Chapter 6 Conventional Financing 1 Chapter Objectives Identify the characteristics of a conventional loan. Define amortization. Identify different types of conventional loans. Discuss the use of private mortgage insurance. Contrast conforming and nonconforming loans. Discuss methods of secondary financing. 2 Conventional Loans Usually made by bank or institutional lender Not insured or guaranteed by a government agency Conforming Written to guidelines set by governmentsponsored entities Freddie Mac Fannie Mae May be sold in secondary market 3 1
Traditional Conventional Loans Traditionally: Long-term Fully amortizing Fixed rate Anything else is nontraditional (SAFE Act) Long term Payments typically spread over 25-30 years Some 40-year terms available 4 Amortization Amortization: Reduction of loan balance by repaying principal on a regular basis Amortizing loans Payments applied to interest and principal Fully amortizing: Total payments over term pay all interest and principal Also called self-liquidating Regular payments reduce loan by end of term Amounts applied to principal and interest differ Negative amortization Interest paid not sufficient to cover accrued interest from previous month 5 Amortization Schedule Sample 6 2
Fixed Rate Interest rates that remain constant for loan term Advantage for borrower: Rates can t go up If they go down, borrower could refinance Advantage for lender: Guaranteed rate of return 7 15-Year Loans Amortized over 15 years Less risk for lender so lower interest rate Higher payment for borrower but less interest paid 8 Bi-Weekly Payment Plan Set up like conventional fixed rate, 30-year loan Payments made every 2 weeks (26 / year) Usually pay off 30-year loan in about 22.3 years Example: $70,000 fixed-rate loan at 10.5% with 30-year amortization Schedule Payment # of Payments Total Amount Paid Monthly $640.32 360 $230,515.20 Bi-weekly $320.21 532 $170,351.72 9 3
Conforming Loans Meet Fannie Mae/Freddie Mac standards May be sold on secondary market Qualifying standards 28% housing expense ratio 36% debt-to-income ratio Borrower must qualify under both ratios Borrower should have at least: 5% own funds for down payment 2 months of reserves on deposit 10 Nonconforming Loans Do not meet Fannie Mae/Freddie Mac standards: Exceeds maximum loan amount established by Fannie Mae/Freddie Mac (jumbo loan) $417,000 single-family limit (higher in some locations) Credit quality of borrower Known as B or C borrower A-minus conventional loan Interest rates and fees determined on basis of risk factors 11 Conventional Programs Classified by percentage of down payment Loan-to-value: Amount borrowed compared to property value Lesser of sales price or appraised value Higher LTV = lower down payment = more risk Standard 80% conventional loan requires 20% down 12 4
80% Conventional Loan Bill wants to buy a house that is selling for $160,000, and the lender has approved him for an 80% conventional loan. How much can Bill borrow? $160,000 x.80 = $128,000 What would be the required down payment? $32,000 down If the house appraises for $150,000, how much can Bill borrow? 80% = $120,000 maximum loan What other options does he have? Offer seller appraised value Come up with additional $8,000 for the down payment 13 Higher LTV Loans 90%, 95%, 100% loan-to-value Possible because of private mortgage insurance (PMI) and secondary financing More stringent qualifying standards/may not be available May have higher interest rates, fees, etc. 90% LTV At least 5% of down payment from personal cash reserves 95% LTV Requires owner-occupancy Entire down payment from personal cash reserves 14 Loans for Special Needs Special needs such as: Small down payments but excellent credit Marginal credit but large down payment Good credit but limited documentation Programs such as: Stated income Low-doc or no-doc NINA (no income no assets) Easy qualifier Rare in today s marketplace; current conditions drive availability 15 5
Private Mortgage Insurance (PMI) Offered by private companies to insure lender against borrower default Allowed lenders to make loans above 80% LTV Required on loans with less than 20% down PMI premiums: Fee at closing w/ renewal premium One-time PMI premium Lender paid mortgage insurance (LPMI) 16 How PMI Works 17 PMI: Fee at Closing and Renewal Companies offering PMI use rate cards to determine monthly premium 18 6
