement is called a purchase money loan, or a carryback loan.

Underwriting Standards_ Funds for closing

At closing, an FHA borrower must have enough cash to cover the minimum cash investment, the prepaid expenses, and any discount points he has agreed to pay. No reserves are required. The borrower may use gift funds to help close the transaction. The donor of the gift funds must be the borrower's employer, a close relative, a close friend, a charitable organization, or a government agency. As we discussed earlier, family members are not necessarily required to make a gift of their funds. A close family member may provide secondary financing to cover the minimum cash investment. A close family member may also loan the funds to the FHA borrower without requiring a second mortgage or any other form of security. FHA borrowers may also be permitted to borrow money to close the sale if the loan is secured by collateral other than the property being purchased with the FHA-insured mortgage. For example, if the borrowers can borrow money against their car or vacation property, the loan funds may be used to close the sale. This loan must be from an independent third party, not the seller or a real estate agent involved with the transaction, and the collateral must actually be worth the loan proceeds. -Loan must be from independent 3rd party -Value of collateral must equal loan proceeds

Income Analysis: Housing expense to income ratio

Bank conventional loan requirements: Housing expense to income ratio may not exceed 28% The second income ratio used for conventional loans is the housing expense to income ratio. The housing expense to income ratio considers only the applicant's proposed monthly PITI payment as a percentage of the applicant's monthly income. The benchmark maximum housing expense to income ratio for conventional loans is 28%. The proposed housing expense, including principal, interest, taxes, and insurance, generally must not exceed 28% of the loan applicant's stable monthly income. Remember, the Shimadas' stable monthly income is $7,400. To calculate their maximum housing expense using the benchmark housing expense ratio, multiply $7,400 by 28%. $7,400 times .28 equals $2,072. You don't need to factor in the Shimadas' other debts. $2,072 is the maximum housing expense they can afford under the housing expense to income ratio. $7,400 Monthly income x .28 =$2,072 Max housing expense Don't include other debts Maximum payment under total debt to income ratio:$1,836 Maximum payment under housing expense to income ratio:$2,072 The next step is to compare the results of the total debt to income ratio and housing expense to income ratio calculations. The lender will treat the smaller of the two figures as the maximum allowable expense. So the largest monthly mortgage payment the Shimadas can qualify for is $1,836. Note that the Shimadas' maximum mortgage payment is substantially less under the total debt to income ratio than the housing expense to income ratio. That's true in most cases, because most buyers, like the Shimadas, have significant monthly obligations in addition to their housing expense.

Total Debt to Income Ratio: Benchmark ratio

Bank of Commerce conventional loan requirements: Total debt to income ratio may not exceed 36% 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. Let's look at an example to see how the total debt to income ratio works. The Shimadas are applying for a mortgage that would require monthly payments of $1,762. The couple's stable monthly income is $7,400. Their recurring obligations include a $60 minimum charge card payment, a $568 car loan payment, and a $200 personal loan payment. Now let's find the maximum monthly housing expense the Shimadas can qualify for under the total debt to income ratio. First multiply $7,400 by 36%. $7,400 times .36 equals $2,664. Now subtract all of their other debts: $2,664 minus $60, minus $568, minus $200, equals $1,836. So the Shimadas could qualify for a maximum monthly housing expense of $1,836. $7,400 Monthly income x .36 =$2,664 Max total payment - $60 Charge card payment - $568 Car loan payment - $200 Personal loan payment =$1,836 Max housing expense

VA-Guaranteed Loans: Loan guaranty

Because VA loans are guaranteed by the federal government, lenders are willing to make the loans without requiring a downpayment. A lender's risk of loss if a VA borrower defaults is minimal. The VA guaranty is similar to private mortgage insurance in that it only covers a portion of the loan amount. The maximum guaranty available for a particular transaction depends on the loan amount and median area home prices in the property's county. For example, for loans over $144,000 and up to $417,000, the guaranty amount is 25% of the loan amount. (So that's a $104,250 guaranty for a $417,000 loan.) For loan amounts over $417,000, the guaranty is 25% of the loan amount, up to the maximum specified for the county. Currently, the maximum guaranty amount in most counties in $104,250, though this ranges higher in some expensive counties. Higher limits apply to Alaska, Hawaii, Guam, and the Virgin Islands. So, if a loan's guaranty amount was $250,000 (the highest amount in any California county), the lender could lose up to $250,000 because of borrower default and the entire loss would be covered by the federal government.

ARM Features: ARM checklist

Because adjustable-rate mortgages are complicated, if your buyers are interested in getting an ARM, you should help them understand how all of the elements fit together. Encourage them to ask the lender the following questions: -What will the initial interest rate be? -How often will the interest rate change? -How long is the first rate adjustment period? -How often will the payment change? -Is there a limit to how much the interest rate can be increased? -Is there a limit to how much the payment can be increased at any one time? -Does the loan allow negative amortization? -Can the loan be converted to a fixed-rate loan?

Income Analysis: Total debt ratio preferred

Because the total debt to income ratio takes all of the buyer's monthly obligations into account, lenders generally consider it a more reliable indicator of the maximum mortgage payment the buyer can afford than the housing expense to income ratio. In fact, Fannie Mae no longer sets a benchmark housing expense to income ratio; Fannie Mae treats the housing expense only as one component in the total debt to income ratio.

Income Analysis: Ratios are guidelines

Both Fannie Mae and Freddie Mac consider the benchmark income ratios to be guidelines rather than inflexible limits. They might be willing to accept a loan where either or both benchmarks are exceeded, as long as there are other factors that suggest that the loan would be a safe investment despite the income ratios. These considerations might include: -a large downpayment, -a substantial net worth, -a demonstrated ability to accumulate savings and -avoid debts, - education or training that indicates strong potential for increased earnings, or -significant energy-efficient features in the home being purchased. However, if there are factors that suggest increased rather than decreased risk, a lender will probably be unwilling to approve a loan if the applicant's income ratios exceed the benchmarks. For instance, a lender would be unlikely to accept a total debt to income ratio over 36% on a loan with an LTV over 90% or an adjustable-rate loan, since such a loan would represent increased risk. Even if compensating factors do make a total debt to income ratio over 36% acceptable, neither Fannie Mae nor Freddie Mac will accept a ratio over 45% on a manually underwritten loan application. If an automated underwriting system is used, there's no set maximum. The system will decide whether the higher ratio is acceptable in the context of overall risk presented by the application.

Cal-Vet Loans: Characteristics

Cal-Vet loans are very attractive to veteran borrowers. Here are some of their characteristics. -Maximum loan amount -Loan-to-value ratios -Funding fee -Origination fee -Other fees -Interest rate -Loan term -Prepayment -Secondary financing -Occupancy -Insurance -Assumption

Cal-Vet Loans: Characteristics: Prepayment

Cal-Vet loans can be prepaid without penalty.

Cal-Vet Loans: Characteristics: Interest rate

Cal-Vet loans have a below-market interest rate that may vary according to market rates, but cannot go up more than 0.5% over the loan's term.

Underwriting Conventional Loans: Net worth

Cash reserve requirements Limits on gift funds For a conventional loan, the borrower may be required to have two or three months' mortgage payments in reserve after paying the downpayment and closing costs. Gift funds may be used toward the downpayment, but a borrower usually must contribute at least 5% of the purchase price out of his own funds. When a lender evaluates a conventional loan applicant's net worth, there aren't many special guidelines to follow. For the most part, the lender simply applies the same standards that would be used for any type of loan. However, there are a few special rules concerning how much cash the borrower is required to have in reserve, and certain limits on the use of gift funds. It's a good idea for a conventional loan applicant to have at least two months' worth of mortgage payments in reserve after making the downpayment and paying all closing costs. Having even more funds in reserve tends to strengthen an application; conversely, having less funds will weaken it. Some lenders require conventional loan applicants to have the equivalent of 2 months' mortgage payments in reserve. For 95% loans, 3 months of reserves are sometimes required. If the buyer doesn't have enough cash to pay the downpayment and the closing costs and still have any required reserves left over, the buyer's parents or some other relative may be willing to donate the necessary cash. Lenders refer to this type of donation as gift funds. They generally require certain rules to be followed when gift funds are used to close a conventional loan transaction. First of all, there are rules about who can provide gift funds. The donor generally has to be the buyer's relative, fiance, or domestic partner, or possibly the buyer's employer or a nonprofit organization. Second, the buyer must receive a letter from the donor stating that the funds are a gift and do not need to be repaid. Third, the buyer generally must make a downpayment of at least 5% of her own funds. 1) Donor must be relative, fiance, domestic partner, etc. 2) Gift letter is required. 3) Buyer must contribute downpayment of at least 5 %.

VA-Guaranteed Loans: Eligibility

Certificate of Eligibility To be eligible for a VA loan, a veteran must have served a minimum amount of continuous active duty. To be eligible for a VA loan, the veteran must be issued a Certificate of Eligibility by the VA. This requires the borrower to have served a minimum amount of active duty. This minimum amount varies from 90 days to 24 months of active duty. If you have a buyer who is unsure about his or her eligibility, the buyer should check with the local VA office.

