Mortgage Education Chapter 8 study flash cards (8 of 8)
11. A borrower looking to keep his CLTV below 90% on a home appraised at $200,000 could qualify for______________ A. A first mortgage of $190,000 B. A first mortgage of $180,000 and a HELOC of $25,000 C. Mortgages totaling no more than $180,000 D. A HELOC, if unused of at least $150,000
11. C The correct answer is mortgage(s) totaling no more than $180,000 (90% X $200,000).
12. A borrower has placed $5,000 in earnest money on a $157,000 home and has been approved for a 75% LTV first mortgage. The seller is contributing 4% toward closing costs. Closing costs are $5,250. The borrower is responsible for 1/3rd of annual property taxes of $3,550 that have already been paid. How much cash does borrower need to bring to closing? A. $34,403.33 B. $32,036.66 C. $12,401.33 D. $14,201.33
12. A USES: $157,000 purchase price + $5,250 in closing costs + 33.3% X $3,550 = $163,433.33 SOURCES: $5,000 earnest money + 75% loan X $157,000 + 4% X $157,000 seller contribution = $129,030 Cash needed at closing is $34,403.33.
13. A borrower is closing on a $340,000 loan at 5.5% on March 17. What is his prepaid interest expense? A. $3,121.11 B. $717.26 C. $768.49 D. $1,281.73
13. C $340,000 X 5.5% / 365 = $51.2329 per diem. He owes for 15 days in March (31-16). Therefore, his prepaid interest will be 15 X $51.2329 = $768.49
15. A 1-Year ARM has a starting rate of 3.75% with an initial index of 2.25% and margin of 2.5%. It has caps of 2% / 6%. After two periodic adjustments and modest inflation, what is the maximum interest rate possible? A. 9.75% B. 5.75% C. 7.75% D. 3.75%
15. C Since the caps are 2% / 6%, and there have only been two adjustments, the maximum possible interest rate would be 7.75% (3.75% + 2% + 2%).
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CHAPTER 8 Mortgage Math and Finance Chapter Overview In this chapter, we cover several basic mortgage math and finance topics that will prepare you with a mathematical foundation to perform and communicate the math/calculations and concepts required in the mortgage loan origination business. They include Loan to Value (LTV), Combined Loan to Value (CLTV), how to calculate cash needed for closing, housing payment ratios and total debt ratios, buydowns and discount points, prepaid interest charges, proration, and adjustable-rate mortgages.
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COMMON SOURCES OF CASH Some of the most common sources of cash credits to the borrower are: ✓ The amount of the new mortgage (considered a cash source in a transaction) ✓ The borrower's earnest money deposit ✓ Any seller contributions (i.e., negotiated seller paid closing costs) ✓ Yield Spread Pricing Premium (lender credits) ✓ Credits to the borrower from the seller for property taxes that were incurred but not yet paid or due for the period of time the seller occupied the home ✓ Cash gifts may also be a source of cash for the borrower
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Combined Loan to Value (CLTV) To calculate the Combined Loan to Value (CLTV) for a purchase transaction, add the loan amount for the first mortgage to the loan amount for the second mortgage to arrive at a Total "Combined" Loan Amount. Then, divide the total loan amount by the sales price or appraised value, whichever is lower. 1 st mortgage + 2nd mortgage = Combined Total Loan Amount For example, Assume you have a $121,500 (1st loan) and a $13,500 (2nd loan) for a combined $135,000 (Total Loan Amount). Also, assume the market value of the property is $150,000. To calculate the CLTV, divide the total loan amount by the market value. $121,500 + $13,500 = $135,000 $135,000/$150,000 = 90% CLTV
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Math exercises Situation: Borrower is purchasing a $250,000 home with an 80% LTV first mortgage, a $2,000 earnest money deposit, and a 2.5% seller contribution at closing. Closing is set for July 1. Property taxes are $4,000 per year. The seller paid $900 at the beginning of the year for current calendar year homeowner association (HOA) dues. The borrower's total settlement charges are $6,700. Given this information, how much cash does the borrower need to bring to closing? So, subtracting the total USES from the total SOURCES tells us the borrower will need to bring $46,900 in cash to closing ($257,150 - $210,250 = $ 46,900).
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Mortgage Math and Finance The mortgage industry is driven by numbers, ratios, statistics, and minimum approval levels. Nearly everyone originating loans today uses some type of loan origination software to perform mortgage math calculations quickly and accurately. However, it is important to understand how to perform these basic mortgage calculations and to effectively explain the results to borrowers
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NOTE: Use a calculator to enter 20,000 then divide by 20, hit the percent key, and $100,000 shows in the display.
1. The front-end ratio includes which of the following items? A. Gross monthly income B. House payment and outstanding debt C. Current obligations D. Utilities and water payments
1. A The front-end ratio consists of PITI divided by gross monthly income. Current obligations, utilities and water payments, and outstanding debts are not included in this calculation.
6. To calculate a monthly property tax amount, you: A. Divide the loan amount by the interest rate B. Multiply the loan amount by an estimated tax percentage and then divide by 12 C. Multiply the sales price by the estimated tax percentage and then divide by 12 D. Divide the sales price by the estimated tax percentage and then multiply by 12
6. C To calculate a monthly property tax amount, the sales price, not the loan amount is relevant. Multiply the sales price by an estimate of the tax percentage to determine the yearly amount, and then divide by 12 to get the monthly amount.