Mortgage Insurance $100,000 sales price What is the loan amount? $90,000 What is the fee due at closing? $558 How much will be added to the borrower s monthly mortgage payment? $46.50 19 PMI: One-Time Premium and LPMI One-time PMI premium Offered by some companies No renewal fee Combines initial premium and renewal premiums into one payment Allows borrower to finance the PMI premium Lender paid mortgage insurance (LPMI) Interest rate adjustment made at the time of closing Lender "insures" the home loan themselves Extra interest is tax deductible No monthly premium, so no cancellation 20 PMI: Cancellation Mortgage insurance fulfills purpose when risk of borrower default reduced Homeowners Protection Act (HPA) Applies to single family, owner-occupied homes PMI automatically cancelled at 78% LTV if borrower not delinquent Borrower may request cancellation at 80% LTV if borrower shows timely repayment for 12 months When cancelled, monthly payment reduced by premium amount Does not apply to upfront / one-time PMI premium 21 7
Secondary Financing Buyer borrows from second source for purchase and/or closing costs Seller Original or other lender Allows borrower to get conventional loan without 20% down payment Lenders must consider total amount borrower for qualifying An example of subordinate financing/junior lien 22 Secondary Financing: CLTV Combined loan-to-value Total percentage of property value borrowed Calculated by adding all loan amounts and dividing by lesser of appraised value/sale price LTV considers only first mortgage for PMI $80,000 + $10,000 --------------------------- = 90% CLTV $100,000 23 Secondary Financing: Conditions 5% down payment from personal funds 30-year term maximum; 5-year minimum Interest rate negotiable; cannot be ARM for both No prepayment penalty on second Must have regularly scheduled payments Cannot lead to negative amortization Borrower must qualify based on CLTV Generally require subordination to primary 24 8
Case in Point Secondary financing on a $120,000 purchase $90,000 75% First Mortgage (primary lender) 18,000 15% Second Mortgage (from seller) + 12,000 10% Down Payment (from borrower) $120,000 100% Total Sales Price 25 Lender First and Second (80/20) Conventional 80/20 from same lender 100% CLTV May be sold on secondary market Lender may charger higher interest rate on second to reflect risk Borrower avoids down payment and PMI Repayment negotiable: Fully amortizing Partially amortizing Interest only Less common today 26 80/20: Fully Amortizing Example: A house costs $66,667; buyer makes $6,667 (10%) down payment, gets $50,000 (75%) first mortgage for 30 years at 6%; $10,000 (15%) second mortgage for five years at 7 7/8% Fully amortizing: Total payments over life of loan pay entire balance principal and interest due at the end of the term $299.78 Payment on 1st mortgage ($50,000, 6%, 30 yrs.) + 202.17 Payment on 2nd mortgage ($10,000, 7 7/8%, 5 yrs.) $501.95 Total housing expense (principal and interest only) Second mortgage paid off after 5 years Total monthly payment for the next 25 years is $299.78 27 9
80/20: Partially Amortizing Example: A house costs $66,667; buyer makes $6,667 (10%) down payment, gets $50,000 (75%) first mortgage for 30 years at 6%; $10,000 (15%) second mortgage for five years at 7 7/8% but amortized as though for 30 years Partially amortizing: Payments applied to principal and interest but do not retire debt to end of loan term $299.78 Payment on 1st mortgage ($50,000, 6%, 30 yrs.) + 72.51 Payment on 2nd mortgage ($10,000, 7 7/8%, as if 30 yrs.) $372.29 Total housing expense (principal and interest only) Substantial balloon payment required after 5 years or refinance 28 80/20: Partially Amortizing 29 80/20: Interest Only Example: A house costs $66,667; buyer makes $6,667 (10%) down payment, gets $50,000 (75%) first mortgage for 30 years at 6%; $10,000 (15%) second mortgage for five years at 7 7/8%, interest only Interest only: Scheduled payments only on accrued interest $299.78 Payment on 1st mortgage ($50,000, 6%, 30 yrs.) + 65.63 Payment on 2nd mortgage ($10,000 x 0.7875 / 12) $365.41 Total housing expense (principal and interest only) Balloon payment of entire principal ($10,000) due after 5 year If open-end, interest due may be calculated using daily rate 30 10
