GENERAL MORTGAGE KNOWLEDGE

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1 Learning Objectives GENERAL MORTGAGE KNOWLEDGE This chapter was created based on the General Mortgage Knowledge section of the NMLS National Test Content Outline. There are several topics covered in this chapter, and each has the potential to appear on the NMLS national test in multiple choice question format. In this chapter, students will: Review the Guidance on Nontraditional Mortgage Product Risks and the Subprime Statement on Mortgage Lending Learn about the mortgage product standards the Nontraditional Guidance and Subprime Statement advise Examine the characteristics of loans that will be regulated as higher-priced mortgages and the lending practices and prohibitions required for them Explore the history and recent developments in subprime lending Consider important changes in federal legislation specific to the Home Ownership and Equity Protection Act (HOEPA), including: o The special disclosures and notifications required for HOEPA loans o The lending terms and practices prohibited by HOEPA and the reasons for these prohibitions Explore the basics of fixed-rate and adjustable-rate loans Learn the difference between government loan programs and conventional loan programs Review second mortgages and subordinate financing Gain an understanding of securitization and the role the secondary market plays Investigate special needs properties and borrowers, including nontraditional lending Take a look at the current mortgage lending landscape Review recent developments in the mortgage lending landscape which led to the industry s present condition Examine broad pieces of recent federal legislation that directly impact the business of lending and mortgage origination Understand the impact a single mortgage loan can have on the greater financial markets Learn about the purpose and process of securitization Uncover the meaning of mortgage-backed security and the role it plays in investment in the secondary market Review the steps that turn a mortgage-backed security into a component of additional investment opportunities Define key players in the securitization process General Mortgage Knowledge 1

2 Introduction Between the spring of 2007 and the spring of 2009, there have been drastic changes in the field of mortgage lending. The growth of the mortgage brokerage business was directly tied to the rapid expansion of the subprime lending market, which rose by the whopping rate of 25 percent per year over the period, nearly a ten-fold increase in just nine years. 1 Unfortunately, when interest rates on subprime loans reset, foreclosures on these loans rose at an alarming rate. As loans failed, the investors who purchased these loans experienced huge losses. In a matter of months, the investment market for subprime loans disappeared, and with no funding for new subprime loans, the market collapsed. When the subprime market failed, mortgage brokers experienced significant reductions in the volume of their business. These reductions were inevitable since mortgage brokers were the primary originators of subprime loans. In the wake of the subprime crisis, and for the first time in decades, FHA loans gained popularity. These loans serve the needs of low to moderate income consumers and first time buyers who could no longer turn to the subprime market for financing. When Congress passed the Housing and Economic Recovery Act of 2008, it included provisions to make FHA loans available to more borrowers, including those at higher income levels. Changes in the market have not been limited to the business of brokering loans. Dramatic changes have occurred across the market. One of the most drastic changes was the September 2008 takeover of Fannie Mae and Freddie Mac by the government. Proponents of the government takeover believed that this action was necessary in order to save the GSEs from bankruptcy, which would have resulted in another crippling blow to the economy. Continuing education and exam prep courses prepared by TrainingPro address the development of laws and regulations that relate to mortgage lending. For the past 20 years, mortgage lending has been a dynamic field, and that will not change in the near future. Education is the key to understanding how to meet the demands and challenges of the new lending environment. Conventional/Conforming Mortgage Programs A conventional mortgage is a mortgage NOT obtained through the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the US Department of Agriculture (USDA). There are two types of conventional mortgages: conforming and nonconforming. 1 Governor Edward Gramlich. Remarks at the Financial Services Roundtable Annual Housing Policy Meeting. 21 May The Federal Reserve Board. General Mortgage Knowledge 2

3 Conforming Mortgages A conventional mortgage conforms to loan limits, down payment requirements, borrower income requirements, debt-to-income ratios, and other underwriting guidelines established by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mae purchase mortgages that meet these limits, thereby creating additional funds lenders can use to make new mortgages. The conforming loan limits for 2010 are: One-Family Properties: $417,000 Two-Family Properties: $533,850 Three-Family Properties: $645,300 Four-Family Properties: $801,950 The Federal Housing Finance Agency, which now sets the loan limits, also created higher loan limits for areas of the country designated as high-cost areas. There are high-cost areas in all regions of the country except the Midwest. In high-cost areas, the conforming limit for one-family properties can be as high as $729,750. In Alaska, Hawaii, Guam, and the Virgin Islands, the conforming loan limits can be even higher, ranging from $625,500 to $938,250. General Conventional/Conforming Requirements Income Qualification Conforming loan programs require comprehensive income qualification. Each borrower s income must meet standards and guidelines relevant to the loan program. Some general qualification guidelines include: Standard income documentation for salaried and hourly individuals typically includes paystubs for the most recent 30-day period and W-2s for the most recent two-year period Individuals earning more than 25% of their income in commission must provide up to two years tax returns Individuals who own more than 25% of a business are required to provide up to two years tax returns Individuals who earn non-taxed income such as Social Security, public assistance or disability must provide comprehensive documentation relevant to the type of income. However, they are permitted to gross up those earnings by 25% (i.e. multiply the income by 125%). Credit Qualification Conforming lenders require a comprehensive review of a potential borrower s credit history in order to determine credit capacity and credit character. Fannie Mae and Freddie Mac publish credit eligibility matrices regularly to provide guidance for manual underwriting. These standards are subject to change and are based on the transaction type, number of units and loan- General Mortgage Knowledge 3

