Chapter 12: Residential Mortgages Flashcards
1
Q
Title Theory
A
Title theory is the oldest form of mortgaging, which originated under English common law. Under this system, the borrower was required to temporarily convey ownership of the property to the lender for the duration of the loan period. If the borrower defaulted on the loan during the loan period, the lender took possession of the property.
2
Q
Deed of Trust
A
A deed of trust is used in title theory states in place of a mortgage. The deed of trust temporarily conveys title to a property to a third party called a trustee until the mortgage loan debt is repaid or until default occurs. The borrower is called a trustor; the lender is called the beneficiary. Upon satisfaction of the debt, the title is returned to the borrower by using a reconveyance deed.
3
Q
Several states still use
A
Several states still use a modified form of the title theory of mortgaging. However, today, all states require some form of foreclosure in the event of a default. When the loan is satisfied, a reconveyance deed is executed to the borrower.
4
Q
Lien Theory of Mortgages
A
Florida is a lien theory state. Lien theory allows the borrower to retain the ownership of the property during the loan period. The lender records the mortgage, which creates a lien against the property.
Under the lien theory, the foreclosure process is more involved than under title theory; the borrower is given the right to cure the default instead of simply forfeiting the property.
5
Q
Promissory Notes
A
When money is borrowed to purchase real estate, the lender requires the borrower to sign a promissory note, also called a note or bond.
The promissory note is a legal instrument that includes the borrower’s promise to repay the loan with interest according to the terms of the note. The note is evidence of a personal debt, and contains the names of the parties, the rate of interest, the amount of money borrowed, and the loan repayment terms. The note is a contract between the lender and the borrower.
6
Q
Note of Even Date
A
The promissory note is often identified as a note of even date, meaning that the promissory note was created on the same day as the mortgage. A promissory note provides no collateral to the lender other than the borrower’s promise to repay the loan. When the promissory note is unsecured, the lender is in a risky position if the borrower defaults and fails to repay the loan as agreed. Consequently, lenders prefer to have some security that helps assure repayment of the note.
7
Q
Secured Note
A
A promissory note that is secured by a mortgage.
8
Q
What is a Mortgage?
A
A mortgage accompanies a note and is security for its repayment. A mortgage is the borrower’s pledge of the mortgaged property to secure the repayment of the note. Obtaining the mortgage from the borrower reduces a lender’s risk of loss resulting from a borrower’s default on the loan. The lender records the mortgage on the public record, which creates a lien against the property. This gives the lender the ability to foreclose on the borrower’s property in the event of default. The proceeds of a foreclosure sale can be applied to the outstanding balance of the note.
9
Q
Hypothecation
A
The pledge of property as security for a loan
10
Q
Parties to a Mortgage
A
The property owner, the mortgagor, is the party who gives the mortgage to the lender to secure the loan. The lender, the mortgagee, is the party who receives the mortgage from the property owner. The mortgagor owns the real property, while the mortgagee owns the mortgage, which is personal property.
11
Q
Requirements for a Valid Mortgage
A
A valid mortgage must:
• Be in writing,
• Be signed by the mortgagor,
• Conform to the same requirements as any valid contract,
• Contain the legal description of the property, and
• Be witnessed by two persons.
12
Q
Recording the Mortgage
A
Normally, the mortgagee records the mortgage to provide constructive notice of the lien. The promissory note is rarely recorded, but the note is referred to in the recorded mortgage. Recording the note would allow other lenders to know the exact details of the loan, which would give them the ability to offer better terms and “raid” the originating lender’s customers.
13
Q
Satisfaction of Mortgage
A
When a loan has been paid in full in a lien theory state, such as Florida, the mortgagor should receive a letter of satisfaction from the mortgagee within 60 days of the loan payoff. This letter states that the loan terms have been fully satisfied. It should be recorded in the public records to offset the lien that was created when the original mortgage was recorded.
14
Q
First Mortgage
A
The first mortgage, also referred to as the first lien, is the primary claim on a property that takes precedence over all other subsequent (junior) mortgage claims and most other liens. A first mortgage is often used to purchase the property. In the case of foreclosure, the first mortgage will be paid first.
Mortgage liens are given priority by the date they were received. When a loan is used to finance a property, it is usually the first lien placed against the property and, therefore, has the highest priority over all liens with the exception of real estate taxes and special assessments.
15
Q
Junior Mortgage
A
A junior mortgage is one that is subordinate to a first or prior (senior) mortgage. A junior mortgage often refers to a second mortgage, but it could also be a third or fourth mortgage. A home equity loan and home equity line of credit (HELOC) are two common types of junior mortgages.
16
Q
Subordination Agreement
A
A subordination agreement is a written contract in which a lender who has secured a loan by a mortgage or deed of trust agrees with the property owner to subordinate the first loan to a new loan (giving the new loan priority in any foreclosure or payoff). The agreement must be acknowledged by a notary so it can be recorded in the official county records.
A subordination agreement is used to grant first lien status to a lienholder who would otherwise be secondary to a first lien.
A mortgage subordination agreement is frequently used when there are two mortgages on a property, a first mortgage and a second mortgage, and the mortgagor wants to refinance the first mortgage.
17
Q
What happens if the holder of the second mortgage does not subordinate the lien of its mortgage to the new mortgage?
A
the new lender will not refinance the first mortgage. This is due to the fact that when the first mortgage is refinanced, it is essentially paid off and replaced with a new loan.
What was the second mortgage then becomes the first mortgage, and the newly refinanced mortgage would become a lower priority lien. The second mortgage holder does not want to incur the additional costs of releasing its mortgage and re-filing, so the second mortgage holder will subordinate its lien to the lien of the replacement (refinanced) mortgage to all the refinanced first mortgage to remain in first lien status.
18
Q
What are the provisions designed to protect both the lender and the borrower?