#1. Financing Programs

Conditions in the real estate market also affect what kinds of loans lenders offer. A lender's top priority is always to make sure that its investments are protected and profitable, so it may emphasize certain types of loans under different market conditions. A lender might change its loan offerings as key interest rates move up or down, or depending on whether the local real estate market is a buyer's market or a seller's market. Lenders often send real estate agents information on their interest rates and new loan offerings, and agents should stay informed about current financing options. In particular, you should keep watch for special programs that benefit first-time home buyers.

Conventional Loans: Conventional loan amounts

Conventional conforming loans are subject to conforming loan limits, which are set by the Federal Housing Finance Agency, the agency that oversees the secondary market agencies. These limits apply to loans for one- to four-unit dwellings. The conforming loan limits are based on median housing prices nationwide and may be adjusted annually to reflect changes in median prices. Conventional loans that exceed the conforming loan limits are known as jumbo loans. For these loans, lenders usually charge higher interest rates and fees and apply stricter underwriting standards. Jumbo loans are generally ineligible for sale to the major secondary market agencies.

#5. Conventional Loans: Making conventional loans affordable

Conventional loans can be used to finance transactions in unconventional ways. There are a number of ways to make a conventional loan suit an individual buyer's particular needs. And lenders offer a variety of special loan programs that don't involve government backing. To give you some idea of the range of options available, we'll look at: -buydowns, -mortgages with lower initial payments, -low-downpayment mortgages, and -programs targeted at low-income buyers and low-income neighborhoods.

Jumbo loans (Load limits)

Conventional loans that exceed the conforming loan limits. A conventional loan can't be purchased by Fannie Mae or Freddie Mac if it exceeds the applicable conforming loan limit. Currently, the conforming loan limit for single-family homes in most areas of the country is $417,000. The limit is higher in areas where housing is more expensive. For these loans, lenders usually charge higher interest rates and fees and apply stricter underwriting standards. Jumbo loans are generally ineligible for sale to the major secondary market agencies. For 2013, the conforming loan limit for single-family homes in most parts of the country is $417,000. In areas where housing is more expensive, the limit goes up to a maximum of $625,500, based on area median housing prices. In Alaska, Hawaii, Guam, and the Virgin Islands, where housing is exceptionally expensive, the maximum is even higher.

#4. Conventional Loans: Underwriting conventional loans

Conventional underwriting standards are mandated by Fannie Mae and Freddie Mac The major secondary market agencies that buy conventional loans, Fannie Mae and Freddie Mac, have specific rules for underwriting these loans. It's worth noting that in recent years, the agencies have modified their underwriting procedures, partly as a result of using automated underwriting software. The borrower's income, net worth, and credit reputation are still taken into consideration, but the agencies' methods of evaluating that information are different.

Total Debt to Income Ratio: Revolving debts

Credit card and charge accounts are called revolving debts. With this type of debt, the amount owed each month is variable, and the account is not supposed to be paid off by a specific date. The lender will typically use the minimum monthly payment owed on each revolving account in calculating a loan applicant's total debt to income ratio.

Loan Fees: Discount points

Discount points are used to increase the lender's immediate yield on a loan. In exchange for a lump sum payment up front, the lender is willing to make the loan at a lower interest rate. In other words, the lender "discounts" the loan for a flat fee. The lower interest rate means that the borrower's monthly payment will be lower, which makes it easier for the borrower to qualify for the loan. Like the origination fee, discount points are paid at closing. They are usually paid by the BORROWER, but the property SELLER or a THIRD PARTY may pay the points to help the borrower afford the loan. Discount points are quite common nowadays. A lender that offers a below-market interest rate typically compensates for it by charging discount points.

Seller Financing: Other ways sellers can help

Even if a seller can't afford to offer financing to a buyer, there are other ways the seller can help the buyer close the transaction. -Buydown -Contribution to closing costs -Equity exchange -Lease/option

Fixed and Adjustable Rates: 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. For example, suppose the current index rate is 5%. The lender's margin is 2%. 5% plus 2% equals 7%. So the lender charges the borrower 7% on the loan. The 2% margin is the lender's income from the loan.

FHA-Insured Loans: Characteristics: Owner-occupancy

FHA borrowers must intend to occupy the property they're financing with an FHA loan as their primary residence. FHA loans generally cannot be used to finance investment (rental) properties. However, an FHA loan can be used for the purchase of a property with up to four dwelling units, provided the owner uses the property as her primary residence.

FHA-Insured Loans: Assumption

FHA loan can be assumed only by buyer intending to occupy the property FHA loans contain due-on-sale clauses, so certain limitations on assumption apply. For example, an FHA loan can generally be assumed only by a buyer who will occupy the property. The lender will review the creditworthiness of the buyer before agreeing to an assumption.

FHA-Insured Loans: Characteristics: Maximum loan amount

FHA maximum loan amounts are based on median housing prices. In some areas, the FHA maximum loan amounts are considerably lower than the maximums for conforming conventional loans.

FHA-Insured Loans: Characteristics: Mortgage insurance

FHA mortgage insurance is required on all FHA loans, regardless of the size of the downpayment. (By contrast, private mortgage insurance is only required for conventional loans with a loan-to-value ratio over 80%. But as a practical matter, the vast majority of FHA loans are low-downpayment loans, so mortgage insurance would be required in any event.)

FHA-Insured Loans: Characteristics: Prepayment penalty

FHA-insured loans never call for a prepayment penalty. FHA loans can be paid off at any time without penalty.

Buydowns: Limits on buydown amount

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. If the loan-to-value ratio is over 90%, the contributions can't exceed 3% of the property's sales price or appraised value (whichever is less). If the LTV is between 75% and 90%, the contributions can't exceed 6%. And if the LTV is under 75%, the contributions can't exceed 9%. Contribution Limits: LTV > 90%: No more than 3% LTV 75-90%: No more than 6% LTV < 75%: No more than 9%

Fannie Mae

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.

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. Next, the "overall layering of risk" is considered. 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.

VA-Guaranteed Loans: Characteristics of VA loans: Repayment plans

If a VA borrower runs into temporary financial difficulties such as illness or unemployment and misses payments as a result, a VA loan officer can help the borrower negotiate a repayment plan with the lender.

Making Conventional Loans Affordable: Buydowns

In a buydown arrangement, the seller (or a third party) pays the buyer's lender a lump sum of money at closing so that the lender will charge the buyer a lower interest rate. A buydown may be permanent or temporary. It works essentially the same way as paying discount points. The lump sum paid at closing increases the lender's upfront yield on the loan. As a result, the lender is willing to charge a lower interest rate. In essence, the seller pays the lender to make the financing affordable for the buyer. The seller does not actually have to come up with any cash to arrange for a buydown. Instead, the amount of the buydown is simply deducted from the seller's net proceeds during closing and transferred to the lender. A buydown plan benefits the buyer in 2 ways. First, the buyer's monthly payments are lower than they would otherwise be. Second, the lender may qualify the buyer on the basis of the reduced payments, making it easier for the buyer to qualify for the loan. Buydowns are most commonly used when interest rates are high and potential buyers might otherwise be priced out of purchasing a house. 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. Permanent buydown: For entire loan term Temporary buydown: For first few years of loan

FHA-Insured Loans: Characteristics: 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.

Basic Loan Features: Loan fees

In addition to interest, mortgage lenders charge their borrowers loan fees. Loan fees may also be referred to as "points," which is short for percentage points. A "point" is equal to one percentage point, or one percent, of the loan amount. Almost all mortgage loans involve an origination fee that covers the administrative costs of processing the loan. Discount points (the other type of loan fee) increase the lender's yield from the loan. Lenders often charge discount points in exchange for a lower interest rate for the borrower. For instance, if a lender is charging four points on a $100,000 loan, that means the lender will collect a one-time fee at closing of $4,000 (4% of $100,000). Two common forms of loan fees are origination fees and discount points.

Seller FinancingOther ways sellers can help: Equity exchange

In an equity exchange, instead of requiring the buyer to pay the downpayment entirely in cash, the seller accepts some other asset—such as recreational property, a car, or a boat—as all or part of the downpayment. Again, this kind of transaction enables the buyer to close the sale with significantly less cash.

Buydowns: Temporary buydowns

In contrast to a permanent buydown, a temporary buydown doesn't reduce the interest rate for the life of the loan. Instead, it simply reduces the interest rate and the monthly payments in the early years of the loan term. Temporary buydowns appeal to sellers, because they can cost less than permanent buydowns. And temporary buydowns appeal to buyers who believe that they can grow into larger mortgage payments over the next few years. There are two types of temporary buydowns: 1) level payment and 2) graduated payment. 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 2 years of the loan; the buyer would then pay the note interest rate for the remainder of the loan term. Level Payment Buydown: Year 1-2: 8% Year 3-30: 10% With a graduated payment buydown, the reduced interest rate increases in steps, usually each year. A 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.