4 to-value/combined loan-to-value. However, as an example, the minimum credit scores for 2009 ranged from Seller Financing (Concessions) Fannie Mae and Freddie Mac permit borrowers to obtain seller financing also known as concessions in conforming loan transactions. Seller concessions are limited to 6% for borrowers who make a down payment of 10% or higher. Seller concessions are limited to 3% for borrowers who make a down payment of less than 10%. Additional Information on Conforming/Conventional Loans Fannie Mae s Single Family Selling and Servicing Guides, Announcements and Lender Letters provide extensive details on conforming/conventional loan requirements. These resources may be found at Government (FHA, VA, USDA) Non-conventional mortgages are mortgages obtained through government agencies such as the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA) and the US Department of Agriculture (USDA). The following factors include an overview of some of the recent highlights and changes to conforming/conventional loan requirements. Fannie Mae s Single Family Selling and Servicing Guides, Announcements and Lender Letters provide extensive details on conforming/conventional loan requirements. These resources may be found at Effective April 2010, Fannie Mae made changes to borrower qualification on adjustable rate mortgages with initial periods of five years or less. In order to qualify for purchase/securitization, the borrower in the relevant loan transaction must qualify at the greater of the note rate plus 2% or the fully indexed rate (index + margin). Effective February 2010, Fannie Mae permits financing up to ten investor properties (one-unit residential) if certain criteria apply: 25% down payment on each investment property Minimum credit score of 720 No late mortgage payments in the previous 12 months No bankruptcies or foreclosures in the previous seven years Two years of tax returns showing rental income from all rental properties Six months of reserves for principal, interest, taxes and insurance for each investment property General Mortgage Knowledge 4

5 As of December 2009, Fannie Mae expanded acceptable loan terms for subordinate financing to include: Negative amortization Balloon payments due in less than five years Prepayment penalties FHA Loans The Federal Housing Administration (FHA) does not make, buy or sell loans. It insures loans. In the event of foreclosure, the lender is protected by mortgage insurance issued by the government through the FHA. The insurance covers the full value of the loan. The FHA was originally created during the Great Depression when the high rate of foreclosures discouraged lenders from making new mortgage loans. President Franklin Delano Roosevelt and Congress established the FHA in 1934 with the enactment of the National Housing Act. The passage of the National Housing Act and the establishment of the FHA were components of FDR s New Deal programs to rescue the U.S. economy from the ravages of the Depression. The FHA gave the business of mortgage lending a jumpstart by insuring the full value of mortgages for qualified borrowers. By insuring loans, the FHA eliminated the risk of loss from foreclosure, thereby encouraging lenders to make new mortgages. In 1965, the FHA became a part of the Department of Housing and Urban Development (HUD). Since that time, HUD has been the federal agency that is responsible for issuing the rules that regulate FHA-insured loans. On its website, HUD reports that since 1934, The FHA and HUD have insured over 34 million home mortgages. 2 In the recent past, the primary function of the FHA mortgage insurance program was to ensure that low-income families, first-time buyers, and other borrowers who could not qualify for conventional loans could obtain a mortgage. FHA lending limits established the maximum amount that a borrower could borrow for an FHA home loan, and these limits helped to reserve FHA-insured loans for homebuyers who did not have access to other mortgage products. However, now that mortgages are less available for a wider range of Americans, Congress responded by including provisions in the Housing and Economic Recovery Act that are intended to make FHA loans available to more consumers. FHA loans are now available to more Americans as a result of higher loan limits. These limits are posted on HUD s website for each county in each state, Guam, and the U.S. Virgin Islands. The limits for 2009 are $271,050 in low-cost areas of the country and $625,500 in high-cost areas. HUD addressed the need for higher loan limits stating: For several years, FHA's loan levels were below the cost of the average home in communities across the nation. As a result, families who needed FHA mortgage 2 General Mortgage Knowledge 5