Assumption of Conventional Loan Assumption: One party takes over primary liability of loan with no change in loan terms Seller remains secondarily liable unless lender provides release Lender response to assumption request includes: Accept assumption and leave loan terms intact Accept assumption, but charge fee and/or increase interest rate Allow the assumption, but keep seller secondarily liable Not allow the assumption and exercise a call provision Must be stated in the note or mortgage 31 Mortgage Exercise 6-1 A potential borrower is applying for a conventional loan to purchase a primary residence. Currently he pays $500 in rent, $420 for an auto loan, $170 toward his VISA bill, and $300 on a student loan each month. His gross monthly income totals $4,900, and his take-home pay after taxes is $3,700. 32 Mortgage Exercise 6-1 1. What is the maximum house payment including principal, interest, taxes, and insurance for which the borrower will qualify? Monthly debt is $890 (auto loan + VISA + student loan); rent does not count as debt Conventional guidelines allow housing expense ratio of 28% and total debt-to-income ratio of 36%, based on gross monthly income Under the 1st ratio, he qualifies for $1,372 ($4,900 x.28) Under the 2nd ratio, he qualifies for $874 ($4,900 x.36 = $1,764; $1,764 - $890 = $874) You must accept whichever ratio is lower 33 11
Mortgage Exercise 6-2 A borrower is seeking a fixed rate, conventional loan to purchase a home. The sale price is $189,500 and the property has been appraised at $191,500. The buyer will make a 10% down payment and finance the balance with a 75% conventional first mortgage at 6% interest for 30 years and a 15% second mortgage. The second mortgage bears interest at 11% and calls for a balloon payment after five years (amortized on the basis of a 30-year schedule). There will be a 1.5% loan fee on the first mortgage. (To complete this exercise, refer to the Payment Rate Chart found in the Appendix.) 34 Mortgage Exercise 6-2 1. What will the loan amounts for the first and second loans be? What are the LTV and the CLTV? $189,500 Purchase price x 0.75 % of 1st loan $142,125 1st loan amount $189,500 x 0.15 % of 2nd loan $28,425 2nd loan amount Loan-to-Value = 75% CLTV = 90% (75% 1st loan + 15% 2nd loan) 35 Mortgage Exercise 6-2 2. How much will the buyer pay at closing for down payment and loan fees? $189,500 Purchase price x 0.10 Down payment % $18,950 Down payment $142,125 Loan amount x 0.15 Fee % $2,132 Loan origination fee (rounded) $18,950 + $2,132 = $21,082 (Total due at closing) 36 12
Mortgage Exercise 6-2 3. What is the monthly payment on the first mortgage, including principal and interest? ($142,125 / 1,000) x 6.00 Payment rate $852.75 Monthly P&I 1st loan 37 Mortgage Exercise 6-2 4. What is the total monthly payment for both loans? $189,500 Purchase price x 0.15 $28,425 2nd loan ($28,425 / 1,000) x 9.53 Payment rate $2,709.89 Monthly P&I 2nd loan $852.75 + $270.89 = $1,123.64 Total monthly principal and interest payment 38 Mortgage Exercise 6-2 5. The review appraisal just came back at $185,000. What happens now? You must use the lower of the appraised value or the purchase price. The buyer would either need to bring an additional $4,500 to closing, or the purchase price and therefore the loan amounts would need to be adjusted accordingly. 39 13
Key Term Review Amortization Conforming Loan Conventional Loan Fixed Rate Loan Jumbo Loan Loan-to-Value Ratio (LTV) Negative Amortization Private Mortgage Insurance (PMI) Secondary Financing Self-Liquidating 40 Summary 1. Conventional loans Not insured or guaranteed by government agency; long term, fully amortizing, fixed rate Amortizing loan Payments applied to principal and interest Fully amortizing Total payments of principal and interest retire debt at end of loan term May be 15-year or 30-year, conforming or nonconforming A bi-weekly payment structure allows borrower to make equivalent of one extra monthly payment each year so balance is paid faster, saves interest 15-year loans retire sooner and save interest, higher payments Conforming meet Fannie Mae/Freddie Mac standards; can be sold on secondary market Qualifying standards are 28% (housing expense) and 36% (total DTI) Nonconforming loans do not meet Fannie Mae/Freddie Mac standards; cannot be sold to them, but others may buy Credit quality Size of loan (jumbo) exceeds Fannie Mae/Freddie Mac maximum loan amounts 41 Summary 2. Conventional loan programs 80%, 90%, 95%, some for special needs 80% conventional = 80% loan-to-value (LTV) Ratio of loan amount to appraised value or sales price, whichever is less 80% loan requires 20% down payment 90% or 95% requires at least 5% down payment from borrower s cash reserves (no gifts) Interest rates and fees may be higher on higher LTV PMI required above 80% LTV 42 14