VA-Guaranteed Loans: Underwriting standards

Income Ratio Method Residual Income Method To qualify for a VA loan, a veteran must meet the underwriting standards set by the Department of Veterans Affairs. A VA loan applicant must qualify under both the income ratio method and the residual income method. The applicant's total debt to income ratio should not exceed 41%. The residual income method is used to determine whether the applicant will have sufficient cash flow for other expenses after paying the mortgage payment and other monthly obligations. The veteran's income will be analyzed using two different methods, an income ratio method and a residual income method. The veteran must qualify under both methods. The income ratio method works essentially the same way as income ratios for conventional and FHA loans. However, VA borrowers have to qualify under only one ratio, the total debt to income ratio. As a general rule, a VA borrower's total debt to income ratio should not be more than 41%. (Even though there is only one ratio, they must also qualify under the residual income method, which uses a table of minimum incomes rather than a ratio.) VA LOANS USE ONLY ONE RATIO: -Total debt to income ratio should not exceed 41%. Let's look at an example. Ben is eligible for a VA loan. He earns $2,800 a month, and his total monthly obligations add up to $375 a month. To see how big a house payment Ben can qualify for with a VA loan, multiply $2,800 by 41%, or .41. The answer is $1,148. Now subtract his monthly obligations from $1,148, and you get $773. Ben can qualify for a $773 monthly housing expense under the total debt to income ratio. First: $2,800 Montly income x .41 =$1,148 Second: $1,148 - $375 Total monthly obligations = $773 Qualifies for monthly housing expense under the total debt to income ratio The second method used to qualify VA borrowers is the residual income analysis, which is also called CASH FLOW ANALYSIS. This is to make sure that after paying the monthly mortgage payment and other recurring obligations, the borrower has enough money left over to meet all other basic expenses without becoming overextended. With this method, the underwriter subtracts the proposed housing expense, all other recurring obligations, and certain taxes from the veteran's income to determine his residual income. The taxes that are deducted from the veteran's income include all the taxes that are deducted from his paycheck, including federal, state and local income taxes, social security taxes, and Medicare taxes. The monthly maintenance and utility cost estimate is calculated by multiplying the number of square feet of living area in the house by 14 cents. (The VA refers to the borrower's PITI payment plus the maintenance and utility cost estimate as the monthly shelter expense.) The veteran's residual income that results from this calculation should be at least one dollar more than the VA's minimum requirement. The minimum requirement varies depending on where the veteran lives, her family size, and the size of the proposed loan. For example, the residual income required for a family of three living in California when the loan amount is less than $80,000 is $859. The residual income required for a family of four living in California when the loan amount is $80,000 or more is $1,117. Let's return to the example of Ben, and calculate his residual income. Suppose Ben lives in California and is a divorced father with one child. He wants to buy a 1,500 square-foot home that costs $107,000. Start with his monthly income, which is $2,800. Now deduct his federal and state income taxes, which are $350. We also need to subtract his social security and Medicare taxes, which are $214. Next, we must deduct his recurring monthly obligations, which are $375. Subtract the monthly maintenance and utility costs, which is $210. ($.14 x 1,500 square feet = $210.) And finally, we must deduct his proposed housing expense, which is, at most, $773. $773 was the figure we obtained from applying the 41% total monthly obligations to income ratio. $2,800 minus all these expenses equals $878. According to the VA, Ben's residual income must be at least $823. Since Ben's residual income is well above the required minimum, he should have no problem qualifying for the $773 proposed monthly housing expense. Residual Income: $2,800 Monthly income -$350 Federal and state income taxes -$214 Social security and Medicare taxes -$375 Recurring monthly obligations -$210 Monthly maintenance and utility costs ($.14 x 1,500 square feet = $210.) -$773 Proposed housing expense ($773 was the figure we obtained from applying the 41% total monthly obligations to income ratio) =$878 > $823 (Residual income must be at least $823) (No problem qualifying for the $773 proposed monthly housing expense) Note that the residual income guidelines are just that—only guidelines. If a VA loan applicant doesn't fall within the guidelines, the lender takes other factors into consideration. In addition to residual income, the lender should also consider factors such as the applicant's ability to accumulate a significant net worth and use credit wisely, the size of the downpayment, and the number and ages of any dependents. The 41% income ratio is also somewhat flexible. A lender can approve a VA loan if the applicant's income ratio is above 41% when the applicant can show other favorable characteristics, such as a substantial amount of liquid assets, a substantial downpayment, or significantly more residual income than the minimum amount required by the VA. APPROVED: -Income ratio: 43% -Cash reserves: $10,000 -Downpayment: $15,000 If the applicant's residual income is at least 20% over the required minimum, the lender may approve the loan even if the income ratio is significantly higher than 41% and there are no other compensating factors. APPROVED: -Income ratio: 45% -Required residual income: $1,117 -Borrower's residual income: $1,370

Primary Financing: Encumbered property

It's relatively uncommon for a seller to own his home free and clear. Typically, the seller financed the purchase of the property and still owes money on that loan when he decides to sell. For example, suppose Wallace is selling his home for $200,000. He would prefer to finance the sale and receive installment payments from the buyer, Ellen. But there's a first mortgage on the property in the amount of $110,000. Wallace doesn't have enough cash to pay off the $110,000 loan at closing, and a buyer is unlikely to have that much cash to invest in the home as a downpayment. Ellen could assume the existing mortgage, and the seller could finance the rest of the purchase price with a seller second. But there's another alternative that may be more attractive: wraparound financing. *Sales price: $200,000 Existing loan: $100,000

Mortgages with Lower Initial Payments: Balloon/reset mortgages

Like two-step mortgages, balloon-reset mortgages come in 5-25 and 7-23 versions. A balloon/reset mortgage is a partially amortized loan that comes due after 5 or 7 years. At that point, the borrower has the choice of paying off the loan with a balloon payment, which will probably require refinancing, or else resetting the loan to current market interest rates. However, with a balloon-reset mortgage the initial 5- or 7-year period is actually the entire loan term. Although the size of the monthly payments is calculated based on amortization for a 30-year loan term, the entire mortgage balance becomes due after 5 or 7 years. In essence, a balloon-reset mortgage is a partially amortized loan with a balloon payment. At the end of the 5- or 7-year period, the borrower may choose to pay off the loan. This will usually require refinancing to get the cash for the balloon payment. Alternatively, the borrower may choose to reset the loan. If the loan is reset, the loan continues and the interest rate is set to the current market interest rate. The interest rate and monthly payments will be fixed for the remaining 23 or 25 years of the loan term. Balloon payment: Usually requires refinancing Reset: Switch to current interest rate for duration of loan. Resetting the loan enables the borrower to avoid refinancing charges. The borrower will be allowed to reset only if certain requirements are met; for instance, the borrower must not have been delinquent on mortgage payments or have encumbered the property with other liens. Of course, in some cases it may still be to the borrower's advantage to refinance the loan, especially if interest rates have dropped during the initial part of the loan term.

Conventional Loans: Risk-based loan fees

Loan-level price adjustments may be charged to conventional borrowers whose loans will be sold to Fannie Mae or Freddie Mac. The size of the charge depends on the borrower's credit score, the loan-to-value ratio, and other risk factors. In addition to the standard origination fee, most conventional borrowers will be charged a loan-level price adjustment (LLPA) if the loan is going to be sold to one of the secondary market agencies. The amount of this charge depends on the borrower's credit score and LTV. The riskier the loan, the larger the LLPA.

Making Conventional Loans Affordable: Mortgages with lower initial payments

Many home buyers, especially first-time buyers, are starting out in their careers. They may have limited incomes and high debts from student loans, but expect their incomes to increase steadily. If these buyers can obtain a loan with lower initial payments and larger payments later, they may be able to afford a more expensive house than they otherwise might. Of course, if their incomes fail to increase, payment shock is likely. We've already discussed loans with two-tiered repayment schedules, in the context of adjustable rate mortgages. But there are also a number of other options that offer lower payments in the initial years of the loan, with less uncertainty than an adjustable rate loan. Options that we'll discuss include two-step mortgages, balloon-reset mortgages, and interest-only mortgages.

Cal-Vet Loans: Characteristics: Maximum loan amount

Maximum amounts vary from county to county; the highest loan amount allowed anywhere is $521,250.

Fixed and Adjustable Rates: Interest rate caps

Most ARMs have an interest rate cap, to help protect the borrower from "payment shock." Adjustable-rate loans have caps on how much the interest rate or the monthly payment may go up, in order to prevent 'payment shock.' Without caps, rapidly rising interest rates and corresponding payment increases could easily make a once-manageable monthly payment unaffordable. Payment shock occurs when the loan's interest rate rises so rapidly that the borrower can no longer afford to make the mortgage payments. An interest rate cap protects the borrower from payment shock because it limits how much the loan's interest rate can go up, regardless of what the index does. By limiting interest rate increases, the rate cap also prevents the monthly payment from increasing too much. Most ARMs have two kinds of rate caps. One kind limits how much the interest rate can increase in any one adjustment period. The other limits how much the interest rate can increase over the entire life of the loan. Common rate caps are 2% per year and 6% over the life of the loan.