A
Acceleration Clause Cognovit Clause Defeasance Clause Due-on-Sale Clause (alienation clause) Escalation (or Escalator) Clause Exculpatory Clause Insurance Clause or Covenant of Insurance Maintenance Clause or Covenant of good repair Open-End Clause Prepayment Clause Receivership Clause Release Clause Right-to-Reinstate Clause Subordination Clause Tax Clause or Covenant to Pay Taxes
19
Q
Acceleration Clause
A
allows the lender to declare the entire outstanding balance due and payable immediately whenever default occurs. Without having this ability, the lender would have to sure each time the borrower defaulted, month after month. By calling the entire balance due at one time, this clause avoids the time and expense of that process.
20
Q
Cognovit Clause
A
gives a lender the right to foreclose at its option by requiring a borrower to admit any future default at the time a loan is obtained. The borrower is prevented from defending against a foreclosure, which results in an automatic judgment in favor of the lender when the loan documents are presented in court. This is obviously a very harsh provision and is not allowed in Florida.
21
Q
Defeasance Clause
A
provides protection for the borrower as it requires the lender to acknowledge performance by the borrower. The defeasance clause holds the lender’s rights in check as long as the borrower performs as agreed in the note and mortgage. The defeasance clause is the only legally necessary clause in a mortgage.
22
Q
Due-on-Sale Clause or alienation clause
A
in a loan or promissory note stipulates that the full balance may be called due-on-sale upon transfer of ownership of the property used to secure the note. This clause prevents a borrower from transferring any interest in the mortgaged property without permission of the lender. If the property is sold, or any substantial interest in it is conveyed, the lender has the right to declare the entire loan balance due and payable immediately. The due-on-sale clause prevents an assumption of the mortgage by an unqualified borrower. Any borrower interested in assuming the existing loan would have to apply and be approved by the lender.
23
Q
Escalation (or Escalator) Clause
A
allows a lender to increase the interest rate based on the occurrence of an event, such as a change in the use of the property or consistently late payments.
24
Q
Exculpatory Clause
A
limits the lender’s rights in a foreclosure to the amount received from the sale of the foreclosed property. If the balance of the promissory note has not been paid in full from the proceeds of the sale, the lender cannot obtain a deficiency judgment for the unsatisfied amount. This is referred to as nonrecourse financing since the lender has no recourse against the borrower for the unsatisfied portion of the loan.
25
Insurance Clause or Covenant of the Insurance
is the borrower’s promise to maintain adequate insurance coverage. Mortgages typically require the borrower to carry fire and hazard insurance in an amount at least equal to the unpaid balance of the loan. Should a property burn to the ground or be severely damaged in a storm, the borrower may not be financially able to replace or repair the structure, thereby exposing the lender to the possibility of loss.
26
Maintenance Clause or Covenant of good repair
is a provision that requires the borrower to maintain the property properly during the term of the loan, to protect the property’s value. If a property is not maintained properly and the value diminishes, a lender could lose money in a foreclosure action.
27
Open-End Clause
allows a borrower to borrow additional funds based on the same mortgage after the loan balance has been paid down. This ability is usually limited to the amount of the original loan amount. This can reduce the cost involved in obtaining an entirely new loan. The lender generally reserves the right to increase the interest rate. A mortgage containing this provision is similar to an equity loan or revolving line of credit.
28
Prepayment Clause
allows a borrower to pay off a loan early, thereby avoiding the interest that would otherwise have to be paid. In Florida, a borrower has the right to prepay a loan whether this right is expressed in the mortgage or not. When interest rates are high, lenders would prefer that a loan not be paid ahead of schedule. During these times, some loans may include a prepayment penalty clause within the prepayment clause. A penalty clause requires the borrower to pay a certain amount to the lender for the privilege of prepaying the debt.
29
Receivership Clause
is used in mortgages on income-producing real estate. If the investor should default, the lender may ask the court to appoint a trustee, referred to as a receiver, to manage the property during the foreclosure process, collect the rents, and maintain the property. This serves to protect the asset that serves as security for the loan. Without this provision, the borrower could pocket the rents and allow the property to deteriorate, thereby reducing its value.
30
Release Clause
is found in mortgages that cover more than one parcel of land, usually those given by builders and developers. A builder developing several lots in a subdivision under a construction loan that covers the entire project would not be able to sell a single lot if the buyer could not obtain a first mortgage loan. To resolve this problem, a release clause is used which releases the individual lot from the original loan upon payment to the construction lender of a specified amount of money.
31
Right-to-Reinstate Clause
is a loan clause that gives a borrower the right to cure a loan that is in default by paying loans payments that are in arrears, along with accrued interest, late payment charges, and legal costs incurred by the lender before the foreclosure is finalized. Once the borrower has done this, they can resume making scheduled loan payments.
32
Subordination Clause
allows a lien recorded earlier to be placed in a secondary position to a new lien. A subordination clause is commonly used to finance vacant land when development is planned. The seller voluntarily agrees to allow a mortgage that they hold on the land to be placed in lower propriety than another loan so that the developer can obtain a construction loan to complete the project.
33
Tax Clause or Covenant to Pay Taxes
consists of the borrower’s promise to pay the property taxes during the period of the loan. Should the borrower fail to pay the taxes as required, the property could be sold in a tax foreclosure sale, which would remove the lien created by recording the mortgage. The lender would have to seek enforcement of the promissory note and hope to collect any deficiency on the basis of a personal judgment.
34
Down Payment
A down payment is an upfront cash contribution that is made by the purchaser in order to qualify for a mortgage, lower payments, receive more favorable loan terms, or eliminate the need for mortgage insurance. The down payment plus the mortgage loan amount is the purchase price.
35
Equity
Equity is the difference between the current market value of a property and the amount the owner still owes on the mortgage. The initial down payment creates equity. The owner builds, or increases, equity with each mortgage payment that reduces the principal (loan balance). The loan-to-value ratio, reflects the degree to which a property is financed. As equity increases, the loan-to-value percentage decreases.