6 insurance to qualify to buy a home were effectively locked out of the process. In some cases, borrowers turned to exotic subprime loans. 3 Advantages of FHA loans include low down payments, no prepayment penalties, and fee limits on closing costs. Recent changes to FHA guidelines have altered the requirements for these loans, including an increase in upfront Mortgage Insurance Premiums (MIP), using a combination of FICO scores and down payments for new borrower qualification, and reducing allowable seller concessions from 6% to 3%. FHA requires the borrower to invest in the loan transaction by making a 3.5% down payment based on sales price or appraisal (whichever is less) it can be from the borrower s own funds, gift funds or housing authority grants. In its January 20, 2010 announcement, FHA Announces Policy Changes to Address Risk and Strengthen Finances, The new guideline states that new borrowers will be required to have a minimum FICO score of 580 to qualify for the FHA s 3.5% down payment program. New borrowers with less than a 580 FICO score will be required to put down at least 10%. More details about FHA guidelines will be found in the next course module, Loan Origination Activities. Additional factors for FHA loans include the following: Upfront and annual MIP as mentioned, MIP is used to insure loans in the event of default. Both are expressed in basis points and calculated based on loan term and loan-tovalue. HUD is authorized to make adjustments to MIP requirements as needed to maintain the security of the FHA Mutual Mortgage Insurance Fund. Updated MIP requirements may be found on the HUD website via Mortgagee Letter. Seller concessions sales concessions are limited to 6% of the sales price, or else they are treated as inducements to purchase which results in reduction of the mortgage. Sales concessions may include the following: o Loan discount points o Loan origination fees o Interest rate buy downs o Closing cost assistance o Payment of condo fees o Builder incentives o Down payment assistance o Monetary gifts 3 Department of Housing and Urban Development. HUD announces New, Permanent Mortgage Loan Limits. 10 Nov General Mortgage Knowledge 6

7 o Personal property Seller credit pursuant to Mortgagee Letter , seller-paid credits are not disclosed on the GFE. However, on the HUD-1 the relevant charge is shown in the borrower s column and a credit to offset the charges is entered in Section J along with a reduction to the seller s proceeds in Section K. If the seller contributes to more than one expense, the credit is shown as a lump sum payment on the HUD-1. Cash-out refinances FHA has specific limits on the maximum LTV for cash out refinance transactions: o If a borrower has owned a property as his/her principal residence for at least 12 months or more, he/she is eligible for a maximum of 85% of the appraised property value for a cash-out refinance transaction o If the borrower has owned a property for less than 12 months, he/she is limited to 85% of the lesser of the appraised value or the initial sales price for a cash-out refinance transaction FHA Programs FHA offers a number of programs to meet the needs of eligible borrowers. Several popular programs include: 203 (b) Home Mortgages: FHA s primary program, 203 (b) is a fixed-rate program used to purchase or refinance one- to four-unit family dwellings Condominium Mortgages: The 203 (b) program may also be used to purchase a unit in a condominium. FHA has a number of specific requirements regarding the condo project. For example, the condo must be part of a project with at least two units, and 50% of the units must be owner-occupied. More information on FHA mortgages for condos may be found in Mortgagee Letter B. 251 Adjustable-Rate Mortgages: The 251 program is based on 203 (b), with the added feature of an adjustable rate. FHA offers a number of different types of ARMs, including one-, three-, five-, seven- and ten-year versions. Energy Efficient Mortgages: These loans are allowed for improvements to existing and new construction properties to increase their energy efficiency. Financing is the greater of 5% of the loan or $4,000, with the maximum capped at $8, (a) Growing Equity Mortgages and 245 Graduated Payment Mortgages: Similar in structure, these programs are intended to assist borrowers by lowering the initial costs of their mortgage. Payments increase each year, so the programs are best for borrowers expecting a steady increase in their income over time. 2-1 Buy Downs: FHA permits borrowers to buy down the rate on their fixed-rate loan. Lenders are required to qualify the borrower at the note rate and not the buy down rate. In this type of buy down, the borrower deposits funds in an escrow account in order to offset lower interest General Mortgage Knowledge 7

8 payments the first two years of the loan. For, the borrower might qualify at 6.5%. He/she would pay 4.5% the first year, 5.5% the second year and then begin paying the note rate after that. 203 (g) Officer and Teacher Next Door: The 203 (g) program is intended to revitalize communities by offering homes for sale at a 50% discount off the HUD appraised value to teachers, law enforcement officers and fire fighters/emts. HUD requires a mortgage agreement to be signed for the discounted amount although no payments or interest is charged as long as the borrower fulfills a three-year owner occupancy requirement. VA Loans The Department of Veterans Affairs (VA) guarantees home loans. Veterans who qualify for a VA loan must obtain a Certificate of Eligibility (COE). Determinations of eligibility are based on the length of service and are issued to veterans who were not discharged dishonorably. Although there are a few exemptions, including exemptions for veterans with disabilities, most VA loans include a non-refundable funding fee, which the veteran can finance. The funding fee ranges from 0.50% to 3.30%, depending on what type of loan the veteran is obtaining and whether it is his/her first time use of loan eligibility or a subsequent use. The VA funding fee can also be financed. Disabled veterans, spouses of disabled veterans, and surviving spouses of veterans who died in service do not pay the funding fee. The funding fee is considered non-refundable unless the borrower is overcharged or inadvertently charged. The VA also limits the amount veterans can be charged for other fees. In addition, the veteran can be charged a 1% flat origination fee and reasonable discount points. Closing costs cannot be financed in purchase transactions. VA loans are made based on a total (back) debt ratio of up to 41%. While VA underwriting doesn t look at the housing (front) debt ratio, it does consider residual income when qualifying borrowers. Based on the geographic area, the borrower must be guaranteed a certain amount of income every month after expenses. The veteran is required to occupy the subject property as his or her primary residence, however VA loans are assumable. The buyer must qualify for the assumption, but does not need to be a veteran. However, the full entitlement of the original borrower is not available for use again until the assumed loan is repaid. The loan guaranty is based on the veteran s entitlement; the VA will guarantee a loan amount four times the amount of the eligibility listed on the veteran s COE. A veteran s maximum entitlement is $36,000. Investors will generally not purchase a loan without a minimum of 25% guarantee. The VA does not have maximum loan amounts, although loan size can be limited by transaction types. The maximum guaranty for certain loans in excess of $144,000 is 25% of the $417,000 loan limit. The loan limit for a one unit property is $417,000 so the maximum guaranty is General Mortgage Knowledge 8