FHA-Insured Loans: Characteristics: 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.

Conventional Loans: Assumption

Most conventional loans contain due-on-sale or alienation clauses, which means that the loan can be assumed only with the lender's permission. The lender will evaluate the new buyers to make sure that they are creditworthy. The lender will usually charge an assumption fee, and may also raise the interest rate.

Conventional Loans: Secondary financing

Most lenders will allow a borrower to use secondary financing in conjunction with a conventional loan, but will impose some restrictions. The restrictions are intended to prevent the borrower from overextending himself and defaulting on the primary loan. For instance, many lenders require that the repayment term on a secondary loan cannot be less than 5 years. A loan with a shorter term would probably require a balloon payment during the first few years of the primary loan, when the risk of default is at its greatest. Not Acceptable: Primary loan: 30-year term Secondary loan: 1-year term with balloon payment

Cal-Vet Loans: Characteristics: Insurance

New Cal-Vet borrowers under age 62 are required to purchase life insurance through the Cal-Vet program. If the borrower dies during the loan term, the insurance proceeds will be applied toward the loan amount. Cal-Vet borrowers also purchase reduced-cost homeowners insurance through the program, which provides flood and earthquake protection.

Amortization: Partially amortized loans

Not all loans are fully amortized. There are also partially amortized loans and interest-only loans. A partially amortized loan requires regular payments of both principal and interest. However, the monthly payments are not big enough to completely pay off the debt by the end of the loan term. There is some principal left at the end of the term, which must be paid off in one lump sum, called a balloon payment. For example, a partially amortized $90,000 loan might have a $15,000 balance remaining at the end of the loan term. The borrower would have to make a final balloon payment of $15,000 to pay off the loan. In such a situation, the borrower typically must come up with the payoff funds through refinancing. Refinancing means using the funds from a new loan to pay off an existing mortgage.

Seller Financing: Types of seller financing

Now let's consider some of the different forms seller financing can take. -Seller seconds -Primary financing -Wraparound financing

#6. Government-Sponsored Loans: FHA-insured loans

Now let's turn our attention to government-sponsored mortgage loans. We'll be looking at the two major federal home loan programs, the FHA-insured loan program and the VA-guaranteed loan program. We will also consider California's state-sponsored Cal-Vet program. The FHA-insured loan program is administered by the Federal Housing Administration, and the characteristics of FHA loans are established by the federal government. The FHA does not actually make loans. Instead, it insures loans made by banks and other institutional lenders. In fact, the FHA is sometimes referred to as a giant mortgage insurance agency because its main function is insuring loans. 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 will compensate lender for losses suffered because of loan default

#3. Conventional Loans

Now we'll begin looking at the various loan programs available to borrowers. Loans issued by institutional lenders (such as banks or savings and loans) fall into two broad categories: 1)conventional loans and 2) government-sponsored loans. If your buyer goes to a bank and gets a loan that is not insured by the FHA, guaranteed by the VA, or sponsored by some other federal, state, or local government agency, that loan is called a conventional loan. A conventional loan is simply any institutional loan that is not insured, guaranteed, or otherwise sponsored by a government agency.

Making Conventional Loans Affordable: Low-downpayment programs

Often the problem for home buyers, especially first-time buyers, is not whether they have a reliable source of income. Many lenders have special conventional programs that allow downpayments of less than 5%. Some of these require a small downpayment from the borrower's own funds, while others allow all of the funds to come from other sources. Instead, it's not having enough cash saved up to cover the downpayment, closing costs, and cash reserves required for a conventional loan. In many cases, even the 5% downpayment required for a 95% conventional loan may be out of reach. However, many lenders offer special conventional loan programs that allow borrowers to make smaller downpayments and receive cash from alternative sources. The specific requirements for these programs will vary from lender to lender, but here are two examples: 1) A loan with a 95% LTV, requiring a 3% downpayment from the borrower's own funds and allowing the other 2% to come from other sources. 2) A loan with a 97% LTV, requiring a 3% downpayment from the borrower's own funds, plus a 3% contribution to closing costs from other sources. The allowable alternative sources of funds may include -gifts or unsecured loans from relatives, -employers, -public agencies, -nonprofit organizations, or -private foundations. More than one source may be used to assemble the necessary funds. In addition to having low downpayment requirements, these programs often further reduce the borrower's need for cash at closing by requiring only one month's mortgage payment in reserve, or even by having no reserve requirement. (This is in contrast to the 2 or 3 months of reserves that some lenders require for conventional loans.)

VA-Guaranteed Loans: Characteristics of VA loans: No downpayment

One of the biggest advantages of VA loans is that they don't necessarily require a downpayment. A VA loan can equal the sales price or appraised value of the home, whichever is less. This allows many veterans to buy homes who would otherwise be unable to do so.

Seller FinancingOther ways sellers can help: Buydown

One popular way to help the buyer is with a buydown. To buy down the interest rate on the buyer's institutional loan, the seller doesn't actually have to pay the lender a lump sum at closing. Instead, the seller's net proceeds from the sale are reduced by the cost of the buydown. From the seller's point of view, a buydown is similar to a price reduction. As we discussed earlier, though, a buydown may help the buyer more than a straight price reduction would, by making it easier for the buyer to qualify for an institutional loan with a lower interest rate.

Types of Seller Financing: Primary financing

Primary Financing = Seller is only source of financing Primary financing may be used whether property is encumbered or unencumbered Seller financing may be the only form of financing that a buyer receives. This can be very flexible, and the seller may choose to ignore typical qualifying standards. Primary financing is easiest when the seller's property is unencumbered. Now let's turn our attention to seller financing as primary financing, when the home seller is the buyer's only source of financing. Seller financing is at its most flexible when it is primary financing. Lenders' guidelines no longer have to be followed, and qualifying standards can be virtually ignored if the parties choose to do so. Seller financing can be used as primary financing when the property is either encumbered or unencumbered. We'll look at unencumbered property first. That's when the seller owns the property free and clear—it's not encumbered by a mortgage or deed of trust.

Homeowners Protection Act

Requires lenders to cancel the PMI on a loan and refund any unearned premium to the borrower once certain conditions are met. The lender must automatically cancel the PMI when the loan's principal balance is scheduled to reach 78% of the home's original value (the appraised value of the home when it was purchased), unless the borrower is delinquent on payments. The borrower may request that the lender cancel PMI when the principal balance is scheduled to reach 80% of the home's original value. If the borrower's payment history is good, the value of the property has not decreased, and the borrower has not taken out additional loans against the property, then the request must be granted. Note that these requirements do not apply to loans closed before July 29, 1999, nor do they apply to certain high-risk or non-standard loans. Nevertheless, most lenders will typically allow PMI to be canceled on older loans once the loan-to-value ratio has been reduced to a specified level. In addition, the Homeowners Protection Act requires that all lenders send an annual notice informing borrowers of their PMI cancellation rights, regardless of when the loan was originated.

Cal-Vet Loans: Characteristics: Secondary financing

Secondary financing is allowed only if the Cal-Vet loan amount and the secondary loan amount do not add up to more than property's appraised value.

FHA-Insured Loans: Seller contributions

Seller contributions are limited to 6% of amount financed As you know, sometimes a seller agrees to buy down the buyer's interest rate or to pay all or part of the buyer's closing costs. When the sale is financed with an FHA loan, the FHA limits the amount of contributions from the seller (or another interested party, such as a real estate broker) to 6% of the sales price or the appraised value, whichever is less. Any amount over that limit must be subtracted from the sales price before calculating the loan-to-value ratio and minimum cash investment.