36
Interest
Mortgage interest is the compensation a borrower pays a lender for the use of the lender’s money to purchase a property. The interest rate is a percentage of the loan that must be paid in addition to the loan amount, or principal. The interest rate on a mortgage loan is determined by prevailing interest rate levels and by agreement between the lender and the borrower. The interest rate may be fixed or adjustable.
37
Loan Servicing
Loan servicing is the administration of a loan from the time the money is borrowed until the loan is paid off (satisfied). Loan servicing includes such things as sending monthly payment statements, collecting payments, maintaining records and balances, managing any escrow funds, collecting and pay taxes, forwarding net proceeds to the mortgage note holder, and following up on delinquencies. A loan servicer can be a financial institution or a lender. Loan servicers are typically compensated by retaining a percentage of each mortgage payment. In addition to collecting servicing fees, loan servicers also benefit from being able to invest and earn interest on a borrower’s escrow payments as they are collected until they are paid out for taxes and insurance.
38
Escrow (Impound) Account
An escrow, or impound account is established to hold money collected by the lender from the borrower to pay hazard insurance and property taxes when they become due. By ensuring that the taxes and insurance will be paid on time, the escrow account protects the lender from tax liens and uninsured losses that the borrower can’t repay.
39
PITI Payment (Principal, Interest, Taxes, and Insurance)
Many lenders require the borrower to pay a portion of the annual insurance premium and real estate taxes each month along with the principal and interest due for the period. This type of monthly payment is referred to as a PITI payment. This money is held in the escrow account. The lender assumes responsibility for the payment of these charges from the impound account, thereby avoiding the possibility that the borrower would fail to make the payments when required.
40
Take-Out Commitments
A take-out commitment is a type of mortgage purchase agreement. Under a take-out commitment, a long-term investor agrees to buy a mortgage from a mortgage banker at a specific date in the future. The investor is referred to as a take-out lender, and is usually an insurance company or other financial institution. A take-out commitment is an agreement to provide long-term financing to replace an interim short-term loan.
A take-out commitment may be made in construction or other projects when short-term financing, such as construction financing, is initially beneficial, but the borrower anticipates long-term financing to become more advantageous at a later date.
41
Mortgage Loan Fees
Mortgage loan fees are fees that are charged by the lender and paid by the borrower to cover overhead and administrative costs and to provide some amount of profit for the lender.
These fees have a serious effect on the cost of financing, which must be made clear to the borrower. Two such fees are generally charged as a percentage of the loan amount: loan origination fees and discount points. Real estate licensees should be able to discuss these fees and explain both their purpose and financial effect on the borrower (effective yield).
42
Loan Origination Fee
Mortgage lenders typically charge a loan origination fee to pay for the administrative costs of processing the loan. The loan origination fee pays the lender’s overhead for facilities, salaries, and commissions.
Loan origination fees are expressed as points. One point is 1% of the amount borrowed expressed in dollars. The loan origination fee is a one-time charge that must be paid by the borrower and is an additional cost necessary to obtain the loan. Anywhere from one to four points is not uncommon.
43
To include the loan origination fee
Unfortunately, many borrowers do not have the extra money on hand to pay these charges. It is not uncommon for a borrower to have to increase the amount of the loan to include the loan origination fee along with the amount needed to purchase the property. The borrower will then pay interest on the origination fee as well as the amount needed to buy the property.
44
Discount Points
Discount points are an upfront payment to the lender in exchange for a lower mortgage rate, which decreases the monthly mortgage payment for the life of the loan.
One discount point is an upfront payment of 1% of the loan amount (not the purchase price) which is paid at closing. The payment of discount points reduces the borrower’s interest rate, resulting in a lower monthly mortgage payment. Paying discount points does not reduce the amount borrowed.
The breakeven point for the borrower is dependent on the discount amount paid and the length of time of the loan. If the borrower keeps the mortgage for five to ten years, they will most likely save money in the long run by paying discount points. If the borrower keeps the loan for a short period-of-time, before the breakeven point, the lender would benefit from the upfront discount payment.
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Effective Yield
Whether points are paid for origination fees or an upfront interest prepayment to discount the interest rate, there is a cumulative effect on the total amount paid by the borrower. In some cases, the upfront payment of points can effectively raise the rate of interest the lender receives above the borrower’s loan rate.
The effective yield is the rate of return received by the lender. The effective yield will very depending upon the number or points paid, the amount of any discount, and the length of time the borrower keeps the loan.
A simple rule of thumb calculation is sometimes used to approximate the change in interest payment over the life of the loan as a result of this upfront point payment. This approximation is based on the assumption that the borrower keeps the loan for eight years. The actual effective yield will be less for longer loan periods and more for shorter loan periods.
The rule of thumb is that for each point charged upfront by the lender, the rate of interest increases approximately 1/8 percent. The exact amounts will be calculated and provided by the lender.
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The Need to Qualify the Property and the Applicant
Mortgage lenders are investors. They expect borrowers to pay back the amount borrowed plus interest in order to make a profit on the loan. Lenders do not want to go through a foreclosure any more than borrowers do. To minimize the risk of foreclosure, both the borrower and the collateral must be qualified before a loan will be approved.
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Mortgage Underwriting
The application process begins when the potential borrower contacts a lender to inquire about available loans and loan terms. An application is generally taken by a loan processor and passed on to a mortgage underwriter. The mortgage underwriter reviews and verifies the information contained in the application to determine if the applicant is qualified for the loan requested. The process of risk evaluation is called mortgage underwriting, and is discussed later in this section.
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The Loan Application
Whether or not the applicant will obtain a mortgage loan depends upon how complete, accurate, and truthful the application is. During the mortgage underwriting process, the information contained in the application is verified by contacting current and past employers and creditors.