9 $104,250. VA loans can be for purchases or refinances and can be used for a number of different transactions including: Traditional purchases Construction refinances Installment land sales contracts Loan assumptions Traditional refinances Interest rate reduction refinance loans (IRRRLs) USDA Loans The Rural Development Housing & Community Facilities Programs of the United States Department of Agriculture make and guarantee loans to qualified applicants. Loans made under the USDA program are referred to as Section 502 loans; they are described under 7 CFR Part 3550 Direct Single Family Housing Loans and Grants. Section 502 loans are made for the purpose of assisting low-income borrowers purchase homes in rural areas. USDA loans can be used to: Build a home Repair, renovate or relocate a home Purchase a lot/home site Prepare a lot/home site, including water and sewage facilities USDA loans are made for 30-year terms, and there is no required down payment. However, the lender must use debt ratios to ensure the borrower is adequately able to repay the loan. Lenders approved to make USDA loans include: State housing agencies Farm credit institutions Lenders approved by HUD (i.e. FHA approved lenders or Ginnie Mae mortgage backed securities issuers) VA mortgagees Lenders approved by Fannie Mae or Freddie Mac. Non-conforming Mortgages A non-conforming loan is a conventional mortgage loan that exceeds current maximum loan limits and underwriting requirements established by Fannie Mae and Freddie Mac. Examples of non-conforming loan include: General Mortgage Knowledge 9

10 Jumbo loans, which exceed the loan limits established by Fannie Mae and Freddie Mac (With conforming loan limits set at a high rate, many loans that were once nonconforming jumbo loans are now conforming loans) Alt-A, which is a designation for loans made to borrowers who do not represent the greatest credit risk of subprime but who still do not quite meet the underwriting requirements for conforming prime rate loans Subprime loans, which are higher-interest loans made to borrowers with blemished credit or other qualification issues that do not conform with Fannie Mae and Freddie Mac underwriting requirements Nontraditional Mortgage means any mortgage product other than a 30-year fixed-rate mortgage. This definition is specifically provided in the federal S.A.F.E. Mortgage Licensing Act of Niche loans, which are loans for borrowers with unique circumstances or needs. Super Conforming Loans - the Housing and Economic Recovery Act of 2008 authorized Freddie Mac to publish higher conforming loan limits. Super conforming loans are used in certain high-cost areas and may be made for amounts up to $729,750 for one-unit properties and as much as $1,403,400 for four-unit properties. Freddie Mac and FHFA s websites provide more detail on super conforming loans. 4 Option ARMs, which offer flexible payment options prior the date of adjustment. Common payment options might include: fully amortized (i.e. 30 year fixed rate), interest-only or a special introductory rate such as 1%. Paying the introductory rate can result in negative amortization. Hybrid ARMs A hybrid ARM is a mortgage loan with a fixed rate during the first three to five years of the loans. After the initial fixed-rate period expires, the loan becomes an adjustable-rate loan. Lenders offer a variety of hybrid loans, which are referred to by their initial fixed period and adjustment period. For example, a 3/1 hybrid loan is a loan in which the interest is fixed for a period of three years and then adjusts once each year for the duration of the loan term. Other hybrid loan products include 5/1, 7/1, and 10/1 ARMs. Hybrid ARMs are good products for borrowers who know that they will only live in a home for a few years. Nontraditional ARMs Beginning in 2003, and until the subprime mortgage market meltdown in the spring of 2007, ARMs known as nontraditional mortgages increased in popularity. Nontraditional mortgage products include, but are not limited to, interest-only ARMs and payment-option ARMs. The Federal Reserve Board made revisions to the CHARM booklet due to the proliferation of these products and in response to growing concerns that borrowers do not understand the risks General Mortgage Knowledge 10