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1. Loan to Value (LTV) This is probably the most important and quickest measure of risk that the lender is willing to assume. Endless studies prove the lower the LTV ratio, the more likely the borrower will repay the loan. LTV essentially expresses the proportion of investment in the transaction that the lender accepts versus that of the borrower. The lower the LTV, the more cash or equity the borrower has in the deal. Put another way, it defines how much skin in the game the borrower is investing in the transaction. A loan's risk level increases as LTV rises. The maximum LTV ratio for residential mortgages that lenders will accept today ranges from 80 to 95% for many conventional lenders and up to 96.5% for FHA loans. VA loans will allow a borrower to have 100% LTV, but the government is essentially partially guaranteeing the loan based on the veteran's level of entitlement (including bonus entitlement). The minimum guarantee is 25% of the loan amount. To calculate the LTV, divide the loan amount by the sales price or appraised value, whichever is lower. If a borrower is seeking a $135,000 loan on a new property valued at $150,000, the LTV is 90%. ($135,000/$150,000 = 90% LTV) To calculate the LTV for a refinance transaction, divide the loan amount by the appraised value. A borrower receiving a $120,000 loan on a home appraised at $150,000 is receiving an 80% LTV loan. ($120,000/$150,000 = 80% LTV) Another way to view this concept is: % of lender's risk + % of owner's equity = 100% (market value of the property) OR Loan amount % + Owner's equity % = 100% The appraiser's opinion of market value provides the current value of the property. The maximum LTV is set by the loan program selected by the borrower. So, the difference between the loan value and the market value is the owner's contribution, which must be brought to the closing table in the form of cash, seller's concessions, gifts, etc. The more equity the owner has in the property, the more likely they will honor the terms of the loan. (Equity is part of the borrower's net worth and losing it can have a significant financial impact.) In volatile housing economic times when property values depreciate, some owners found themselves "upside down," or in other words, owing more to the lender than the property's current market value. Often, the borrower had little equity to start with (0% to 10%). Some owners abandon these loans and properties when LTVs rise above 100%.
10. Which of the following would be included in the prepaid category of borrower costs? A. The credit card charge for the appraisal B. The lender's requirement to place 5 months of property tax reserves in escrow C. The annual premium for homeowner's insurance required at closing D. The cost of title insurance for the lender
10. C Only the homeowner's premium due at closing for the upcoming year is considered a prepaid expense. The appraisal fee is a closing cost even though it might have been paid by the borrower prior to closing. The tax reserve requirement is in the escrow reserves category, not prepaid. The title insurance is also a closing cost.
14. A borrower is closing on a home on April 14. The estimated annual property taxes are $3,883.33. What amount should show on his CD? A. $1,095.85 credit to borrower B. $3,129.66 credit to borrower C. $1,117.13 expense to borrower D. $1,201.33 expense to borrower
14. A The seller occupied the home for 103 days (31+28+31+13), and the per diem property taxes are $3,883.33 / 365=$10.6393. Therefore, the borrower will receive a credit for $1,095.85 (103 days X $10.6393).
2. Which of the following formulas would apply for calculating cost of discount points? A. Loan Amount x Origination Points (as a %) = Discount points in % B. Loan Amount x Discount Points (as a %) = Cost of discount points C. Loan Amount X Back-end % = Cost of discount points D. Loan Amount x PITI = Cost of discount points
2. B Loan Amount X Discount Points expressed as a % = Dollar cost of discount points. Multiply the loan amount by the discount percentage to find the dollar amount of the discount.
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2. How to Calculate Cash Needed for Closing To calculate the amount of cash the borrower will need for closing, the Loan Estimate (LE) is a useful tool. The mortgage loan originator should enter all relevant costs for the real estate and loan transaction into pages 1 and 2 of the LE, along with the anticipated inflows of cash to the borrower such as loan proceeds, seller contributions, gifts, and other credits at closing. Next, total all the uses (needs) for cash and all the borrower's sources of cash. Subtract the uses from the sources, and the difference is the cash needed at closing. Here is the step-by-step approach. CASH TO CLOSE USING THE LE Start with the 1st page of the LE and use it to calculate and provide borrower explanation. Bottom of page 1: Provides the estimated closing costs and the total estimated cash to close, including the closing costs derived from Section J on page 2. Section J on page 2: Provides a summary workup of the closing costs you calculated in sections D and I on page 2. It then calculates the Cash to Close, highlighting: • The closing costs • Any closing costs financed • The down payment required from borrower • Any deposits made by the borrower (i.e., earnest money paid per a purchase agreement) • Seller credits or any other adjustments Here are examples from the LE showing the application of the items listed above.
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2. Math exercises: Situation: Borrower has $20,000 cash down payment available for the purchase of a home appraised at $145,000. What is the lender's LTV? Solution: For this deal to work, we know the lender would need to loan $125,000 (the difference between the value of the home and the cash down payment). So, $125,000 / $145,000 = 86.2% LTV Practice: 1. If the lender would loan no more than 85% LTV on a property valued at $145,000, how much cash would the borrower need to put down? 2. If the mortgage loan originator advised the borrower that based on his credit report and scores, the loan program he would qualify for has a maximum LTV of 80%, what is the maximum value home he should look at since he has $20,000 for a cash down payment? 3. If the borrower qualified for an FHA loan program that requires as little as 5% cash at closing for down payment and settlement costs, what is the maximum value home he could purchase with $10,000 cash? Solutions: 1. If lender is willing to loan 85% of $145,000, or $123,250, then borrower needs the difference in cash: ($145,000 - $123,250) = $21,750 2. One way to solve this is: Since the LTV is 80%, we know the cash down payment (or owner's equity) must be 20% because the loan plus the equity must equal 100% of the market value. Since our borrower has $20,000 cash to put down, and that represents 20% of the value, we need to find out what 100% of the value is. Therefore, we can express it in an equation as: $20,000/20% = What market value? Divide $20,000 by 20% to solve for the maximum value home of $100,000
3. Which of the following is not included in the total monthly house payment calculation? A. Principal B. Monthly interest cost C. Monthly cost of property taxes D. Gross monthly income
3. D Gross monthly income is not used to calculate the total monthly housing payment (PITI), but all other answers are.
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3. In this situation, if we know $10,000 represents 5% of the maximum value home in which he could qualify, we express it as: $10,000/ 5% = What value home? Divide $10,000 by 5% and the answer is $200,000 NOTE: Use a calculator to enter 10,000 then divide by 5, hit the percent key, and $200,000 shows in the display.
4. When estimating homeowner's insurance, which of the following is not considered? A. A percent of the sales price based on past experience B. Estimate it equal to the amount charged for flood insurance C. Estimation based upon known information from the location of the property D. Information from an insurance agent
4. B Flood insurance is priced very differently from homeowner's insurance. The best option is getting an actual quote from an insurance agent. In any case, use a reliable method for estimating homeowner's insurance cost. The amount may change once an actual quote is received; be sure to update the LE.