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Lender Risk
When a loan is approved, the lender assumes a number of risks. The primary risk is that the borrower may default on the loan. If the borrower defaults, the lender can sue to have the mortgaged property sold at foreclosure, but there is no guarantee that the proceeds of the sale will be sufficient to cover the loan balance.
50
Spouse Signatures
The signature of only one spouse is required on a mortgage loan application, unless state or local law dictates otherwise.
If the income of a spouse is required to meet the lending institutions’ credit standards for loan approval, the spouse must also sign the application. When both parties sign the loan documents, they become jointly (mutually) and severallyn(individually) liable for the debt.
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The Equal Credit Opportunity Act (ECOA)
The ECOA requires lenders to judge every loan applicant on the basis of the applicant’s own credit rating and income. Lenders are required to consider a spouse’s income, part-time income, alimony, child support, or separate maintenance in the approval process. The ECOA allows the lender to question applicants on the stability and source of income, but the lender cannot refuse to consider income because of the source.
An applicant may request inclusion of another individual’s income or credit history in order to quality for a loan, in which case the lender will consider both the cosigner’s and applicant’s income and credit history.
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Lenders Cannot Discriminate
Lenders cannot discriminate against borrowers on the basis of race, color, religion, national origin, sex, marital status, age, or receipt of income from public assistance programs.
The loan officer cannot ask questions regarding birth control practices, intentions concerning the bearing or rearing of children, or the capability of bearing children. They are prohibited from asking questions based on race, color, religion, national origin, or sex.
However, in order to avoid discrimination based on a borrower’s ethnic background, HUD requires lenders to ask about a borrower’s race. The lender is still prohibited from discrimination on the basis of race. HUD uses the information to review lender records to make sure that the lender is not routinely turning down minorities or charging them higher fees.
53
If an applicant request a lender to consider income derived from
alimony, child support, or separate maintenance payments in order to qualify for a loan, the lender can ask questions concerning the income source, duration of the income, and frequency of the payments.
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Mortgage Underwriting
To assess the risk of default or collection problems, lenders evaluate both the applicant and the property before approving a mortgage loan. The process of qualifying the applicant and the property is called mortgage underwriting.
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Qualifying the Property
The property that will serve as collateral for the loan is evaluated or appraised to determine if it is of sufficient value. The appraiser analyzes the property and issues a report giving an objective estimate of the property’s market value. The appraiser’s estimate will not necessarily be the price agreed upon between the seller and potential buyer. The underwriter is concerned with the market value of the property.
56
Redlining
When a lender refuses to loan based on the racial or economic factors of the neighborhood in which a property is located, the practice is called redlining, which is prohibited by federal law.
Loans cannot be refused based on the fact that a property is located in a certain geographical area, age of the property, income of residents in the area, or racial composition of the area.
57
Qualifying the Applicant
An applicant is evaluated to determine if they can repay the proposed loan. The lender evaluates the applicant’s credit history and employment record as indicators of the applicant’s desire and ability to repay the loan.
58
An applicant is evaluated by what criteria?
Credit History
Income
Other Assets
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Credit History
the underwriter obtains a report from a credit-reporting agency and reviews the applicant’s credit history. The credit report includes information about debts and repayment for the preceding seven years. Negative information such as slow repayment, collections, repossessions, foreclosures, judgments, and bankruptcies may cause the underwriter to refuse the application.
A potential buyer’s credit score is used to evaluate the risk associated with a loan, whether or not the lender will make the loan, and if so, determines the rate of interest the lender will charge. Credit scoring was introduced by the Fair Isaac & Company (FICO) over 30 years ago. As a real estate licensee, it is important to have a fundamental understanding of this very important loan-qualifying tool.
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FICO
- Payment History (35%)
- Outstanding debt (30%)
- Credit history age of open accounts (15%)
- Credit report inquiries (10%)
- Type of credit (10%)
The FICO score measures the borrower’s willingness to meet debt obligations and weighs heavily on the lender’s decision to underwrite a loan.
Fico scores can range from 300 up to 850; the higher the score, the lower the risk of default by the borrower. Different types of property, such as single-family versus two- or three-family homes, will typically be underwritten using different score requirements. Scores below 580 are considered to be poor and those above 660 are considered to be excellent.
Scores must be thought of as an indicator of risk. Applicants who have scores below 580 may not automatically be denied credit; however, the interest rate will probably be higher and the type of financing available may be limited.
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Income
the applicant’s income must be enough to cover the proposed mortgage payment and other monthly expenses. The applicant’s source(s) of income must be reasonably dependable and stable. Continuous employment for at least two years in the same occupational field is generally used as criteria for loan approval. A person’s income indicates his or her ability to make the payments required to repay the loan. The applicant’s stable monthly income can be derived from regular wages from a full-time job, bonuses, commissions, overtime pay, part-time earnings, self-employment income, retirement income, alimony or child support, or investment income. Mortgage lenders will not accept income from temporary employment, unemployment compensation, or contributions from family members to meet the lender’s standards for making a loan.
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Other Assets
the underwriter reviews the other assets of the applicant, such as other real estate, automobiles, stocks, bonds, artwork, and so on. The accumulation of assets is a strong indicator of future creditworthiness. These assets may also be attached in the event of a foreclosure and resulting deficiency.
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Risk Evaluation
The risks facing lenders in making residential loans include default by the borrower, a decline in the value of the property that serves as security for the loan, and a lack of other assets that could be attached in the event of a foreclosure and subsequent deficiency.
Lending institutions have relatively consistent requirements that an applicant must meet before a mortgage loan will be originated. Mortgage lenders use income ratios and loan-to-value ratios to qualify a potential borrower for a loan.
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Income Ratios
The income of an applicant is the primary consideration when underwriting a loan. It must be adequate to allow for the continued repayment of the loan. If a borrower’s expenses exceed certain percentages of his or her monthly income, the borrower may have difficulty making the required payments.
Ratios are a simple method used by lenders to evaluate a borrower’s financial ability to meet the financial obligation once a loan has been approved.