11 associated with these products. In particular, all borrowers do not seem to understand that interest-only payments do not reduce the principal balance on a loan and that certain payment options with payment-option mortgages can result in negative amortization. The origination of nontraditional ARMs has come to a halt as a result of high delinquency and foreclosure rates on these types of loans and renewed commitment to strict lending standards. Amendments to Fannie Mae Selling Guides Also as of December 2009, Fannie Mae provided updates to the policies regarding FHAapproved condo projects for conventional mortgage loans, acceptable credit scores for manual underwriting, acceptable subordinate financing for DU Refi Plus and Refi Plus and changes to existing mortgage loan eligibility for Refi Plus mortgage loans. For more detailed information about these updates please visit: Following is a summary of the changes. FHA-Approved Condo Project Eligibility FHA-insured loans secured by condo units in FHA-approved projects with the project type code U FHA-Approved Project are eligible to be purchased by Fannie Mae. Changes have been made to the following: General information on project standards Condo project eligibility FHA-approved condo review eligibility Geographic-specific condo project considerations These changes were effective February 1, Credit Score Versions Fannie Mae is now specifying the acceptable credit score versions that must be used for manually underwritten loans, effective February 1, These versions are: Equifax Beacon 5.0 Experian/Fair Isaac Risk Model V2SM TransUnion FICO Risk Score, Classic 04 For more details about Fannie Mae s credit score requirements please visit: DU Refi Plus and Refi Plus Subordinate Financing Fannie Mae recently expanded the acceptable subordinate financing terms for DU Refi Plus and Refi Plus mortgage loans. These include: Mortgages with negative amortization Subordinate financing that does not fully amortize under a level monthly payment plan where the maturity or balloon payment date is less than five years General Mortgage Knowledge 11

12 Subordinate financing with prepayment penalties Existing Loan Eligibility for Refi Plus Fannie Mae recently expanded eligibility for DU Refi Plus and Refi Plus to include existing mortgages that were covered by recourse or indemnification agreements where such agreements were not needed to meet Fannie Mae s minimum credit enhancement requirements applicable to loans with LTV ratios greater than 80%. More information on these changes can be found by clicking here: Guidances The downturn in the subprime market began in the fourth quarter of Growing numbers of defaults and foreclosures contributed to market decline, and there was pressure from those within and outside of the mortgage lending industry to offer an immediate response to the emerging subprime crisis. Months and years of political debate and administrative procedures are involved in the enactment of laws and the adoption of new regulations. Knowing that legislative and regulatory solutions were long-term goals, the federal banking regulatory agencies responded to the crisis by writing: The Interagency Guidance on Nontraditional Mortgage Product Risks and The Statement on Subprime Lending Guidance on Nontraditional Mortgage Product Risks In 2006, the Government Accountability Office (GAO) conducted a study to assess how much consumers understand about nontraditional mortgage products. The GAO concluded that nontraditional mortgages are complex products that borrowers did not understand. It also determined that disclosures currently used in lending transactions do not offer an adequate explanation of the terms included in nontraditional mortgage products. Federal and state regulatory agencies have made efforts to improve disclosure requirements for nontraditional mortgages. However, with criticism of these mortgage products mounting and Congressional hearings on nontraditional mortgage products underway, banking agencies were under pressure to offer an immediate response to the crisis. The first response was a joint effort by the federal banking regulatory agencies. These agencies drafted a Proposed Guidance on Nontraditional Mortgage Products and issued their final version of the Interagency Guidance on Nontraditional Mortgage Product Risks in October, There were concerns that a large percentage of mortgage professionals, including state-licensed entities such as mortgage brokers and loan originators, were left without guidance standards. States regulators worked quickly to fill the regulatory gap. On November 16, 2006, the Conference of State Bank Supervisors (CSBS) and the American Association of Residential General Mortgage Knowledge 12

13 Mortgage Regulators (AARMR) published their Guidance on Nontraditional Mortgage Product Risks for State-Licensed Entities. The federal and state Guidances are almost identical. Both are divided into three sections that address areas of concern and a section on recommended practices. The guidances consist of general recommendations rather than specific standards and practices. Following is a summary of the general guidelines presented in the four sections of the Guidance issued by CSBS and AARMR. Loan Terms and Underwriting Standards The Guidance addresses the need for stricter underwriting standards for nontraditional mortgages, especially with regard to the analysis of the repayment ability of the borrower. The Guidance provides: underwriting standards should address the effect of a substantial payment increase on the borrower s capacity to repay when loan amortization begins. 5 While emphasizing the importance of a more thorough repayment analysis for nontraditional loans, the Guidance urges the most stringent repayment analysis for: Nontraditional mortgages that include reduced documentation and/or the simultaneous origination of a second-lien loan Nontraditional loans offered to subprime borrowers Nontraditional loans that finance the purchase of non-owner-occupied investment properties The Guidance defines nontraditional mortgage products as those that allow borrowers to exchange lower payments during an initial period for higher payments during a later amortization period. Nontraditional products may also be referred to as alternative or exotic mortgage loans. Types of loans the Guidance specifically cites include interest-only loans and payment-option adjustable-rate mortgages. With regard to underwriting, the Guidance strongly discourages certain lending practices and terms. Making a collateral-dependent loan in which the borrower has no source for repayment other than the collateral is a practice that is essentially prohibited. The State Guidance warns: Providers that originate collateral-dependent mortgage loans may be subject to criticism and corrective action. 6 The Guidance also discourages lenders from making loans characterized by a large spread between low introductory rates and the fully indexed rate. As the Guidance notes, with these types of loans, borrowers are more likely to experience negative amortization, severe payment shock and an earlier-than-scheduled recasting of monthly payments. 7 5 State Guidance on Nontraditional Mortgage Product Risks, page 3 6 Id. at 5 7 Ibid. General Mortgage Knowledge 13