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4. Housing Payment Ratios and Total Debt Ratios Lenders and their underwriters have a responsibility to make an "ability to repay" ATR determination on every loan. ATR has shifted the emphasis back to traditional measures like borrower's debt-to-income ratios, with perhaps less reliance on just credit scores. Each of the major loan programs available today looks to debt-to-income ratios as a primary screening tool when underwriting mortgage loan applications. The "front-end" ratio or housing expense ratio divides total monthly housing expenses by monthly gross income. The "back-end" ratio or total obligations ratio is the result of the sum of total monthly housing expenses plus other fixed monthly obligations divided by monthly gross income. First, it is important to define total monthly housing expenses. Another way to express total monthly housing expenses is PITI. PITI is an acronym for "principal plus interest plus taxes plus insurance." Even though someone owning a home would have other monthly expenses (utilities, trash collection, etc.), PITI represents the total housing expense for which a lender has a vested interest in making sure the borrower pays on time. PRINCIPAL + INTEREST+ REAL ESTATE TAXES + HOMEOWNERS INSURANCE = PIT Principal is a monthly amount of money to repay the loan. Interest is a fee or rent paid each month on the use of the borrowed money. Principal represents a systematic monthly return to the lender OF the money borrowed. Interest represents a systematic monthly return ON the money borrowed. Principal and Interest: The amount of principal and interest is mathematically calculated with a financial calculator or computer software that is readily available to mortgage loan originators. So, students do not have to manually calculate the principal and interest portion of the monthly payment. The amount of principal and interest payment is determined by the amount of the loan, the number of payments to be made, and the annual interest rate. Assume the loan amount is $200,000, the number of payments is 360 (30 years x 12 per year), and the annual interest rate is 6%. The monthly P+I in a fully amortized, level payment loan is $1200 per month. (The actual P+I is $600 per $100,000 borrowed.) A fully amortized loan is one with a repayment structure that completely pays back the borrowed money with interest using a constant, level payment each month of the loan term. Note: The above example uses a factor or dollar amount per $100,000 borrowed. Many loan originators use tables (factor tables) that show a dollar amount per month for the number of 1,000 borrowed. All factors change with term and interest rate. Example: a 30-yr. term at 6.00% interest is $6.00 for every 1,000 borrowed. On a $200,000 loan, the math is $6.00 x 200 or $1200 per month P & I. (Yep! The factor per $1000 @ 30 years @ 6% just happens to be $6.00 per $1,000.) Taxes: The "T" in PITI stands for taxes, which include property taxes and perhaps other financial obligations tied to the property, such as homeowner association due and other government mandates, such as community development district dues. For our illustrations, just property taxes will be used. Each area of the country is different regarding property taxes; however, one can often estimate the monthly taxes by multiplying the sales price by a taxing percentage appropriate for that area. Tax certificates and local Tax Collector websites provide the exact percentage for taxes. In the following illustration, the sales price is $200,000, and local property tax percentage is 1.75%. (Sales Price x Tax %) / 12 months = Estimated monthly taxes ($200,000 x 1.75%) = $3,500 $3,500 / 12 = $291.67 $291.67 = is the estimate to use for monthly taxes Insurance: The final "I" in PITI stands for insurance. This insurance category will include homeowner's insurance, and if applicable, mortgage insurance and flood insurance. For our illustrations, just homeowner's insurance will be used. The monthly homeowner's insurance premium can be calculated in a similar manner as property taxes above. In the following illustration, the sales price is $200,000, and property insurance percentage is .5% (Sales Price x Property Insurance %) / 12 = Estimated Monthly Homeowner's Insurance ($200,000 x .5%) = $1,000 $1,000 / 12 = $83.33 $83.33 = is the estimate to use for homeowner's insurance Putting it all together: To calculate the total housing payment, you simply add the totals. Principal & Interest + Estimated Taxes + Estimated Insurance = PITI $1,200.00 + $291.67 + $83.33 = $1,575.00 PITI is the sum of principal + interest + taxes + insurance. PITI will be used in the numerators (top half of the fraction) of both the front-end and the back-end debt-to-income ratios. Gross Monthly Income: Next, it is important to define gross monthly income. The denominator (bottom half of the fraction) of both debt-to-income ratios is the gross monthly income of the borrower. All stable, recurring, documented income of the borrower(s) can be used here. Fannie Mae's weekly pay standard formula is: Hourly wage x Number of hours worked per week x 52= Annual / 12 = Monthly If you are starting with an hourly wage, and your borrower works 40 hours per week, remember to multiply those two to get a weekly amount. Then multiply the weekly amount by 52 to get the annual earnings. Divide the annual earnings by 12 to get the monthly earnings. Each Example: $25 per hour @ 40 hours is $1,000 per week. $1,000 x 52=$52,000 annually. $52,000 / 12 = $4,333 per month. But what if income is not paid weekly? FNMA uses the following table for required calculations when pay periods vary: HOUSING EXPENSE RATIO (Front End ratio): The housing expense ratio is calculated by dividing PITI by gross monthly income (GMI). In the following example, the projected PITI is $1,575, and borrowers earn $1,900 per week. Remember, $1,900 x 52= $98,800/12= $8,233 gross monthly income. PITI / GMI = HER% (or front-end ratio) $1,575.00 / $8,233= 19.13%
5. If a borrower has $37,500 available for a down payment and wants to avoid buying mortgage insurance so the LTV needs to be at 80% or less, how much house can they afford? A. $197,500 B. $187,500 C. $140,000 D. $219,000