Seller Financing: Potential disadvantages

Seller financing is extremely flexible—the parties can set up any loan payment schedule that makes sense for them. For example, instead of an 80%, 30-year, fully-amortized loan that requires monthly payments, they could agree to a 5% downpayment, bi-weekly payments, and partial amortization with a balloon payment after 7 years. There may be pitfalls, however. Seller Financing Payment Terms: -5% downpayment -Bi-weekly payments -Partial amoritization with BALLOON PAYMENT after 7 years The parties must consider all the consequences of their financing arrangement. For instance, a balloon payment can be a problem for the buyer, who most likely will have to refinance to get the money to make the payment. A buyer should make plans for covering the balloon payment long before it becomes due. The seller also assumes significant risks by offering seller financing. A default on the part of the buyer could create serious financial problems for the seller. The seller must be careful not to extend financing to a buyer who can't afford either the monthly payments or the balloon payment, if any. Also, in a seller-financed transaction, the seller isn't cashed out—that is, she doesn't get all of her equity in the property in cash at closing. So sellers who are planning to use the equity in their present home to buy a new home generally can't offer seller financing. And even if the sellers don't need all the equity right away, they still need to make sure that the buyers' downpayment and monthly payments will provide enough cash to meet their immediate needs. Just like a lender, a seller must consider whether extending credit to the buyer is a good investment. Depending on how other categories of investments are doing, seller financing may not generate the best rate of return. In a period when mortgage interest rates are low (such as 4%) but the stock market is generating solid returns (such as 7%), it would make better financial sense for the seller to put his money into a mutual fund rather than into a loan to a buyer. If a seller charges an interest rate that is below a specified minimum, he might be penalized under the Internal Revenue Service's imputed interest rule. Under this rule, if an interest rate is below a set minimum, the IRS will treat some of the principal received in each payment as interest, which is taxable. If the seller is taxed on principal as well as interest received, this can cancel out any potential tax benefits. You should always advise clients to seek tax advice from a lawyer or accountant before offering seller financing. -Imputed interest rule: If interest rate is too low, principal received may also be taxable income Finally, when a seller is going to provide secondary financing for the buyer, the seller must consider the importance of lien priority. The seller's loan will have lower priority than the primary loan made by an institutional lender. In that case, the institutional loan would be repaid first out of the proceeds of a foreclosure sale. If the primary loan is larger than the total proceeds from foreclosure, the secondary lender (in this case, the seller) will receive nothing. So just like a lender, the seller must carefully consider whether the value of the property is adequate to provide security for both the primary and secondary loans.

Fixed and Adjustable Rates: Negative amortization caps

Some ARMs have both a mortgage payment cap and an interest rate cap. Others have only an interest rate cap, or only a payment cap. Either way, the borrower is protected from payment shock. However, if the ARM has a payment cap but no rate cap, the borrower may run into negative amortization. Negative amortization occurs when unpaid interest is added to the loan's principal balance. This can happen with an ARM if the payment increases don't keep up with increases in the loan's interest rate, so that the payment amount doesn't cover the interest accruing each month. Most loans cap negative amortization or are structured to prevent it. 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. Negative amortization can also occur when an ARM's interest rate adjustments occur more frequently than the payment adjustments. For example, if the rate adjustment period is six months, but the payment adjustment period is one year, the borrower may end up paying too little interest while waiting for the payment adjustment to catch up to the rate adjustment. Most ARMs are structured to avoid negative amortization. Ex. May 2013: Payment: $2,000 Interest owed: $1,950 Unpaid balance: $250,000 June 2013: Payment: $2,000 Interest owed: $2,050 Unpaid balance: $250,050 However, if negative amortization is a possibility, the ARM usually includes a negative amortization cap. A negative amortization cap limits the amount of unpaid interest that can be added to the principal balance. Typically, a negative amortization cap limits the total amount the borrower can owe to 125% of the original loan amount.

Conventional Loans: Secondary market

Some lenders make conventional loans to keep in their own portfolio 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. However, most lenders want to be able to sell their conventional loans on the secondary market. The loans will be easy to sell if they comply with the underwriting rules set by the major secondary market agencies, Fannie Mae and Freddie Mac. Loans that conform to these rules are called conforming loans, and loans that do not are called nonconforming loans. Our discussion of the characteristics of conventional loans will reflect the rules established by Fannie Mae and Freddie Mac for conforming loans.

Basic Loan Features: Secondary financing

Sometimes a home buyer gets two loans at the same time. One of those loans is a primary loan for most of the purchase price. The other loan is used to pay part of the downpayment or closing costs required for the first loan. This second loan is referred to as "secondary financing." Secondary financing can come from a variety of sources. It can come from the same lender who originates the primary loan, or from another lender, or from the seller, or from a private third party. Secondary financing may have an impact on the primary lender's security interest in the borrower's property. So most lenders require certain rules to be followed when secondary financing is used. For instance, the borrower usually must qualify based on the combined payment for both the primary and secondary loans, so that she doesn't become financially overextended. And the borrower may be required to make a minimum cash downpayment with her own funds, even if the secondary financing will cover most of the downpayment required for the primary loan. *Common Restrictions -Buyer must qualify on basis of combined payments -Buyer must make at least some cash downpayment

Seller Financing: How seller financing works: Real Estate Contract

Sometimes a seller may choose to use a real estate contract instead of a promissory note and mortgage or deed of trust. A real estate contract allows the buyer to take immediate possession of the home, but the buyer doesn't get legal title until the full purchase price is paid. If your sellers want to offer financing to a buyer, you should recommend that they talk to a lawyer about which documents to use. Never try to advise sellers about the finance instruments. In fact, in almost any seller-financed transaction, it's a good idea for both the buyer and the seller to get expert legal advice and have the documents prepared by a lawyer. If the seller wishes to prepare the documents himself, they should at least be reviewed by a lawyer before the parties sign them.

Effective income

Stable monthly income. The applicant's gross income from all sources that can be expected to continue for the first 3 years of the loan term. Two ratios help determine the sufficiency of an applicant's effective income. The two ratios are the fixed payment to income ratio and the housing expense to income ratio. Generally, an FHA loan applicant's fixed payment to income ratio may not exceed 43%, and his housing expense to income ratio may not exceed 31%. The applicant must qualify under both ratios. -Maximum fixed payment to income ratio: 43% -Maximum housing expense to income ratio: 31% The applicant's fixed payments include the proposed monthly housing expense plus all recurring monthly charges. The housing expense includes principal and interest, property taxes, hazard insurance, one-twelfth of the annual premium for the FHA mortgage insurance, and any dues owed to a homeowners association or condominium association. Recurring monthly charges include the monthly payments on any debts with ten or more payments remaining. Alimony and child support payments, installment debt payments, and payments on revolving credit accounts are all included. Fixed payments: -Principal -Interest -Property taxes -Hazard insurance -Mortgage insurance premiums -Homeowners dues Recurring monthly charges -Child support payments -Installment debts -Revolving credit accounts Let's look at an example. Vera is applying for an FHA loan. She has a reliable monthly salary of $3,750. She also receives $500 a month in child support payments from her ex-husband. Her effective income totals $4,250 a month. Vera pays the following monthly recurring charges: a $199 car payment, a $40 minimum credit card payment, and a $150 personal loan payment. Monthly Income: $3,750 - Salary $500 - Child support Monthly Debts: $199 - Car payment $40 - Credit card payment $150 - Personal loan payment First, multiply Vera's effective income by 43% to see how much she can spend a month on her total fixed payments. $4,250 times .43 = $1,828. Now subtract her recurring monthly charges from her maximum total fixed payments. $1,828 minus the $199 car payment, minus the $40 credit card payment, minus the $150 personal loan payment, equals $1,439. Vera can qualify for a $1,439 monthly housing expense under the total fixed payments to income ratio. Next, multiply her effective income by 31%, to see how large a monthly housing expense she can afford under the housing expense to income ratio. $4,250 times .31 = $1,318. $1,318 is the maximum monthly housing expense Vera can qualify for under this second ratio. Since she must qualify under both ratios, the lender will use the lower figure arrived at with the housing expense ratio. So Vera's maximum monthly housing expense for an FHA loan is $1,318. $4,250 Effective income monthly total x .43 =$1,828 Monthly allowed total fixed payments - $199 Car payment - $40 Credit card payment - $150 Personal loan payment =$1,439 Monthly housing expense under the total fixed payments to income ratio $4,250 Effective income monthly total x .31 =$1,318 Maximum monthly housing expense qualification under second ratio Must qualify under both ratios, the lender will use the lower figure arrived at with the housing expense ratio. So maximum monthly housing expense for an FHA loan is $1,318. If an FHA loan applicant's income ratios are over the 43% or 31% limit, he might not qualify for an FHA loan. In some circumstances, though, the lender could approve the loan in spite of high income ratios. For example, if the applicant has a conservative attitude toward credit and has at least 3 months' mortgage payments in reserve after closing, the underwriter could approve the loan even though the applicant's fixed payment to income ratio is over 43%. Note, however, that if a loan applicant's debt to income ratio exceeds 43% and the applicant's credit score is below 620, the FHA requires the application to be manually underwritten. APPROVED: -Fixed payment to income ratio: 45% -Credit rating: 720 -Cash reserves: $10,000 The seller or another party may pay discount points to reduce the interest rate and help the loan applicant afford the loan. But no matter how large the temporary buydown actually is, the FHA will qualify the applicant using the note rate. For instance, even if the seller makes a large enough buydown to reduce the loan's interest rate from 9% to 6% in the first year, the buyer would still be required to qualify for the loan at 9%, the note rate.

FHA-Insured Loans: FHA loan amount

The 203(b) loan program is aimed at low- and middle-income home buyers, so there are maximum loan amounts. However, eligibility is not limited to buyers with incomes under a certain limit. Theoretically, a billionaire planning to purchase an inexpensive property could qualify for an FHA loan—as long as the loan amount doesn't exceed the maximum and she intends to occupy the home as her primary residence. FHA maximum loan amounts are tied to conforming loan limits for conventional loans and may be adjusted annually. Maximum loan amounts vary from one place to another, because they are based on local median housing costs. An area with expensive housing has a higher maximum loan amount than a low-cost area. There are different loan ceilings for one-, two-, three- and four-unit residences. For 2013, the maximum loan limit for single-family homes is generally $271,050 but can be as high as $729,750 in high-cost areas. The ceiling is even higher in Alaska, Hawaii, Guam, and the Virgin Islands.