65
What are the two income ratios generally used to determine whether or not a loan will be approved?
Housing Expense Ratio
| Total Obligations Ratio
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Housing Expense Ratio
is the percentage of the borrower’s monthly gross income that is required to make the monthly loan payment, which is one-twelfth of the annual principal payment, interest, taxes, and insurance (PITI). The PITI payment must also include homeowner’s or condominium association dues, if applicable. Utilities are not included in the ratio. Mortgage insurance can be included, if required.
Monthly PITI payment ÷ Monthly gross income = Housing expense ratio
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Total Obligations Ratio
is the percentage of the borrower’s monthly gross income that is required to make the monthly loan (PITI) payment plus payments on any other recurring debt obligations. Recurring obligations include installment debts which have more than ten remaining payments (i.e. auto payments), revolving debts (i.e. credit cards), and other debts (i.e. child support or alimony). The total obligations ratio is a more realistic measure of the applicant’s ability to make the monthly loan payments.
Monthly PITI payment + Other Monthly Obligations DIVIDED by Monthly Gross Income = Total obligations ratio
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Maximum Ratio Values
lenders impose different maximum ratios, depending on the type of loan:
o Conventional- conventional lenders typically require that a borrower not exceed a housing expense ratio of 28% and a total obligations ratio of 36%.
o FHA- to qualify for an FHA loan, a borrower must not exceed a housing expense ratio of 31% and a total obligations ratio of 43%.
o VA- to qualify for a VA loan, a borrower must not exceed a total obligations ratio of 41%. The Veterans Administration does not use the housing expense ratio. Instead, a residual income calculation is used based on the loan amount, income of the veteran, and size of the family.
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Lenders can approve loans with higher ratios
due to factors unique to a particular borrower. The income ratios are guidelines for the lenders to use as a standard for approving loans, but circumstances may cause them to apply different standards.
For example, a borrower with an extremely good credit history may be granted a loan even though the total obligations ratio may be higher than normal. Other compensating factors a lender may consider include a large down payment, asset accumulation or projected increases in income.
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Loan-to-Value Ratio (LTV)
The loan-to-value (LTV) is the percentage of the property’s value that is represented by the loan. The higher the loan-to-value ratio is, the higher the risk of loss is to the lender in the event of a foreclosure. The borrower also has a higher risk since increased payments make the risk of default higher.
To calculate the LTV ratio, the loan amount is divided by the lesser of the purchase price or appraised value as shown in the following formula:
Loan amount ÷ Purchase price or appraised value = Loan-to-Value Ratio
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Methods of Sale of Mortgaged Property
```
Cash Sale
Assumption of the Mortgage
Assumption with Novation
Subject to the Mortgage
Contract for Deed
```
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Cash Sale
a property can be sold for all cash to the seller, who could use the cash received at closing to pay off an existing mortgage lien. The property can then be conveyed free of the mortgage.
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Assumption of the Mortgage
mortgages that do not contain a due-on-sale clause can be assumed by a buyer without permission of the lender. Only a small assumption fee is required to convert the paperwork. In the real estate market, these are called nonqualifying mortgages. The buyer assumes personal responsibility for repayment of the balance due on the promissory note and acknowledges the existence of the mortgage.
The original borrower (the seller) becomes a guarantor with secondary responsibility for repayment of the promissory note.
In the even of default, the foreclosure will proceed based on the mortgage; the lien is foreclosed and the property is sold. If a deficiency exists after the foreclosure sale, the lender looks to the buyer for satisfaction. If the buyer is unable to pay the deficiency, the lender looks to the former seller for satisfaction.
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Assumption with Novation
Assumptions With Qualifying
| Novation
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Assumptions With Qualifying
mortgages that contain a due-on-sale clause cannot be sold with an assumption without the knowledge and approval of the lender. In the real estate market, these are called assumptions with qualifying. The cost to the buyer/borrower is less than the cost of obtaining a new loan, but the lender may insist on a change in the interest rate as a condition of the assumption. If the assumption is approved, the buyer assumes personal liability for the balance of the promissory note and acknowledges existence of the mortgage.
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Novation
the lender removes the seller’s name from the loan and substitutes the name of the new buyer/borrower. Substituting the seller’s name with the borrower’s name is referred to as novation. Novation releases the seller from any further liability for the debt. In the event of default, the foreclosure will proceed based on the mortgage. If a deficiency exists following foreclosure, the lender looks only to the buyer for satisfaction.
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Subject to the Mortgage
if a mortgaged property is sold subject to the mortgage, the new owner acquires ownership without assuming personal responsibility for the balance of the promissory note. The existing mortgage continues to use the property as security for the debt.
When a property is sold subject to the mortgage, only the original borrower remains liable for the balance of the promissory note. The buyer acknowledges the existence of the mortgage. If the buyer defaults on the mortgage, the lender will foreclose and the property will be sold to satisfy the balance due on the note.
If a deficiency exists following a foreclosure sale, the buyer is not responsible; only the former seller is liable for the deficiency.
If the existing mortgage contains a due-on-sale clause, the property cannot be sold subject to the mortgage.
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Contract for Deed
An agreement in which the property owner agrees to give the buyer a deed after the buyer pays the owner a specified amount of money. As such, a contract for deed is a form of owner financing.
Usually, the contract requires the buyer to make payments over time with interest payable on the unpaid balance. After the buyer pays all of the payments called for under the contract, the owner gives the buyer a deed to the property.
During the term of the contract for deed, the buyer is entitled to possession of the property and is required to keep the property insured and pay the real estate taxes.
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Verification of Loan Balance
When a mortgaged property is sold and the mortgage on the property is to remain, the buyer would want to have the seller verify the current loan balance.
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Estoppel Certificate/ Letter
The seller can obtain an estoppel certificate (also called an estoppel letter) from the lender, which is a letter that verifies the principal balance owned on the loan. The seller must request this information since a lender will not provide it to unauthorized parties without permission from the original borrower.