5. B A $37,500 down payment that equals 20% of the purchase price would purchase a home worth $187,500.
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5. Buydowns and Discount Points Borrowers and sellers may choose to pay money upfront at loan closing to reduce the interest rate on the loan. These interest rate reductions can be temporary (the most common is for the first one to three years of the loan) or permanent (for the entire term of the loan). Temporary buydowns are often used by builder-developers to facilitate the sale of the home. The builder pays the lender a lump sum at the beginning of the loan to reduce the interest rate, therefore, reducing the monthly payments so more potential buyers are interested and can qualify. The reduced monthly payment also lowers both front-end and back-end ratios. A common temporary buydown is known as a 3-2-1 buydown. It reduces the loan's payment equivalent to an interest rate that is 3% less in the first year, a payment equivalent to 2% less in the second, and a payment equivalent of 1% less in the third year. The builder/seller puts the additional funds in an escrow buydown account from which the lender draws to make up the full payment at the note rate. This is particularly appealing to first-time homebuyers and young professionals because they expect their incomes to rise in the near future and want to own a home as soon as possible. The lower interest rates in the early years make the housing payment more affordable and improve their debt-to-income ratios. The builder can maintain a higher selling price (therefore higher comparable sales) than the market might normally bear by offering the financing incentive. An example of this might be: Builder offers the following financing incentive on a home selling for $150,000. By paying 10% down, the buyer/borrower will enjoy a 3% annual interest rate equivalent for the first year and monthly P+I payments of $569. In year two, the annual interest rate equivalent is 4%, and monthly P+I payments are $644. In year three, the annual interest rate equivalent is 5%, and monthly P+I payments are $725. Then, in years 4 through 30, the interest rate is at the present market rate of 6% with monthly P+I payments of $809.39. Remember, as part of a larger marketing arrangement, the builder makes a payment to the lender to fund a temporary buydown account at closing to subsidize the payment difference between the required note rate payment and the borrower payments for 3 years. Permanent Buydowns with Discount Points Lenders offer everyone (borrower or seller) the opportunity to pay a lump sum at the beginning of the loan to reduce or "buydown" the interest rate. The fee the borrower pays is known as a discount point - each discount point costs the borrower 1% of the gross loan amount. In return, the lender reduces the interest rate for the entire term of the loan. Typical buydown costs for permanent buydowns are interest-rate sensitive, but the market traditionally works off a 4/1 ratio. (4 points buy the interest rate down 1%) An example of this might be: Lender offers the following mortgage loan choices. 6.00% annual interest rate no discount points 5.75% annual interest rate one discount point 5.50% annual interest rate two discount points For every discount point paid, the cost is 1% of the loan amount. Therefore, a $200,000 loan at 5.75% that carries one discount point will cost an additional $2,000 in origination costs. To determine whether buying down the interest rate by paying discount points is in the borrower's best interest, they must truly evaluate how long they are likely to hold on to that mortgage loan and evaluate and recapture the true cost of paying an extra $2,000 now. For many borrowers, paying discount points is not the best use of their money. Even if the discount points are paid from the seller's concession to help with closing costs, perhaps that concession can be used more effectively to lower the purchase price or pay for other settlement costs. Today, most borrowers do not hold on to their mortgages for more than six years due to relocation, change in family size, interest rate fluctuations, or the need to refinance. (Loan life expectancy is rate sensitive). A borrower would need to hold on to a mortgage loan for ten or more years to pay back the initial cost of the discount points. The mortgage loan originator can help the borrower analyze whether paying discount points is worth the interest reduction benefit received. A Final Word on Discount Points While it is nice to receive a "discount" interest rate on a major purchase like a home, make sure your borrower understands the full picture. Most borrowers struggle to obtain the cash needed for the closing, so buying down the interest rate may not be an option. Lenders are not giving anything away. They are equally well off with any of the options the borrower chooses, each one returns the same effective yield on their invested funds. Every discount point that lenders collect at closing raises their effective yield or total return on the loan by 1/4% on average. Furthermore, when the loan is not held the full 15 or 30 years of its term, it raises the lender's effective yield even higher. Raising the yield to the lender is very similar to increasing the APR or annual percentage rate to the borrower. Note: Unless a seller pays discount points in a transaction or discount points are financed in a refinance transaction, seldom does a borrower pay discount points on a sale transaction.
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6. Prepaid Interest or Daily Interest Charges This is a cost to the borrower at closing to cover the interest on the loan from the day of closing until the first day of the next month, or until the first day of the normal mortgage payment cycle if the payment is due on a day of the month other than the first. It is best to illustrate this concept with an example: Let us assume a loan closes on April 16. The first monthly payment will be due at the beginning of June rather than on May 1. That first payment in June will cover the interest that accrued on the loan during the month of May. In other words, interest is paid in arrears (at the end of the period in which the expense was incurred). Every additional payment for the life of the loan will work the same way; interest will be paid in arrears for the previous monthly period. Loan closes on April 16 15 Days of Interest Due --> Full 31 Days of Interest Due for May --> Interest for April and May payable June 1 --> From April 16 through April 30, the lender is due interest on the loan from the borrower. To collect this, the lender imposes a fee at closing known as "pre-paid interest." Pre-paid interest is a charge to the borrower for the interest incurred from the day of closing (April 16) to the end of the month (April 30). It is called pre-paid because it is the only time throughout the loan when interest is not paid in arrears. This is the daily interest not collected by any regularly scheduled payments but is due to the lender from the day of closing. The daily rate of interest is also called per diem interest. In the situation above, we know the lender will collect prepaid interest at closing for the 15 days from the day of closing, April 16 through the end of April. In different parts of the country, the day of closing may not be charged to the borrower, so check with your closing agent. Also, be careful to count the days exactly; there are 15 days between April 16 and April 30, including the day of closing, April 16. Be sure to check with the lender and/or closing agent regarding the due date of the first monthly payment. (Payments are not all scheduled for the first day after the first full month.) Next, calculate the per diem interest. Some loans will use a 360-day year (banker's year); however, most use the normal 365 days. We will use 365. To calculate the annual amount of interest, multiply the beginning balance of the loan by its annual interest rate. For example, a $200,000 loan at 6% annual interest will cost the borrower $12,000 ($200,000 x 6%) in interest in the first year. Then, divide $12,000 by 365 to get the per diem interest: ($200,000 X 6%) / 365 = $32.8767 per diem interest Finally, multiply that per diem interest by the number of days owed by the borrower to calculate the amount of pre-paid interest: 15 days X $32.8767 = $493.15 pre-paid interest
7. Which of the following would yield a per diem rate in the month of July for an annual expense of $1500? A. $1500 / 30 = $50 B. $1500 / 12 = $125 C. $1500 / 31 = $48.39 D. $1500 / 365 = $4.11
7. D A per diem rate is determined by dividing the annual charge by 365. Therefore, an annual expense of $1500 when divided by 365 days is a per diem charge of $4.11
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7. Prepaids Section F of the Closing Disclosure (CD) highlights the required prepaids the borrower is charged for homeowners' insurance, mortgage insurance, pre-paid interest, and property taxes. Math exercises Problem: In preparation for closing, the following costs have been itemized. Place each one with the correct amount in one of the following categories: A. Closing Cost B. Pre-paid Item C. Reserves The cost items are: State transfer taxes on the new mortgage - $1,100 Lender requires ($240)—4 months of flood insurance in escrow at closing Mortgage loan originator fee of 1.5% on $200,000 loan Per diem interest on $200,000 loan at 5%, closing on January 29 Annual property taxes are $4,000—lender wants 6 months in escrow Lender's title insurance policy is $245 Homeowner's insurance annual premium $4,200—must be paid at closing Solution: A. Closing cost items: State taxes on new mortgage -- $1,100 Mortgage loan originator fee -- $3,000 Lender's title insurance policy -- $245 B. Pre-paid Items: Per diem interest - 3 days x ($200,000 x 5%) / 365 = $82.19 Homeowner's insurance annual premium -- $4,200. C. Reserves to be Deposited: Flood insurance (4 months) =$240 Property tax escrow (6 months) = $2,000
8. Which of these is not typically included in the back-end ratio? A. Principal B. Taxes C. New auto installment loan debt D. Optional golf club dues
8. D The traditional back-end ratio includes the principal, interest, taxes, insurance, and contractual monthly obligations, including installment loans lasting longer than 10 months. Of the four answers, clearly the optional golf club dues are NOT included in the back-end ratio.