14 Risk Management Practices The Guidance provides that originators of nontraditional mortgage loans should adopt more robust management practices and manage these exposures in a thoughtful, systematic manner. 8 The need for strict management practices is especially critical for loan providers with concentrations in nontraditional mortgages. The Guidance does not establish specific requirements for risk management, but it does suggest the following as components of an effective risk management policy: Establish appropriate limits on risk layering (An example of risk layering is offering a nontraditional mortgage to a borrower with poor credit scores and using reduced documentation, thereby assuming three distinct types of risk in making the loan) Set growth and volume limits by loan type Monitor compliance with underwriting standards Oversee the practice of third parties such as mortgage brokers Consider how to respond if the secondary market decreases its purchase of nontraditional loans Anticipate the need to repurchase nontraditional loans if the sold loan losses exceed expectations Consumer Protection Issues The Guidance urges originators to provide consumers with information on the risks of nontraditional mortgages even before they receive disclosures required under the Truth-in- Lending Act. Ideally, consumers should have information about the risks associated with products like interest-only loans and payment-option loans while shopping for a mortgage. The Guidance also urges the protection of consumers by avoiding the use of promotional materials that emphasize the benefits of nontraditional mortgages without describing their liabilities. Misleading advertisements are not only a disservice to consumers, but place the advertiser at risk for administrative enforcement actions, lawsuits, and penalties under the Truthin-Lending Act, the Federal Trade Commission Act, and consumer protection laws enacted at the state level. Recommended Practices Recommended practices for addressing the risks associated with nontraditional mortgages include: The use of good communication with loan applicants The development and use of effective control systems for legal compliance and risk management 8 Id. at 6 General Mortgage Knowledge 14

15 Communication with Consumers One of the most important aspects of good client communication is advising loan applicants of the risks associated with nontraditional ARMs. These risks include: Payment shock when amortizing payments begin Loss of equity in the home used to secure the mortgage if the payment agreement allows negative amortization to occur The inclusion of prepayment penalty terms in the agreement Additional costs associated with reduced documentation loans The Guidance encourages loan originators to show borrowers the consequences of accepting interest-only and payment-option loans. The Interagency Guidance on Nontraditional Mortgage Product Risks that federal agencies drafted includes three model forms for disclosures for consumers who are considering nontraditional mortgage products. The State Guidance did not incorporate these model forms, but they are an excellent resource for mortgage lenders and brokers that are trying to create a program for consumer protection. The first document is a narrative description of interest-only mortgages and payment-option mortgages and a description of what happens to the loan balance under these types of lending arrangements. The second sample document is a chart that compares the impact of different mortgage features on principal balance and monthly payments. The third sample document is a monthly statement for payment-option loans that shows the impact of each payment choice on the loan balance. The use of these or similar disclosures shows a commitment to the goal of helping consumers make informed choices about nontraditional mortgage products. Control Systems Control systems for the origination of nontraditional mortgage products should include: Employee training to ensure that originators communicate effectively with loan applicants about the risks and benefits of nontraditional mortgages and accurate information on new mortgage products, as they evolve Use of compensation programs that do not encourage originators to direct loan applicants to expensive, risky products Measures by mortgage companies to ensure that third parties, such as independent brokers, are effectively managed and are operating in compliance with the law A copy of the Guidance is available on CSBS s website. 9 Statement on Subprime Mortgage Lending Six months after publishing the Guidance on Nontraditional Mortgage Product Risks, the Federal Bank Regulatory Agencies determined that it was important to provide a direct response to the crisis unfolding in the subprime lending market. They drafted a supervisory guidance that focuses on the risks of making subprime ARM loans to subprime borrowers. The Federal 9 General Mortgage Knowledge 15