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Selling the Mortgage Contract
A mortgage is the personal property of the lender. Once a loan has been made, the lender may wish to sell the right to receive the income from the loan to another investor. An assignment can be used to transfer the rights.
The original lender that transfers the right is the assignor. The investor who receives the right to receive the income is the assignee.
The assignee can verify the outstanding balance of the mortgage by requesting an estoppel letter from the borrower.
After assignment, the original lender (assignor) typically continues to service the loan, collecting loan payments from the borrower and sending the payments to the investor (assignee).
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Default
Failure to perform as agreed in the promissory note is called default.
When default occurs, the lender has the right under the mortgage contract to pursue legal action against the borrower for payment of the debt.
Under title theory of lending, a borrower’s default results in the lender taking possession of the mortgaged property. The borrower loses all rights.
Under the lien theory of lending, the lender must file a foreclosure suit in court and prove to the court that default has occurred.
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Equity of Redemption
is the right of a borrower to cure the default before foreclosure rather than lose the property. The borrower must pay the entire balance of the debt plus any interest and costs that has accrued since the default. Equity of redemption exists in Florida up to the moment of foreclosure.
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Statutory Right of Redemption
is the right that allows a borrower to redeem from a foreclosure for a period-of-time after a foreclosure sale. In some states, this right may be exercised for up to one year after the sale. This right is not recognized in Florida.
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A Judicial Process
Foreclosure is enforcement of a mortgage lien by a lender. In Florida, foreclosure is a judicial process in which the lender brings suit in court against the borrower in default, based on the mortgage. The lender petitions the court and requests a judgment against the party in default.
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Lis Pendens
When a lawsuit is filed, the lien holder will usually file a lis pendens (Latin for “pending litigation”), thereby, giving public notice that the property specified in the filing is the subject of litigation and a judgment lien may later be placed against it.
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Public Sale
The court, once the judgment has been rendered, orders a public sale of the property with the proceeds of the sale used to repay the lien.
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Writ of Execution
The final order of the court, called a writ of execution, will direct the clerk of the circuit court as to the amount required at the sale to satisfy the claim or claims of creditors.
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Proceeds from the Foreclosure Sale
At the foreclosure sale, the proceeds are used to pay any superior liens first. The remaining proceeds are used to pay junior lien holders based on the priority of the liens. Junior lien holders may wish to join in the suit to protect their rights in the property.
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Surplus Funds Go To Mortgage
If all lien holders have been paid from the proceeds of the foreclosure sale, any surplus funds remaining are paid to the mortgagor.
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Deficiency Judgment
Any lien holder who is not paid from the proceeds of the foreclosure sale may obtain a deficiency judgment. A deficiency judgment is a personal judgment against the borrower based on the promissory note. A deficiency judgment may be recorded anywhere the debtor may be located and foreclosed against on any real or personal property the debtor may own.
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There are variations in the foreclosure process from state to state
Strict Foreclosure
Judicial Foreclosure
Deed in Lieu of Foreclosure
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Strict Foreclosure
a form of non-judicial foreclosure, allows a lien holder to take possession of the property after a borrower defaults on a debt and retain all money received. Strict foreclosure is a harsh method not permitted in Florida.
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Judicial Foreclosure
in Florida, requires the lender to bring suit in court to prove default has occurred. The borrower has a right to defend against the suit. If the lender prevails, a judgment in favor of the lender is handed down and the property is advertised for sale at public auction. The proceeds of the sale will be applied to the balance of the lien.
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Deed in Lieu of Foreclosure
is an alternative to a foreclosure sale. A mortgagor who is in default can voluntarily deed a property to a lien holder in lieu of payment of a debt. The lien holder may not be willing to accept the title, however, as they would have to assume liability for any other liens against the property.
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Short Sale
A short sale transaction is a sale transaction in which a seller, confronted with the threat of a foreclosure, enters into a settlement agreement with the lender where the lender consents to a sales price for the property that is below the outstanding loan balance. In other words, the sale proceeds fall short of the amount owed to the lender.
The lender in a short sale transaction generally requires that the real property has been offered for sale on the market for a certain number of days at a reasonable price in order for the lender to feel confident that the short sale offers being presented are legitimate offers from legitimate buyers in that real estate market. The lender typically requests either a broker price opinion (BPO), an actual appraisal, or both.
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What may prevent the possibility of a short sale transaction?
The fact that real property might have more than one lien against it may prevent the possibility of a short sale transaction, since junior lien holders do not have any incentive to agree to a short sale transaction settlement if there is nothing in it for them. It is possible for any one creditor to refuse to reduce and release its respective lien and, therefore, stop a short sale transaction from taking place.
In addition, if a lender has mortgage insurance on the loan, then that insurer will likely become a party to the negotiations because the insurer will be requested to pay out a claim on the lender’s loss.
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The benefits of a short sale to the SELLER
* Being released from most, or all, of the personal indebtedness
* Incurring a lesser impact on their credit rating than an actual foreclosure
* Avoiding any public notoriety associated with a judicial foreclosure
* Receiving perhaps more generous settlement terms than those at the end of a formal foreclosure process
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The benefits of a short sale to a LENDER
* The cost savings when compared to the dollar outlay of an inevitable judicial foreclosure proceeding
* Avoidance of the responsibility of actually selling the property
* Lower risk of loss due to any defaulting borrower’s revenge on the subject property, such as vandalism and theft.
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FHA Insured Mortgage Loans
The Federal Housing Administration (FHA) was created in 1934 to provide sound lending practices, promote home ownership, and upgrade housing standards. The FHA is a part of the U.S. Department of Housing and Urban Development (HUD).
The FHA does not make loans. Instead, it insures loans made by approved local lenders. The loan is funded by a lending institution, such as a mortgage company, bank, or savings and loan association.