Cal-Vet Loans

The Cal-Vet program helps veterans purchase farms and one-unit residential properties. The state purchases and takes title to the property, then sells the property to the veteran under a land contract. Cal-Vet loans require a downpayment and have maximum loan amounts. Interest rates and fees are generally low, and 95 to 97 percent LTV ratios are common. For veterans who live in California, there is a second veterans' loan program: the California Veterans Farm and Home Purchase Program. The loans made through this program are referred to as Cal-Vet loans. The state Department of Veterans Affairs processes, originates, and services the loan. As you've seen, in the federal loan programs the government insures or guarantees a home buyer's loan. The Cal-Vet program works differently. The state of California actually purchases and takes title to the property that the veteran wants, and then sells the property to the veteran through a land contract. The veteran buyer holds only an equitable interest in the property until the contract price is paid in full, at which point he receives a grant deed to the property. The property a veteran purchases through the Cal-Vet program must be either: -a farm or -a single-family dwelling (a house), -condominium unit, or -mobile home.

Underwriting Standards: Income ratios

The FHA's term for stable monthly income is effective income. Effective income is the applicant's gross income from all sources that can be expected to continue for the first three years of the loan term.

FHA-Insured Loans: History of the FHA

The Federal Housing Administration was created by the federal government in 1934, during the Great Depression, in order to help people with low and moderate incomes buy homes. The FHA loan program was the primary source of low-downpayment mortgages for most of the twentieth century. Today, the FHA is an agency within the Department of Housing and Urban Development. The FHA does not originate loans, but rather provides mortgage insurance for loans made by banks and other lenders. FHA programs are targeted at low- and middle-income home buyers. The FHA offers a variety of loan programs, such as home rehabilitation loans and energy efficiency loans. However, the most widely used FHA-insured loan program is the 203(b) program, which is oriented toward helping low- and moderate-income buyers purchase homes.

VA-Guaranteed Loans: Restoration of entitlement

The VA loan guaranty available to a particular veteran, which is sometimes called the veteran's "guaranty entitlement," does not expire. However, if a veteran uses her entitlement to purchase a property, she can obtain another VA loan only if the loan is repaid and the entitlement is therefore restored or reinstated. A veteran who has used his full entitlement to get a VA loan can get another VA loan only if his entitlement is restored. Entitlement is restored if the first loan is repaid, or if another eligible veteran agrees to assume the loan and substitute his or her entitlement for the seller's entitlement. Suppose Jennifer purchased a home with a VA loan in 1995. She used up her guaranty entitlement when she purchased this home. Thirteen years later, she decided to sell her home. With the sale proceeds, she paid off the entire remaining balance of her VA loan. When the loan was repaid, Jennifer's guaranty entitlement was restored. If she decides to buy another home, she can use her entitlement to get another VA loan. $100,000 Previous loan balance $125,000 Proceeds from sales of house Guaranty Entitlement Restored A veteran may have his entitlement restored even if the loan is not paid off when the home is sold. The new buyer must also be a veteran who agrees to assume the loan and substitute his entitlement for the seller's entitlement. The loan payments must be current, and the buyer must also be an acceptable credit risk. If all these conditions are met, the veteran can request a substitution of entitlement from the VA. -Seller sells property without paying off VA loan -Eligible veteran buyer agrees to assume loan and substitute his own entitlement -Restoration of entitlement will be granted

Basic Loan Features

The basic features of a mortgage loan include the repayment period, the amortization, the loan-to-value ratio, a secondary financing arrangement (in some cases), the loan fees, and a fixed or adjustable interest rate. Note that most of these features are part of any type of mortgage loan, whether it is conventional or government-sponsored.

Monthly shelter expense

The borrower's PITI payment plus the maintenance and utility cost estimate

Conventional Loans: 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.

Fixed and Adjustable Rates: Mortgage payment adjustment period

The interest rate charged on a loan affects the amount of the monthly payment. So an ARM also has a mortgage payment adjustment period, which sets how often the lender can change the amount of the borrower's monthly payment. Usually, the payment adjustment period coincides with the interest rate adjustment period. For example, an ARM with a one-year rate adjustment period is likely to have a one-year payment adjustment period, too. If the interest rate on the loan is adjusted, the lender will also adjust the mortgage payment.

Fixed and Adjustable Rates: ARM features

The key features of an ARM include: -the note rate, -the index, -the margin, -the rate adjustment period, -the mortgage payment adjustment period, -the interest rate cap, -the mortgage payment cap, -the negative amortization cap, and -the conversion option.

Cal-Vet Loans: Characteristics: Loan term

The loan term is typically 30 years, although a loan to purchase a mobile home is typically for 15 to 20 years.

Basic Loan Features: Loan-to-value ratios

The loan-to-value ratio (LTV) refers to the relationship between the loan amount and the value of the home being purchased. A loan with a low LTV is less risky than one with a high LTV; because the borrower has made a large investment in the property, default is less likely. For instance, if a house were worth $100,000 and the buyers made a $20,000 downpayment, the loan amount would be $80,000. The loan-to-value ratio would be 80%. If the buyers put down only $10,000, the loan amount would be $90,000, and the loan-to-value ratio would be 90%. Lenders generally feel secure making a mortgage loan with an 80% loan-to-value ratio. That's because a borrower who has invested 20% of the purchase price is unlikely to walk away from the home if financial problems arise. Also, when a loan is 80% of the home's value, the lender knows that even if the borrower does default, a foreclosure sale in most markets is likely to generate at least 80% of the purchase price. This means that the lender will lose little, if any, money on the foreclosure sale. The higher the LTV, the greater the lender's risk of loss in the event of default and foreclosure. Nonetheless, mortgage loans with high LTVs (95%, for example) may be available. Lenders use loan-to-value ratios to set maximum loan amounts for their different loan programs.

Repayment Period: Total interest

The most significant advantage of a 15-year loan is that the total interest paid over the life of the loan is much less. A borrower with a 15-year loan will end up paying much less total interest than a borrower with a 30-year loan. Let's look at our $100,000 loan at 8% interest. If the loan term is 30 years, the borrower will end up paying the lender a total of approximately $264,240. But with the 15-year loan term, the borrower will pay only $172,080. After deducting the original $100,000 principal amount, you can see that $164,240 in interest is paid over the 30-year term, while only $72,080 in interest is paid over the 15-year term. Obviously, this is a tremendous savings for the borrower over the long term. But it comes at the expense of much higher monthly payments. 30-year Loan: $264,240 Total - $100,000 Principal =$164,240 Interest 15-year Loan: $172,080 Total -$100,000 Principal =$72, 080 Interest

Fixed and Adjustable Rates: Note rate

The note rate is simply the ARM's initial interest rate. It is referred to as the note rate because it is the interest rate stated in the promissory note for the loan.

Cal-Vet Loans: Characteristics: Other fees

The only other fees are for a property appraisal, and for a credit check.

Private Mortgage Insurance: Premiums

The premiums for private mortgage insurance are usually paid by the borrower. Mortgage insurers offer various payment plans, such as the following: -flat monthly premium amount added to the monthly mortgage payment; -initial premium paid at closing, plus annual renewal premiums; or -one-time premium paid at closing or financed along with the loan amount

FHA-Insured Loans: Characteristics: Qualifying standards

The qualifying standards for an FHA loan are not as strict as they are for a conventional loan.

Graduated payment buydown

The reduced interest rate increases in steps, usually each year. Year 1: 7% Year 2: 8% Year 3: 9% Year 4-30: 10%

#4. Underwriting Conventional Loans: Credit reputation

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. Ex. Credit score: 720 Low risk Credit score: 660 Moderate risk Credit score: 490 High risk In addition, as you'll recall from the previous section, credit scores are used in determining the risk-based fees (loan-level price adjustments) that borrowers will be charged. Fannie Mae requires a minimum credit score of 620; Freddie Mac may allow a score below 620, depending on the program, but will charge higher fees.

Seller FinancingOther ways sellers can help: Contribution to closing costs

The seller can help the buyer by contributing to the buyer's closing costs. By paying for some of the closing costs that are typically the buyer's responsibility, the seller enables the buyer to close the transaction with less cash. Remember, however, that lenders place certain limits on the amount a seller can contribute towards the buyer's closing costs.

Cal-Vet Loans: Characteristics: Funding fee

The state obtains protection for its loan through either a federal VA guarantee or through private mortgage insurance. For this guarantee, the borrower pays a funding fee between 1.25% and 2.4% of the loan amount, depending on the size of the downpayment and the veteran's military status. If the loan is VA-guaranteed, the funding fee may be financed. If private mortgage insurance is used, the funding fee must be paid up-front. However, the PMI fee is a one-time charge, and the borrower will not pay PMI during the loan term. If the downpayment is more than 20% of the purchase price, no funding fee will be charged.