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8. Proration Certain expenses must be divided up equitably between the borrower and seller. Generally, there is an amount due after the closing, such as property taxes that cover a time period when both the seller and the borrower occupy the home, or there are amounts for annual homeowner's association dues that were paid in advance of the closing and cover a time period both before and after the closing. The process of dividing expenses equitably is called proration; we prorate or divide the expenses between the borrower and seller. The proration method for certain expenses may vary from state to state, and the sales contract may specify prorations to be handled in a specific way. The written contract agreement prevails no matter what was assumed or expressed verbally. Remember, nearly everything is negotiable in real estate, so make sure that the parties' final understanding is in writing. The process of proration divides accrued expenses and pre-paid amounts between the parties. Accrued items are the expenses that the seller currently owes but will be paid by the buyer at a later date. A good example of an accrued item is the annual property tax bill due on the property. Let us assume closing occurs on the 23rd of June. The seller owes property taxes up to the day of closing, from January 1 through June 22. The borrower will pay the entire year's tax bill later this or the next year but will be credited at closing with the amount due for the time the seller occupied the property from January 1 through June 22. Accrued expenses such as these are debited to the seller and credited to the borrower. Pre-paid amounts are the items that the seller has already paid in full but have not been fully used, such as the annual homeowner's association dues that must be paid at the beginning of each year. In this case, homeowners' dues from June 23 (day of closing) through December 31 are prorated. Pre-paid amounts such as these are credited to the seller and debited to the borrower.
9. What is the maximum annual change possible in the rate of a 1-Year ARM, with 2% / 6% caps, in its third year if the index increases by 3 percentage points? A. The maximum rate change is 2% from the previous year's rate B. The maximum rate change is 5% from the previous year's rate C. The rate will not change because the margin stays fixed D. There is not enough information to answer this question
9. A The 2% / 6% caps limit the annual rate change to 2% from the previous year, as long as the rate has not changed more than 6% in its lifetime—which it would not have in the third year.
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9. Adjustable-Rate Mortgages (ARM) An adjustable-rate mortgage works very much like a fixed-rate, fully amortizing, 30-year mortgage. The key difference is an ARM's interest rate is allowed to adjust periodically according to the rules established for the loan. When the interest rate adjusts, the borrower's monthly payment of P+I must change accordingly to systematically pay off the principal balance by the end of the loan. In every ARM loan, certain characteristics are common. Once the interest rate adjusts, the new rate is determined by the formula: INDEX + MARGIN = RATE The index is a publicly reported, independently determined cost of funds chosen by the lender to be used throughout the life of the loan. Lenders are free to choose the index, although most secondary market guidelines call for the index to be one that no single lender can influence, and the rate must be readily available to the public in a published form. The LIBOR index (London Interbank Offer Rate) has been widely used over the years since it reflects not just the business outlook and economics in the U.S. but rather the global economy. Also, the LIBOR has historically been statistically steadier than most U.S.-based cost of funds indices. Note: Just an FYI for now. The LIBOR index was phased out at the end of 2021. It is being replaced by the Secured Overnight Funding Rate or SOFR, which is a middle-of-the-road rate that participants pay to borrow cash on an overnight basis collateralized with treasuries. The margin (or spread) is a percentage set by the lender to cover the cost of doing business and provide a reasonable profit. The margin stays fixed for the life of the loan. The market is very competitive, so margins fall within a tight range. Presumably, every lender faces the same cost of obtaining the money to lend, which is determined by supply and demand in the global market, so the margin is payment for the lender's service. (Servicing fee profit) The borrower's rate of interest on an ARM is the sum of the cost of money plus the lender's cost for providing the loan. How Does an ARM Rate Adjust? Using a 1-year ARM as an example, 45 days prior to the interest change date from the first adjustment and every year after that, the lender calculates: Index + Margin = Rate. The lender establishes the appropriate index 45 days prior to the interest change date to give the borrowers a 30-day notice of what, if any, change in payment is coming. Remember, payments are in arrears. The rate will change based on that formula but LIMITED TO the interest rate caps or ceilings established by the lender at the beginning of the loan. The most common caps are known as 2%/ 2% / 6%. This means in any one-year adjustment period, the most the rate can change is 2 percentage points up or down. The 6% cap means the most the loan can change from its starting rate is 6 percentage points up or down. Most borrowers are concerned with how high the loan rate is allowed to go up if market interest rates skyrocket. They want to be sure they can live with those consequences. In the example, the rate could rise, at most, 6% higher than the starting rate but not go up more than 2% in any one adjustment until the ceiling is reached. On the other hand, the lenders set a floor for how low the adjusted interest rate can go. They set a floor for the minimum rate equal to the margin. Borrowers interested in ARM loans often do not plan on being in the loan very long due to transfer or otherwise. Prudent ARM borrowers also select an ARM with an index that is less volatile, so adjustments are less frequent or punitive. In 2020 and 2021, the interest rate market is expected to remain at a low level, making ARM loans less desirable/valuable vs. longer-term loans. Low rates, such as the December 2020 prime rate of 3.25%, will typically purge the market of ARMS due to heavy refinance activity. 1-Year ARM This becomes more understandable by looking at a sample 1-Year ARM loan. Assume the starting interest rate is 5%, and the caps are 2%/6%. At the start of the loan, let us assume the index is 3%, and the margin established by the lender is 2%. Therefore, the lifetime cap of 6% and the margin at 2% limit the interest rate over the loan's lifetime to a maximum rate of 11% (5% + 6%) and a minimum rate of 2% (the same rate as the margin in case the index goes to zero). In any one-year adjustment period, the interest rate can move 2% from the rate set in the PREVIOUS period. Therefore, in year 2, if the index rose to 4.5%, we look to the formula Index + Margin = Rate to determine how much the rate would change. It looks like this: index + Margin = Rate Year 1 (start of loan) 3.0% + 2% = 5.0% Year 2 4.5% + 2% = 6.5% That rate change to 6.5% is allowed because it is within the lifetime cap of 11% and is no more than the 2%. The rate can change during any one-year period. If at the beginning of Year 3 the index falls to 1.5%, let us see what happens. Again, we look to the formula Index + Margin = Rate to determine how much the rate would change. It looks like this: Index + Margin = Rate Year 1 (start of loan) 3.0% + 2% = 5.0% Year 2 4.5% + 2% = 6.5% Year 3 1.5% + 2% = 4.5% However, the rate change to 3.5% is not allowed because it falls outside the allowable 2% change in any one year. The rate will only fall to 4.5%, in order to stay within the 2% cap, up or down, in any one year. Both caps are important. The rate change must be within the allowable limits of both the 2% periodic and 6% lifetime caps.