16 Reserve published the final version of the Statement on Subprime Mortgage Lending on June 28, Once again, CSBS and AARMR took part in drafting a parallel statement for statelicensed loan originators. Both the federal and state Statements describe subprime borrowers as those who demonstrate a higher credit risk due to: Two or more 30-day delinquencies within the prior 12 months One or more 60-day delinquencies within the prior 24 months Foreclosure, repossession, or charge-off within the prior 24 months Bankruptcy within the previous five years Credit scores that represent a high risk of default Debt-to-income ratio of 50% or higher Often, these borrowers are desperate for debt relief and are attracted to ARMs with low introductory rates. These ARMs soon adjust to much higher rates, resulting in payment shock and even default for the borrower. The Statement identifies the riskiest loans as ARMs that include any of the following features: A low introductory rate that expires after a short period High interest rate caps or no rate caps No documentation or limited documentation of the borrower s income High prepayment penalties or prepayment penalties that are in force for an extended period of time Recent changes to HOEPA rules under Regulation Z and new regulations for higher-priced mortgages address some of these concerns directly. First, they prohibit lending without using specific types of documents to verify repayment ability. Second, they prohibit prepayment penalties after the first two years of a loan s term. The Subprime Statement refers to the Nontraditional Mortgage Product Guidance that the Federal Bank Regulatory agencies and the CSBS/AARMR published in 2006, and encourages the use of these documents in defining sound underwriting principles for subprime ARMs. Both the Nontraditional Mortgage Guidance and the Subprime Statement issue strong warnings against risk layering. An example of common risk layering is the origination of a simultaneous second lien mortgage with no documentation of income or assets while making a first lien subprime ARM. The CSBS/AARMR Subprime Statement does not forbid risk layering, but provides that practices such as reduced documentation in the making of a risky mortgage product should be accepted only when there are mitigating factors that clearly minimize the need for direct verification of General Mortgage Knowledge 16

17 repayment capacity. 10 document them. Furthermore, if there are mitigating factors, the originator must The Subprime Statement encourages the development of control systems that will ensure that loan originators follow sound lending practices. Effective control systems should: Establish criteria for the hiring and training of personnel Ensure that third party service providers, such as appraisers, are competent Create compensation programs that do not reward originators for steering loan applicants towards subprime ARMs instead of encouraging them to consider other products To some extent, the Secure and Fair Enforcement (S.A.F.E.) Mortgage Licensing Act of 2008 addresses these concerns by requiring registration, licensing, and education for a broad range of mortgage professionals. The Subprime Statement strongly encourages complete communication with loan applicants. In particular, originators should help loan applicants to understand: The risk of payment shock when an initial rate expires The consequences of accepting a lending agreement that includes prepayment penalties and balloon payments The need to set aside cash to cover taxes and insurance when the monthly payment does not cover these expenses (Note that an evaluation of repayment ability under revised provisions of HOEPA will require consideration of a loan applicant s ability to meet these costs and that an escrow account for taxes and insurance is required for higherpriced mortgages) Any additional costs they may assume when accepting a reduced documentation loan Communication with loan applicants is the key to preventing default on subprime loans. Clear and meaningful communication between loan originators and loan applicants will allow borrowers to make informed choices about the mortgage products that they choose. If borrowers understand the choices that they are making, they are more likely to make choices that meet their financial needs and goals. A copy of the Subprime Statement is available on CSBS s website Statement on Subprime Mortgage Lending, Page General Mortgage Knowledge 17

18 Mortgage Loan Products Fixed-Rate Loans With a fixed-rate mortgage, the interest is set at the time of closing and does not change during the life of the loan. Although a borrower s interest rate will not change, monthly payments may change if the loan servicer finds that there is a shortage or surplus in the escrow account. Lenders will make fixed rate loans for terms of any length although 10-, 15-, 20-, 25- and 30- year terms are common. In many cases, the shorter the loan term, the lower the interest rate. Loans made for non-standard terms such as 12 years or 27 years generally revert to the interest rate for the next longest standard loan term. In some areas, 40- and 50-year mortgages are also available as an alternative to certain types of nontraditional mortgages. Prepayment One of the most popular features of a fixed-rate loan is the ability to prepay, or reduce the principal balance of the mortgage, without any penalty. The benefit of prepaying a fixed-rate loan is that subsequent payments are devoted more to paying principal and less to paying interest, paying down the loan balance prior to scheduled maturity. A prepayment strategy looks at ways of paying off a loan as quickly as possible while still keeping the lowest possible payment and saving the maximum amount of interest. Prepayment is especially advantageous to fixed-rate loans because, even after the prepayment occurs, the monthly payment remains the same. This means that an early reduction in the principal balance will result in an acceleration of the loan prepaying early saves more interest cost. The benefit of prepayment is not limited to a fixed-rate mortgage, however. Borrowers can still execute a prepayment strategy on an adjustable-rate mortgage and save even more on interest costs. Bi-Weekly Mortgage Payments Another Prepayment Strategy Monthly prepayment is not the only strategy to achieve interest savings. The same effect can be achieved by making an extra mortgage payment each year. This reduces the loan with a term of 30 years to about 24.5 years. The process of making an extra payment every year forms the basis of the bi-weekly mortgage payment plan. Making a payment every two weeks is the same as making an extra mortgage payment every year because there are 26 bi-weekly periods in a year (13 monthly payments). Many loan servicers do not apply the mid-month payment to the loan until after a full monthly payment has been received. Therefore, there are no additional interest savings from a mid-month principal reduction. The bi-weekly payment plan can be applied to both fixed-rate and adjustable-rate loans with a payment plan that allows borrowers to make a payment every two weeks instead of once a month. Theoretically, this helps people who are paid every two weeks to manage their cash flow. General Mortgage Knowledge 18