Amortization: Interest-only loans

The third alternative—the interest-only loan—calls for only interest payments during the loan term. At the end of the term, the entire principal amount is due and must be paid off with a balloon payment. For example, a buyer borrowed $90,000 on an interest-only basis. During the loan term, he paid only the interest due on the loan. At the end of the loan term he must repay the whole $90,000 he originally borrowed. Coming up with a significant amount of cash all at once to make a balloon payment is a hardship for many borrowers. That's why fully amortized loans are so common. In another form of interest-only loan, the borrower makes interest-only payments at the beginning of the term. At the end of this period, the borrower must begin making amortized payments that will completely pay off the principal and interest by the end of the term. Partially amortized loans and interest-only loans cause problems for some borrowers. When the time comes to make a balloon payment, a borrower may have trouble refinancing on good terms. And with a loan that allows interest-only payments in the early years, the payment amount may increase sharply when the interest-only period ends. For most borrowers, a fully amortized loan is the most comfortable option.

Income Analysis: Total debt to income ratio

The total debt to income ratio measures the relationship between the loan applicant's monthly income and all monthly obligations, including the housing expense. The benchmark maximum total debt to income ratio for conventional loans is 36%. The total debt to income ratio measures the relationship between the loan applicant's stable monthly income and his total monthly debt. This monthly debt is made up of the proposed housing expense (which includes the PITI payment: -principal, -interest, -taxes, -hazard insurance, and -any mortgage insurance or homeowners association dues), -plus any other recurring obligations, including -revolving debts, -installment debts, and -other types of debts like -child support or -alimony.

Conventional Loans: Loan-to-value ratio

The traditional loan-to-value ratio for conventional loans is 80%. This means that the loan amount will be 80% of the property's sales price or appraised value, whichever is less, and the borrower will make a 20% downpayment. An 80% loan is considered to be a safe investment for a lender. Most lenders consider an 80% loan to be a safe investment, since the borrower has a strong incentive to avoid default and the lender could probably recover the full amount owed through a foreclosure. Most lenders also offer 90% and 95% loans. For these loans, they often charge higher interest rates and loan fees. The substantial downpayment made by the borrower serves as an incentive to avoid default. And if a default does occur, the lower loan amount gives the lender a reasonable chance of recovering the full amount owed in a foreclosure sale. Lenders will commonly make loans with a higher LTV but, as we'll discuss, may apply stricter standards. The higher the LTV, the higher the lender's risk. A higher LTV means the borrower has made a smaller downpayment. This means the loan payments are higher, which increases the chance of default. It also means that the borrower has invested less of her own money in the home and is more likely to walk away from it if financial difficulties arise. Higher LTV = Danger For these reasons, it's harder to obtain a loan with a 90% LTV than it is to obtain a loan with an 80% LTV. A 95% loan has even stricter qualifying standards. Also, many lenders are wary about making adjustable-rate loans with LTVs over 90%. Default is more likely with an ARM than a fixed-rate loan, because of the potential for rate and payment increases. 90-95% Loan: -Stricter qualifying standards -ARMs: 90% or less -Higher loan fees & interest rates -Private mortgage insurance required Lenders are likely to charge higher loan fees and higher interest rates for higher-LTV loans. And all borrowers who get conventional loans with LTVs of 90% or 95% are required to purchase private mortgage insurance.

VA-Guaranteed Loans: Characteristics of VA loans: Underwriting standards

The underwriting standards for VA loans are more relaxed than the standards for either conventional loans or FHA-insured loans.

Making Conventional Loans Affordable: Targeted programs

There are many conventional loan programs that are specifically targeted at low- or moderate-income buyers. Generally, borrowers can qualify for one of these programs if their stable monthly income is lower than the median income for the metropolitan area or city in question. These programs may allow a maximum debt to income ratio of 38% or even 40% and may have no maximum housing expense to income ratio. They may also have lower downpayment requirements or lower interest rates. In addition, many lenders offer programs targeted toward borrowers purchasing homes in low-income or rundown neighborhoods. A buyer whose income is well above the local median but who is buying in a targeted neighborhood may still qualify for participation in such a program and benefit from lower downpayment requirements and more lenient qualifying standards. Conventional low-downpayment programs may also be available for certain public employees such as public school teachers, police officers, and firefighters. These loans are designed to enable local government employees to afford housing in the communities they serve, rather than being priced out into more distant areas.

VA-Guaranteed Loans: Characteristics of VA loans: No income limits

There are no income limits for VA loans. They are not limited to low- or middle-income buyers.

Seller FinancingOther ways sellers can help: Lease/option

There are times when a buyer simply isn't ready to purchase a home. The buyer may need time to save a downpayment, pay off debts, or improve her credit rating. Or perhaps the buyer needs more time to sell a property she already owns. In these circumstances, a lease arrangement may help the buyer purchase the home. A lease arrangement can take the form of a lease/option. A lease/option is a combination of a lease and an option to purchase. The seller leases the property to a prospective buyer for a specific period of time. At the same time, the seller gives the buyer an option to purchase the property at a stated price during the lease period.

VA-Guaranteed Loans: Characteristics of VA loans: Loan costs

There is no maximum interest rate for VA loans; instead, the rate is negotiable between borrower and lender. The lender may charge no more than 1% of the loan amount as an origination fee. The lender may also charge discount points, which may be paid by the borrower, the seller, or a third party.

Cal-Vet Loans: Eligibility

To be eligible for most Cal-Vet loans, a veteran must have: -served at least 90 days of active duty during a wartime period; -He or she must apply within 30 years after discharge from active duty; -received an honorable discharge; and -under some circumstances, a veteran's surviving spouse may apply for a Cal-Vet loan. However, veterans discharged before 90 days because of service-related disability are eligible—as are California National Guard and U.S. Reserves members, provided they've served one year of a six-year obligation and are first-time home buyers. Some Cal-Vet loans are subject to the following restrictions: -the property's purchase price can't exceed a limit based on average prices in the area; and -the borrower's family income can't exceed a limit that varies with family size and the county. These restrictions don't apply to all applicants. Anyone interested in a Cal-Vet loan should check with the California Department of Veterans Affairs. A surviving spouse may also apply for a Cal-Vet loan if the veteran died of injuries suffered in the line of duty, is designated as missing or a prisoner of war, or died after applying for a Cal-Vet loan.

Repayment Period: Monthly payment amount

To demonstrate the impact of the repayment period, we'll compare a 30-year loan to a 15-year loan. There is no question that a 30-year loan is more affordable. Stretching the loan out over 30 years keeps the monthly payment lower, and therefore easier for the borrower to make. A borrower with a 15-year loan has to make a significantly higher monthly payment. For example, the monthly payment on a $100,000 30-year loan at 8% interest is $734. The monthly payment on the same loan at 8% interest amortized over a 15-year period is $956. Because of the higher monthly payment, a buyer may not be able to qualify for a 15-year loan. Someone who specifically wants a 15-year mortgage might have to make a larger downpayment in order to reduce the monthly payment to an affordable level, or else might have to choose a less expensive house.

Repayment Period: Interest rates

To keep things simple in our comparison, both the 30-year loan and the 15-year loan had the same interest rate, 8%. However, a lender will typically charge a lower interest rate on a 15-year loan than on a 30-year loan. The shorter the loan term, the lower the risk, so the lender can charge less for the loan. Bank's Interest Rates: -30-year fixed-rate: 8% -15-year fixed-rate: 7.5% The interest rate on a 15-year loan is often at least half a percentage point lower than the rate on a comparable 30-year loan. For instance, let's take another look at the 15-year loan for $100,000, except now let's assume the interest rate is 7.5%. The monthly payment would be $927 instead of $956, and the total interest paid over the term of the loan would be only $66,860.

VA-Guaranteed Loans: Characteristics of VA loans: Funding fee

Unlike high-LTV conventional loans and all FHA loans, VA loans do not require mortgage insurance. However, VA borrowers do have to pay a funding fee of 2.15% to 2.4% of the loan amount for no-downpayment loans, depending on the borrower's military status. The fee may be reduced if the borrower is making a downpayment of 5% or more, and is waived for veterans with service-related disabilities. Some lenders allow the veteran to finance this fee along with the loan amount.

#7. Government-Sponsored Loans: VA-guaranteed loans

VA Loans: made by institutional lenders but guaranteed by the government VA loans are guaranteed by the Department of Veterans Affairs, which will reimburse lenders for losses resulting from a borrower's default. Characteristics of VA loans include no downpayment requirement, lenient qualifying standards, no mortgage insurance, and no maximum loan amount. The federal VA home loan program allows eligible veterans to finance the purchase of their homes with low-cost loans. Like FHA loans, VA loans are made by institutional lenders, not by a government agency. VA loans are guaranteed by the U.S. Department of Veterans Affairs, so the lender's risk in making a VA loan is greatly reduced. A VA loan can be used to finance the purchase or construction of an owner-occupied single-family residence—or a multi-family residence with up to four units, as long as the veteran is going to occupy at least one of the units.