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Key Point Review Lenders use Loan to Value and Combined Loan to Value ratios as key measures of loan risk. It is a simple ratio of loan amount divided by the property's market value. To determine cash needed for closing, net the borrower's total cash available to the total amount needed to acquire the property. Numerous settlement charges, prorations, amounts paid in advance, etc. make this calculation quite detailed. The front-end (housing expense) and back-end (total obligations) debt-to-income ratios are also key measures of a borrower's ability to meet the obligations of the loan. Lenders may impose their own rules and methods for calculating these. A borrower or other party may pay money at the beginning of the loan to "buy down" the interest rate for a set number of years or for the entire term of the loan. Sometimes referred to as discount points, the amount paid by the borrower raises the effective yield on the loan to the investor. Borrowers typically pay a prepaid interest amount (or daily interest charge) at closing to cover the interest cost for the number of days between the closing date and the first day of the next month. Certain charges such as annual property taxes are allocated or prorated between seller and buyer based on the closing date to reimburse one another for expenses that are paid by one party for a portion of time the other party occupied the property. The interest rates on ARMs adjust periodically based on the sum of the cost of funds index and the lender's margin. Interest rate changes are subject to limitations or caps that are typically set at 6% for the lifetime of the loan and 2% annually. Lenders are free to set their own caps, the period between interest rate resets, their cost of funds index, and margin.
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Math Exercise Situation: A recent advertisement for a 1-year ARM looked like this: - 4.5% starting rate with ½ discount point - 20% cash down payment - Rates adjust annually, subject to annual cap of 2% and lifetime cap of 6% - Index is 1-year SOFR. Current 1-year SOFR rate is 1.25%. Margin is 3% If the 1-year SOFR fluctuates over the next five years in the following way, how will the rate change? Year 1-Year SOFR rate 2 2.25% 3 5.75% 4 6.50% 5 3.25% Solution: Using the formula Index + Margin = Rate subject to the 2%/6% caps, here's what happens: Year #: Index + Margin = Rate Comments year 1 (starting): 4.50% 2%/6% caps year 2: 2.25% + 3% = 5.25% OK - within caps year 3: 5.75% + 3% = 8.75% NO - limited to 7.25% year 4: 6.50% + 3% = 9.50% NO - limited to 9.25% year 5: 3.25% = 3% = 6.25% NO - limited to 7.25% 5/1 ARM A very popular adjustable-rate mortgage product is the 5/1 ARM. This mixes some of the best features of an adjustable-rate mortgage with the strong features of a fixed-rate loan. The 5/1 ARM loan sets a rate that stays fixed for the first five years and then acts just like a 1-Year ARM from years 6 through 30. It may be suitable for borrowers who know they will not need the loan for more than 5 years (provided there is no prepayment penalty) and can take advantage of an interest rate that is generally priced below the 30-year fixed rates. The 5/1 ARM looks similar to the 1-Year ARM, except there will be 3 caps/ceilings quoted. A typical 5/1 ARM has caps of 5% / 2% / 6%. This means in the initial adjustment period, in year 6, the rate can change by as much as 5%, then in adjustment years 7 through 30, the rate adjustments are subject to the more common 2% / 6% caps.