FHA provides a variety of loan programs for the purchase of manufactured homes, single-family homes, and multifamily properties.
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FHA no income limits
Although there are no income limits to determine who is eligible for FHA insured mortgage loans, FHA’s mortgage insurance programs help low- and moderate- income families become homeowners by lowering some of the costs of their mortgage loans.
The purpose of the insurance is to protect the lender from loss in the event of foreclosure. FHA insured mortgage loans insure the lender 100%. In the event of default of the mortgage loan, the lender is reimbursed by HUD/FHA for losses including foreclosure costs.
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FHA encourages lenders to make loans
FHA mortgage insurance also encourages lenders to make loans to otherwise creditworthy borrowers and projects that might not be able to meet conventional underwriting requirements thereby protecting the lender against loan default on mortgages for properties that meet certain minimum requirements.
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The four most popular loan programs
1. 203(b) Mortgage Insurance
2. 203(k) Rehabilitation Mortgage Insurance
3. 234(c) Condominiums
4. 251 Adjustable Rate Mortgages
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203(b) Mortgage Insurance
basic mortgage insurance for the purchase or refinance of owner-occupied one-to-four-family properties.
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Maximum Loan Amount for 203(b)
limits vary by geographic location. Lower cost areas, such as Ocala and Okeechobee have lower maximum loan amounts than high cost areas, such as Key West. Refer to the HUB website for current limits
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Requirements for qualification of 203(b)
To qualify for an FHA loan, a borrower must not exceed a housing expense ratio of 31% and a total obligations ratio of 43%. The standard maximum loan-to-value ratio for an FHA insured mortgage loan is 96.5%. Closing costs associated with FHA insured mortgage loans may be rolled into the loan balance, as long as the loan-to-value maximum guidelines are still met. The loan plus closing costs must not exceed 96.5% of the home’s appraised value or the selling price, whichever is less. FHA requires eligible borrowers to have a FICO credit score of at least 580 and to provide a down payment of at least 3.5% of the home’s purchase price or appraised value, whichever is less. Borrowers who have a credit score between 500 and 579 are required to provide a 10% down payment. Borrowers who have a FICO score below 500 are not eligible for FHA insured financing.
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formula for maximum loan amount
The maximum loan amount can be determined by multiplying the lesser of the purchase price or appraised value by the maximum LTV ratio.
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Down payment required formula
Purchase price-Maximum loan amount
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Mortgage Insurance Premiums
is required for all FHA insured mortgage loans, regardless of the down payment. This is not the same as private mortgage insurance (PMI) charged for conventional loans. The amount of mortgage insurance premiums required on an FHA insured mortgage loan includes the payment of both an up-front mortgage insurance premium (UFMIP) and an annual mortgage insurance premium (AMIP).
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UFMIP
The UFMIP is paid at the time of closing of the loan, although all or a portion of the mortgage insurance premium may be financed. The UFMIP is 1.75% of the mortgage amount in most cases. If paid in cash at closing, the UFMIP can be paid by the borrower, seller, or a third party. The standard AMIP is .85% of the annual outstanding loan balance divided into 12 monthly payments. As of April 1, 2013, the AMIP must be paid for the life of the loan; it cannot be canceled. Prior to this date, the AMIP was canceled when the loan balance was reduced to 78% or less of the amount borrowed.
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Loan Terms
the interest rate of an FHA insured mortgage loan is determined by negotiation between the lender and the borrower. Interest rates are established by supply and demand in the marketplace. As with other types of loans, points are additional loan fees paid to the lender of an FHA insured mortgage loan.
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Loan Points
. Points raise the effective rate of interest paid by the borrower over the life of a loan. Each point is equal to 1% of the loan amount and may be paid by either buyer or seller. The maximum loan origination fee is 1%. FHA insured mortgage loans must provide the borrower with the right of prepayment without penalty. FHA insured mortgage loans have a maximum term of 30 years. Loans are fixed-rate
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203(k) Rehabilitation Mortgage Insurance
Financing of the purchase of a one-to-four-family dwelling and the cost of its rehabilitation with a single mortgage- this program can also be used by homeowners to refinance as existing one-to four-family dwelling along with the cost of rehabilitation. However, cooperative units are not eligible for this program. This rehabilitation loan program protects the lender by allowing them to have the loan insured even before the condition and value of the property may offer adequate security. A portion of the loan proceeds is used to pay the seller, or if a refinance, to pay off the existing mortgage and the remaining funds are placed in an escrow account and released as rehabilitation is completed. All borrowers qualified by the lender are eligible to apply. The cost of the rehabilitation must be at least $5,000, but the total value of the property must still fall within the FHA maximum loan amount for the geographical area.
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Streamlined 203(k) Program
For less extensive repairs or improvements, there is a Streanlined 203(k) program. The value of the property is determined by the lessor of 1. The value of the property before rehabilitation plus the cost of rehabilitation or 2. 110% (LTV) of the appraised value of the property after rehabilitation. HUD also required that properties financed under this program meet certain basic energy efficiency and structural standards.
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Types of eligible improvements for 203(k)
* Structural alterations and reconstruction
* Modernization and improvements to the home’s function
* Elimination of health and safety hazards
* Changes that improve appearance and eliminate obsolescence
* Reconditioning or replacing plumbing; installing a well and/or septic system
* Adding or replacing roofing, gutters, and downspouts
* Adding or replacing floors and/or floor treatments
* Major landscape work and site improvements
* Enhancing accessibility for a disabled person
* Making energy conservation improvements
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234(c) Condominiums
insurance for 30- year loans to purchase a single-unit condo.
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251 Adjustable Rate Mortgages
mortgage insurance on adjustable rate financing- one-,three-, and five-year adjustable-rate mortgage (ARM) loans are available with interest rates that cannot change by more than 1% per year after the fixed-rate period, with a maximum rate increase over the life of the loan of no more than 5%. Seven- and ten-year loans are available as well. The rates for these loans cannot change more than 2% per year or more than 6% over the life of the loan.