Summary 3. Private mortgage insurance (PMI): Insures lenders against borrower default Borrower shares partial risk (of upper loan limit) May be paid at closing with monthly renewal, as onetime premium, or as higher interest rate Homeowners Protection Act requires automatic cancellation when LTV reaches 78% and borrower is not delinquent Borrower may request cancellation when at 80% LTV and Appraisal confirms value Borrower has timely repayment past 12 months 43 Summary 4. Secondary financing: Buyer borrows money for part of purchase price or closing costs Combined loan-to-value Sum of all loan amounts divided by appraised value or sales price, whichever is less Typical conditions for second loan: 5% down payment 5-year to 30-year term No prepayment penalty Regularly scheduled payments No negative amortization Borrower must afford total payment Second mortgage subordinate to first 44 Summary 5. Repaying second loans Fully amortizing Partially amortizing with balloon payment Payments are scheduled as if the loan term is longer (e.g., 30 years) Balance due sooner (e.g., in 5 years) Smaller payments may help borrower qualify Same lender can provide both loans at different interest rates 45 15
Summary 6. Assumption: One party (buyer) takes over primary liability for the loan of another party (seller) Lender: Can accept assumption and leave loan terms intact Can accept assumption and charge a fee or increase the interest rate May not allow assumption and call the note payable immediately Always consult the original lender or a lawyer concerning assumptions 46 1. What is the term that describes a second mortgage holder agreeing to accept a second position in a refinance transaction? A. alienation B. assumption C. subordination D. subrogation 47 2. A loan that is repaid with periodic payments of both principal and interest so that the entire loan amount is paid in full at the end of the loan term is a(n) A. annualized loan. B. conventional loan. C. fully amortizing loan. D. partially amortizing loan. 48 16
3. Which statement about 15-year mortgages is FALSE? A. There s an earlier loss of interest deduction for income tax purposes. B. Higher interest rates are usually charged. C. They have higher monthly payments. D. They result in less interest owed. 49 4. You are pre-qualifying a buyer for a conventional loan on a house with the purchase price of $160,000. She states she does not want to pay PMI on the loan. In that case, what is the maximum loan amount she can receive (assuming no lender paid PMI)? A. $32,000 B. $128,000 C. $136,000 D. $144,000 50 5. Which type of mortgage is traditionally defined as NOT being insured or guaranteed by the government? A. conventional mortgage B. FHA mortgage C. rural home mortgage D. VA mortgage 51 17
6. When seeking an 80% conventional loan with the seller taking back a second mortgage, the buyer A. can expect to pay a higher interest rate than with a 90% loan. B. may choose which mortgage (first or second) will have lien priority. C. must make at least a 5% down payment from personal funds. D. must make at least a 20% down payment from personal funds. 52 7. Which would likely have the highest PMI cost? A. 80% loan B. 90% loan C.95% loan D. house purchased for cash 53 8. PMI must be cancelled A. anytime the borrower requests it. B. only if the lender is satisfied that the borrower is no longer a credit risk. C. when a home has been paid down to 78% of its original value and the borrower is current. D. whenever a new appraisal is ordered, regardless of the value. 54 18
9. Lenders are often willing to charge lower interest rates for 15-year mortgages because the A. borrower is always a better risk. B. interest rate is fixed for a longer period of time. C. loan funds will be repaid more quickly. D. loan qualifications are much more stringent. 55 10. A buyer is paying $200,000 for a house. He makes a $30,000 down payment, gets a first mortgage for $160,000, and a second mortgage to cover the balance. What is his CLTV? A. 70% B. 80% C.85% D.90% 56 19