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Math Exercise Situation: June 23rd is the closing date, and annual property taxes are $4,000 (not a leap year). Assume the practice is to use the calendar year method and charge the borrower with the day of closing. Solution: 1. Calculate the per diem rate: $4,000 / 365 = $ 10.958904 2. Determine how many days the seller owes: Jan thru June 22 = (31+28+31+30+31+22) = 173 days 3. Amount seller owes for property taxes is: ($10.958904 x 173) = $1,895.89 Practice: Calculate amount seller will be charged: 1. Closing date of February 15, annual property taxes are $2,500 2. Closing date of December 1, annual property taxes due on Dec 31 are $8,000 Solution: 1. Per diem = $2,500/365 = $6.8493 Number of days = 31+14 = 45 Amount seller owes = $6.8493 x 45 = $308.22 2. Per diem = $8,000/365 = $21.9178 Number of days = (31+28+31+30+31+30+31+31+30+31+30) = 334 Amount seller owes = $21.9178 x 334 = $7,320.55
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Math Exercise Situation: Today's 5/1 ARM is advertised as: 4.25% starting rate Caps of 2% / 2% / 6% Index is SOFR. Margin is 2.5% If the 1-year SOFR fluctuates over the next seven years in the following way, how will the rate change? Year 1-Year SOFR rate 2 2.25% 3 5.75% 4 6.50% 5 3.25% 6 4.50% 7 5.75% Solution: Using the formula Index + Margin + Rate subject to the 5%/2%/6% caps, here's what happens: Year#: Index + Margin = Rate Comments year 1 - 5 4.25% Starting rate stays fixed year 6: 4.50% + 2.50% = 7.00% OK - within 5% initial cap year 7: 5.75% + 2.50% = 8.25% OK - within 2% annual cap
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Math Exercises Problems: For each loan example, determine the cost of the pre-paid interest to the borrower. 1. $417,000 loan at 5.5% annual interest closes on January 3 2. $225,000 loan at 6.375% annual interest closes on April 15 3. $625,000 loan at 7.125% annual interest closes on November 29 Solutions: 1. Number of days of interest borrower is responsible for: 29 (NOTE: One way to calculate quickly the number of days left in the month from the day of closing is to subtract the number of days PRIOR to the closing (in this case 2) from the number of days in the month (in this case 31) So 31-2 = 29.) Next, calculate the per diem interest: $417,000 x 5.5% = 22,935 (total annual interest) $22,935 / 365 = $62.8356 (per diem interest) Pre-paid interest cost to borrower: 29 days x $62.8356 = $1,822.23 2. Number of days of interest borrower is responsible for: 16 (30-14) Next, calculate the per diem interest: $225,000 x 6.375% = 14,343.75 (total annual interest) $14,343.75 / 365 = $39.2979 (per diem interest) Pre-paid interest cost to borrower: 16 days x $39.2979 = $628.77 3. Number of days of interest borrower is responsible for: 2 (30-28) Next, calculate the per diem interest: $625,000 x 7.125% = 44,531.25 (total annual interest) $44,531.25 / 365 = $122.00 (per diem interest) Pre-paid interest cost to borrower: 2 days x $122.00 = $244.00
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Math exercises Problem #1: Borrower is purchasing a new home. Monthly P+I is $800. Property taxes are $2,000 per year. Homeowner's insurance costs $115 per month. Other obligations include two more years of car payments at $250 per month, 5.5 more years of student loans at $125 per month, and monthly spousal support of $525 that will end next month. The borrower's income is $4,250 per month. What are the borrower's front-end and back-end ratios? Solution #1: PITI is $800 + ($2,000 / 12) + $115 or PITI is $1,081.67 Total monthly obligations are $ 1081.67 (PITI) + $250 (car payment) + $125 (student loan) = $1,456.67. The spousal support does not need to be included in the calculation because it is not an obligation that extends more than 10 months into the future. Gross monthly income is $4,250 Borrower's front-end ratio is ($1,081.67 / $4,250) = 25.5% Borrower's back-end ratio is ($1,456.67 / $4,250) = 34.3% Problem #2: Borrower's PITI is $1,565, and gross weekly income is $2,000. How much additional contractual monthly obligations can this borrower afford so that his back-end ratio does not exceed 41%? Solution #2: PITI is $1,565 GMI is ($2,000 x 4.333) = $8,666 To maintain a back-end ratio at 41% or less, TMO cannot exceed ($8,666 x 41%) =$3,553 The difference between $3,553 (TMO) and $1,565 (PITI) is $1,988 So, $1,988 is the amount of monthly debt (in addition to the PITI) this borrower can take on without exceeding the 41% back-end ratio. Problem #3: A gorgeous mansion just went on a local bank's foreclosure sale list. PITI is estimated at $2,956 per month, and your applicant carries $1,950 per month in other contractual monthly obligations. What GMI does your applicant need to meet FHA's ratios of 31%/43%? Solution #3: To stay within the 31% front-end ratio: Use the equation PITI/GMI = 31% or ($2,956 / GMI) = 31% That equation becomes $2,956 / 31% = GMI So, GMI must be => $9,535 to meet the 31% front-end ratio. However, another calculation is necessary to determine the minimum monthly income to meet the 43% back-end ratio. Use the equation TMO/GMI = 43% or ($2,956 +$1,950) / GMI = 43% Or $4,906 / GMI = 43% That equation becomes $4,906 / 43% = GMI So, to meet the 43% back-end ratio, GMI needs to be => $11,409. Maximum PITI: If one needs to know the maximum PITI he can afford, it can be determined by multiplying the borrower's gross monthly income (GMI) by the front-end ratio. GMI x Front-end ratio = Maximum PITI 3250 x 28% = $910 Maximum Total Debt: The back-end ratio can be used in a similar equation to find out the maximum acceptable total monthly obligation. GMI x Back-end ratio = Maximum Total monthly obligation 3250 x 36% = $1,170 In this case, the difference between the TMO and PITI is $260 = ($1,170 - $910). So, your borrower's contractual monthly obligations cannot exceed $260. Most borrowers find the backend ratio to be the more restrictive one. To qualify, they may need to shed some debt; they must pay off loans if possible, or sell the asset, restructure the loan payments, or wait until their income catches up to their debts or their debts diminish.