19 However, it may be more practical to utilize an independent prepayment strategy as opposed to using a bi-weekly mortgage payment plan because: There is a greater potential for late payments (twice as many payments to make) The rates for a loan utilizing a bi-weekly payment plan are often not as competitive as those for standard monthly plans Lenders may charge a fee for administering the bi-weekly program FHA Fixed-Rate Loans: The FHA offers 15- and 30-year fixed rate mortgages to qualifying borrowers. These mortgages are available for one- to four-unit homes. VA Fixed-Rate Loans: VA fixed-rate loans are made for 15-, 20-, 25- or 30-year periods. Adjustable-Rate Mortgages (ARMs) A variable-rate or adjustable-rate mortgage (ARM) is a mortgage with an interest rate that may change one or more times during the life of the loan. ARMs are often initially made at a lower interest rate than fixed-rate loans although, depending on the structure of the loan, interest rates can potentially increase to exceed standard fixed-rates. There are two types of protection, one that is mandatory, and one that is voluntary, which are intended to ensure that borrowers understand the amount of interest that they will pay during the term of a variable-rate loan: Mandatory Protection for Borrowers: The Truth-in-Lending Act requires lenders to provide applicants for ARMs with The Consumer Handbook on Adjustable-Rate Mortgages (CHARM). In 2006, the Federal Reserve Board revised the CHARM booklet and use of the new booklet was mandatory on October 1, Lenders must also offer ARM applicants information on every variable-rate loan program in which the consumer expresses an interest. Voluntary Protection for Borrowers: Interest rate caps ensure that payments will remain at a manageable level by limiting the extent to which lenders may increase interest rates. Most loan agreements for ARMs include some type of cap, but caps are NOT mandatory, and lending laws do not establish a limit on the allowable increase on variable interest rates. Caps on ARMs Consumer protections which limit the amount the interest rate or payment on an ARM may change. There are four caps in common use: Initial Rate Cap: A limit on the amount that the interest rate can increase during the first adjustment period for an ARM. Periodic Rate Cap: A limit on the amount that the interest rate can change during any adjustment periods. General Mortgage Knowledge 19

20 Lifetime Rate Cap: A limit on the amount that an interest rate can change over the life of an ARM. aka: Rate Ceiling Payment Cap: A limit on the amount that the payment can change during one adjustment period on an ARM. Payment caps can result in negative amortization Calculation of Increase for ARMs Index and Margin All lending agreements for ARMs include an adjustment frequency (or adjustment period) to establish how often an adjustment to the interest rate can occur. The adjustment usually occurs annually, but may occur monthly or only once every few years. The starting point for the adjustment is the index, which lenders must disclose to borrowers. The index is a common way of measuring the cost of borrowing money. The specific index used to determine the rate adjustments must be disclosed to a potential borrower on the early ARM disclosure provided at application. The index also appears on the promissory note when the loan goes to closing. Common indices include the Treasury Bill Index, the 11 th District Cost of Funds Indexes (COFI) or the London Interbank Offered Rate (LIBOR). The index is subject to change, and is therefore likely to be different each time that there is an adjustment period. An index with a long term offers borrowers more protection from short-term fluctuations in the economy than an index with a short term. For example, a borrower with an ARM that uses a six-month U.S. Treasury bill for the index has less protection from increases in the interest rate than a borrower who uses a three-year Treasury bill as the index. The other number, which lenders must disclose to borrowers in lending agreements, is the margin. The margin is a fixed number that is not subject to change during the term of a loan. The margin is a number, expressed in percentage points, and selected by the lender. The margin represents the lender s operating costs and profit margin. Margins vary from lender to lender, and range from 2.5% to 3%. After the initial fixed period of an ARM expires, the calculation of an increase is made by adding the index to the margin. FHA ARMs: Section 251 of the National Housing Act authorizes the FHA to insure ARMs. Amendments to the National Housing Act in 2003 allow HUD to also begin insuring hybrid ARMs. Under current HUD regulations, the FHA can insure hybrid ARMs that offer fixed rates for one, three, five, or ten years before annual adjustment to the rate of interest begins. One-, three-, and five-year ARMs allow for caps of 1% and 5%. Seven- and ten-year ARMs allow for caps of 2% and 6%. VA ARMs: The Veterans Benefits Improvement Act of 2004 reinstated a program from the early 1990s that allowed the VA to guarantee traditional adjustable-rate mortgages. The Act also allows the VA to guarantee hybrid ARMs. The VA guarantees ARMs including traditional ARMs and hybrid ARMs. Traditional ARMs guaranteed by the VA typically limit annual adjustment to 1% and include a cap of five percentage points on the maximum interest rate General Mortgage Knowledge 20