VA-Guaranteed Loans: Assumption

VA loans can be assumed by anyone—either a veteran or a non-veteran—who passes a complete credit check. The parties must obtain approval for the assumption from the lender or the VA, unless the loan was made before March 1, 1988. After a VA loan is assumed, the original veteran borrower will remain liable for the loan unless he gets a release of liability from the VA. To get a release of liability, the following conditions must be met: 1) the loan payments must be current, 2) the new buyer must be an acceptable credit risk, and 3) the new buyer must assume the veteran's obligations on the loan.

VA-Guaranteed Loans: Characteristics of VA loans: Loan term

VA loans have 30-year terms and are fully amortized. They may not contain any prepayment penalties.

Temporary Buydowns: Qualifying rate

When a buydown is temporary, the lender will not qualify the buyer based on the buydown rate and payment amount, since the buyer will have to be able to afford a higher rate and a larger payment when the buydown period ends. The buyer will usually be qualified based on the note rate. For adjustable-rate loans, the borrower may be qualified based on the note rate plus a specific percentage, or based on the fully indexed rate.

Conventional Loans: Private mortgage insurance

When a conventional loan's LTV is over 80%, the borrower will be required to obtain private mortgage insurance. The mortgage insurance company will insure the lender against losses resulting from foreclosure. Private mortgage insurance, often referred to as PMI, lessens the lender's risk of loss in the event of default. Both Fannie Mae and Freddie Mac require PMI on all loans they purchase that have loan-to-value ratios over 80%. PMI: Required on loans with LTVs over 80%. PMI protects the lender against foreclosure sale losses. The private mortgage insurance company only insures the upper portion of the loan amount, however. For example, a typical policy might cover the upper 25% of the loan amount. In this way, the insurer only assumes part of the risk of loss rather than all of it. PMI: Only insures upper portion of loan amount Let's look at an example. Cynthia is buying a $220,000 home. She's getting a 90% loan to finance the purchase. That means the amount of her loan is $198,000. Because the LTV is over 80%, she must purchase PMI. In exchange for premium payments, the mortgage insurance company insures the top 25% of the loan amount, or $49,500. The insurance company is assuming the risk that the lender may lose up to $49,500 on a foreclosure sale if Cynthia defaults. If a foreclosure sale resulted in an even bigger loss, a $58,000 loss, for example, the insurance would cover $49,500 and the lender would have to absorb the rest. 90% Loan Requires PMI: $198,000 Loan amount x .25 Insured portion =$49,500 Insured amount Lender may foreclose and file claim to cover losses A lender has two options if a borrower defaults on a loan covered by PMI. First, the lender may foreclose on the property, and, if the foreclosure sale results in a loss, file a claim with the insurance company to cover the loss, up to the policy amount. The losses that will be reimbursed by the mortgage insurance company include: -unpaid principal and interest; -unpaid property taxes, -hazard insurance, and -attorney's fees; -the costs of preserving the property during the period of foreclosure and resale; and -the cost of selling the property. Lender may relinquish property to insurer for compensation Alternatively, the lender may relinquish the property to the insurer, then file a claim for actual losses up to the policy amount. Most lenders opt for the first approach.

Primary Financing: Unencumbered property

When the property is unencumbered, primary seller financing can be very straightforward. All the buyer and seller have to do is negotiate the sales price and the terms of the financing. Naturally, the parties have to decide: -when the seller needs to be cashed out, -how big a downpayment the buyer can make, -whether the buyer can afford the monthly payments, and -whether a balloon payment is in the best interest of both parties. When all these decisions have been made, the parties then have the appropriate finance documents prepared. There's a key difference between primary seller financing and a seller second. When seller financing is secondary financing, the sellers have to worry about lien priority. The primary institutional lender virtually always has first lien priority, with the sellers accepting the position of a junior lienholder. When seller financing is primary financing, lien priority is not such a serious concern. The sellers will have first lien position as long as the finance documents are recorded on the closing date. *Instituational lender has first lien priority. First lien priority: Bank Second lien priority: Seller Even so, the sellers still have to be prepared to protect their security interest. A first mortgage doesn't have priority over all other liens. For example, property tax liens and special assessment liens generally have priority over mortgages, no matter what the recording date. If the buyer fails to pay the property taxes, the government could foreclose on the home, and the sellers might take a loss at the tax foreclosure sale. *Property tax and special assessment liens always have first priority Destruction of the premises is another danger. Suppose the buyer fails to keep the property insured and the house burns down. The buyer then defaults on the loan, and the seller has to foreclose. Since the property with a burned-down house is probably worth much less than the amount of the remaining debt, the seller is likely to collect only a small portion of the debt at the foreclosure sale. Sellers can protect themselves by setting up an impound account for taxes and insurance, just as institutional lenders do. Along with the loan payment, the buyer would make monthly tax and insurance payments, which would be deposited into the impound account. The funds in the impound account would then be used to pay the property taxes and insurance premiums when they become due. Many banks, savings and loans, and mortgage companies are willing to provide and service impound accounts for private parties. *Impound account will be used to collect and make tax and insurance payments

Fixed and Adjustable Rates: 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 interest rate and payment amount of an adjustable-rate loan do not change every time that market rates change. The rate and payment adjustment periods determine how often they can change. One-year adjustment periods are common, but many loans are structured so that the first adjustment period is longer than one year, with annual adjustments thereafter. The rate adjustment period limits how often the lender has the right to make an adjustment. Depending on the loan, the rate adjustment period might be 6 months or 18 months 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. 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. In recent years, many ARMs have had a two-tiered rate adjustment structure. These ARMs have a longer initial period before the first rate adjustment can occur, followed by more frequent rate adjustments after that. For instance, a lender might structure an ARM so that the first adjustment does not occur until three years into the loan, followed by a rate adjustment each year from there on. This would be known as a 3/1 ARM. Other two-tiered ARMs are available, such as 5/1 ARMs, 7/1 ARMs, and 10/1 ARMs. The first number always represents the number of years before the first rate adjustment, and the second number indicates that subsequent adjustments will happen once a year. Generally, the longer the borrower has before the first rate adjustment, the higher the initial interest rate on the loan. However, a two-tiered ARM may be an ideal loan for a buyer who plans to sell or refinance his home before the first rate adjustment, since the initial interest rate will still be significantly lower than the rate for a fixed-rate loan.

Basic Loan Features: Adjustable-rate loans

With an adjustable-rate mortgage, the lender periodically adjusts the interest rate charged on the loan to reflect changes in market interest rates. For the most part, mortgage lenders offered only fixed-rate loans until the early 1980s. Then key interest rates went up dramatically, so that many prospective buyers were priced out of the housing market. In addition, rapid fluctuations in interest rates left many lenders uncomfortable about loaning money at a fixed rate for 30 years. Adjustable-rate mortgages (ARMs) were introduced in response to both of these problems. Ex. $300,000 loan for 30 years at 15,5% interest: Monthly payments = $3,914 With an ARM, the lender can periodically adjust the loan's interest rate so that it reflects current market rates. The borrower's initial rate is set according to the market rate when the loan is originated. The loan's interest rate is then tied to one of several indexes, and future interest rate adjustments are based on the upward and downward movements of the index. Because the lender can shift much of the risk of increasing rates onto the borrower, the initial interest rate for an ARM is generally lower than the initial rate for a comparable fixed-rate loan. For instance, at a time when fixed-rate loans are offered at 6 percent, adjustable-rate loans might be available for 5 or 5.5 percent. An adjustable-rate mortgage might seem very attractive because of the low initial interest rate, but the borrower is taking on a significant risk. The loan's interest rate can move steadily upward in response to increasing market interest rates. Increases in the loan's interest rate will drive the borrower's monthly payment amount higher. As a result, borrowers are much less likely to choose adjustable-rate loans during periods when market interest rates are low. When rates are high, though, an ARM makes more sense. If prevailing interest rates drop, so too will the borrower's interest rate and monthly payment.

Total Debt to Income Ratio: Installment debts

With an installment debt, the repayment schedule has a definite beginning and ending date and the monthly payment is a fixed amount. An installment debt is ordinarily counted as part of the loan applicant's recurring obligations only if more than 10 payments remain to be made. For example, suppose your buyer has a student loan with payments of $50 per month. If there are only 10 payments left until the loan is paid off, the lender won't include the $50 payment in the buyer's monthly obligations. But if more than 10 payments remain to be made on the loan, the $50 will be included. There's an exception to this rule. Even when an installment debt is almost paid off, if it's large enough so that it could interfere with the buyer's ability to pay the mortgage, the lender may include the debt in the total debt to income ratio. For example, if your buyer has a car loan with eight payments of $375 per month remaining, the lender would probably include that in the buyer's debt to income ratio.