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Math exercises Problems: For each loan example, determine the cost of the discount points to the borrower and the effective yield on the loan to the lender. Note: for example, purposes each discount point in these examples equals 1/4% in interest rate. 1. $417,000 loan at 5.5% annual interest + 1 discount point 2. $225,000 loan at 6.375% annual interest + 3 discount points 3. $625,000 loan at 7.125% annual interest + 2 discount points Solution #1: Cost of discount points to borrower: 417,000 x 1% = $4,170 Effective yield to lender: 5.5% + 1/4% (same as .250%) = 5.750% NOTE: Use a calculator to convert a fraction to a decimal as shown above by keying in: "1 / 4 =" The calculator will display ".250" Solution #2: Cost of discount points to borrower: 225,000 x 3% = $6,750 Effective yield to lender: 6.375% + 3/4% (same as .750%) = 7.125% Solution #3: Cost of discount points to borrower: 625,000 x 2% = $12,500 Effective yield to lender: 7.125% + 1/2% (same as .50%) = 7.625%
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Math exercises Situation #1: Borrower is purchasing a $250,000 home. Monthly P+I is $1,200. Property taxes are $4,000 per year. Homeowner's insurance and flood insurance cost $195 per month. The borrower is an independent contract attorney earning $75 per hour for 30 hours per week on average. What is the borrower's front-end ratio? Solution #1: PITI is $1,200 + ($4,000 / 12) + $195 Or PITI is $1,200 + $333.33 + $195 = $1,728.33 Gross monthly income (GMI) is $75 x 30 x 4.333 = $9,749.25 So, the front-end ratio is $1,728.33 / $9,749.25 = 17.73% Situation #2: Borrower wants to purchase a $500,000 home, and preliminary estimates of PITI are $4,375 per month. In order to keep the borrower's front-end ratio at or below 28%, what does her monthly income need to be? Solution #2: In this situation, we know PITI is $4,375. We need to divide it by the GMI number that will yield a ratio of 28%. So, the equation is: $4,375 / GMI = 28% We need to solve for GMI. Whenever there is an unknown amount, such as GMI in the denominator of the fraction, and the other two numbers are known, switch the unknown amount with the number to the right of the equal sign (28%). So, your equation becomes: $4,375 / 28% = GMI Now, use the calculator to divide $4,375 by 28% to solve for GMI. Key this in your calculator: 4375 / 28%. The display will show 15,625. So, the borrower needs a monthly income of at least $15,625 to keep her front-end ratio below 28%. Practice Problems: 1. What is the borrower's front-end ratio if P+I is $850, property taxes are $850 per year, mortgage insurance is $600 per year, homeowner's insurance is $75 per month, and annual earnings are $45,000? 2. If the borrower's GMI is $3,750 and the front-end ratio needs to be 28% or less, what is the maximum PITI this borrower could afford? Solutions: 1. Borrower's PITI is $850 + ($850 / 12) + ($600 / 12) + $75 = $1,045.83 Borrower's GMI is ($45,000 / 12) = $3,750 So front-end ratio is $1,045.83 / $3,750 = 27.9% 2. In this case, the equation is: PITI / $3,750 = 28% In order to isolate the unknown amount (PITI) on the left side of the equal sign, multiply both sides of the equation by $3,750. By doing this, the $3,750 is cancelled out in the denominator on the left-hand side of the equation and turns the equation to: PITI = $3,750 x 28% Now, use the calculator to multiply $3,750 by 28% to solve for PITI. Key this in the calculator: 3750 x 28%. Always remember to key in the % sign last and use the % key instead of the "=" key. The display will show 1050. Therefore, the borrower can afford a PITI as high as $1,050 per month given GMI of $3,750 and still keep the front-end ratio at or below 28%. TOTAL OBLIGATIONS RATIO (Back End ratio): The total obligations ratio or back-end ratio of debt-to-income is calculated by adding PITI (known as the total monthly housing payment) to the borrower's other contractual monthly obligations to obtain a total obligations amount. Then, divide total obligations by gross monthly income (GMI) to obtain the back-end ratio. In the following example, PITI is $1,195, and all other contractual monthly obligations total $415. The borrower's GMI is $4,100. PITI + Other Obligations = Total Monthly Obligations (TMO) TMO / GMI = Back-End % $1,195 + $415 = $1,610 $1,610 /$4,100 = 39.3% Other contractual obligations: These are described as all the other legal obligations the borrower must pay each month, along with the proposed new PITI, such as other mortgages, automobile leases, installment debt, student loans, court-ordered payments, and credit card debt. Each loan program may have slightly different requirements, but the most common practice is to include all debt that has MORE THAN 10 remaining monthly payments. However, even some debt payments with 10 or fewer months left are included if the underwriter feels it represents a significant portion of the borrower's gross monthly income. Also, include ALL automobile lease payments and at least the minimum monthly payment due on outstanding credit card debt. A few examples: Type of Debt Included in Total Monthly Obligations? 8 years of payments left on student loans = Yes Automobile lease ending in 3 months Yes Child support for 3 more years = Yes Pays off large balance on credit card each month = No Automobile payments for 13 more months = Yes Revolving credit card balance with a $125 minimum monthly payment due = Yes Small monthly payment on a financed lawn mower that has 5 more months to go = No Furniture installment debt with 11 more months of payments = Yes Monthly childcare expense paid to relative = No
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Practice Problems: 1. Using the information above, if the appraisal came in at $245,000, all other settlement costs remained the same, and the seller was not willing to lower the contract price, how much more cash would the borrower need to bring to closing? 2. If the mortgage loan originator advised the borrower that an 85% LTV loan was available, and the final appraisal review supported the $250,000 contract price, how much cash would the borrower need to bring to closing? Solutions: 1. If the appraisal only came in at $245,000, the lender would loan $196,000 (80% LTV). However, all other sources and uses stay the same, so the result is: Total USES of Cash are: Purchase price $250,000 Settlement charges $ 6,200 Debit for ½ year HOA dues $ 450 TOTAL USES $257,150 Total SOURCES of Cash are: New 80% mortgage $196,000 Earnest money deposit $ 2,000 Seller contribution (2.5%) $ 6,250 Credit for ½ year property taxes $ 2,000 TOTAL SOURCES $206,250 So, subtracting the total USES from the total SOURCES tells us the borrower will need to bring $50,900 in cash to closing. 2. If the lender will loan $212,500 (85% LTV), and the home appraised at the contract price of $250,000, the result is: Total USES of Cash are: Purchase price $250,000 Settlement charges $ 6,700 Debit for ½ year HOA dues $ 450 TOTAL USES $257,150 Total SOURCES of Cash are: New 85% mortgage $212,500 Earnest money deposit $ 2,000 Seller contribution (2.5%) $ 6,250 Credit for ½ year property taxes $ 2,000 TOTAL SOURCES $222,750 So, subtracting the total USES from the total SOURCES tells us the borrower will need to bring $34,400 in cash to closing. Another Method for Identifying Funds Needed from the Borrower is the 1003 A. Cash Needed for Closing Aside from the Loan Estimate, some loan originators may opt to use the loan application FNMA form 1003. This ability also resides in the revised 1003 scheduled for implementation on March 1, 2021, which following a series of questions in Section L4 generates the amount necessary for closing. B. Cash Needed for Monthly Payments Likewise, sections 1b-1e of the new 1003 Application Form collect the sources and amounts of gross monthly income. Section 2 collects financial information on assets and liabilities. And finally, section L3 determines the proposed (required) monthly payment for the property.