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VA Guaranteed Loans
The VA mortgage loan program was created in 1944 to assist military veterans with financing the purchase of reasonably priced homes. The VA mortgage loan program requires little or no down payment, and provides veterans with relatively easy qualification requirements and comparatively low rates of interest.
The VA mortgage loan program guarantees a portion of the loan, up to an entitlement amount, for permanent long-term mortgage loans. These loans are originated by VA approved lenders for owner-occupied residences, including condominiums and mobile homes that meet VA standards. If mortgage money is not available, the VA will loan money directly to a veteran. If default occurs and a loss results from foreclosure, the borrower is responsible for the loss.
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VA Loans Eligibility
A veteran’s eligibility for the mortgage loan program is shown on a certificate of eligibility that is obtained from the VA. This certificate indicates the amount of guarantee for which the veteran is eligible.
A veteran must serve a specified minimum amount of time to be eligible and be honorably discharged. During peacetime, the eligibility period is 181 days, and during periods of military conflict, 90 days. Discharge in less time than required due to service-related disability automatically qualifies the veteran for benefits. Interestingly, the eligibility period was set at 90 days during the Gulf War, but congress has not re-instated the 181-day requirement. Therefore, the current eligibility period is only 90 days.
A veteran’s surviving spouse may be eligible if the veteran was killed in action or died due to service-related injuries. The spouse may also be eligible if a veteran is listed as missing-in-action or as a prisoner of war.
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Entitlement
Entitlement is the amount available for use on a loan. The amount of the veteran’s entitlement has been changed periodically since the program’s inception in 1944. Lenders will generally loan up to 4 times a veteran’s available entitlement without a down payment, provided the veteran is income and credit qualified and the property appraises for the asking price.
The VA entitlement can be used over and over again if a prior loan guaranteed by the VA is repaid, or another qualified veteran, who is willing to apply his or her entitlement to the loan balance, assumes the existing loan.
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Qualification ratios for VA Loan
To qualify for a VA loan, a borrower must not exceed a total obligations ratio of 41%.
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Appraisal for VA Loan
An appraisal must be performed by a VA-approved appraiser and is required to make sure that the property meets the VA’s minimum property requirements and to establish the property’s value. The appraisal cost may be paid by the buyer, seller, or shared.
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VA Maximum Loan Amount
The VA does not set a maximum loan amount. However, the VA approved lender may have a loan limit. Additionally, the amount of the mortgage loan may not exceed the lesser of the sales price or appraised value of the property.
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Down Payment VA Loan
VA loans do not normally require a down payment. A VA loan amount is 100% of the purchase price if the purchase price does not exceed the maximum loan amount.
The VA does not insure loans, but it guarantees the first 25% of losses in the event of foreclosure or default, which reduces the lender’s risk and eliminates the need for a down payment from the borrower. As of January 1, 2018, the VA maximum guarantee amount is $113,275, which is 25% of the maximum loan amount of $453,100. Actual guarantee amounts vary as they are contingent on position and tenure of service.
The borrower is still required to qualify for the loan based on income and credit standards. Lenders may require a down payment to meet the lender’s standards, depending on the amount of the guarantee available and the income of the veteran. A minimum down payment of 5% is required for manufactured home loans.
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Interest Rate
the interest rate is determined by negotiation between the lender and the borrower.
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Funding Fee
the veteran may be required by the lender to pay a funding fee. This fee is similar to an origination fee that is charged in connection with a conventional mortgage loan.
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Lender Fees (Points)
as with other types of loans, points are added loan fees which are paid to the lender for a VA loan. Points raise the effective rate of interest paid by the borrower over the life of a loan. Each point is equal to 1% of the loan amount and may be paid by either buyer or seller, as specified in the contract.
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Prepayment
there is no prepayment penalty for VA loans.
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Conventional Mortgage Loan
is any loan that is not insured or guaranteed by an agency of the government. Conventional mortgage loans made by lending institutions and private lenders are the predominant method in which single-family residences are financed.
Usually, conventional mortgage loans are more difficult for a borrower to obtain than a mortgage under the FHA or VA programs. Conventional mortgage loans typically require a higher down payment than those required by FHA or VA, and traditionally carry a higher interest rate. Since these loans are neither insured nor guaranteed, they carry a higher risk in foreclosure than the FHA and VA loans.
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Private Mortgage Insurance (PMI)
PMI Usually Required When Loan Exceeds 80% of Property Value
To offset the higher risk, and to allow conventional lenders to compete with FHA and VA loans, private mortgage insurance was developed. Private mortgage insurance (PMI) was introduced by the Mortgage Guarantee Insurance Corporation (MGIC) in 1957 and is currently available from several competing firms. Federal lending regulators usually require this insurance when the loan amount exceeds 80% of the value of the property.
Some lenders qualify for self-insurance, and in that event, do not require PMI. However, they may charge the borrower a fee for this protection. With PMI, a conventional borrower may obtain a loan up to 95% of the value of the property.
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Automatic Cancellation of PMI when the LTV is?
78% or less
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Borrower can request PMI cancellation when loan paid down to
80%
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Interest is charged only on
Interest is Charged Only on Unpaid Loan Balance
PMI increases the cost of financing, as the borrower is required to pay a premium for the coverage. Although the monthly payment is higher, interest is charged only on the unpaid balance of the loan.
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Interest Rate Limits (conventional)
F.S. 687 limits the interest rate that may be charged for a loan. Lenders may not charge an interest rate of more than 18% on loan amounts up to $500,000 or an interest rate of more than 25% on loan amounts above $500,000.
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Usury
Charging rates in excess of those established by statute is unlawful and is referred to as usury.
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Amortized Mortgage
is a loan with scheduled periodic payments where the loan payments typically include a portion that applies to the interest owed and a portion that goes toward repaying the loan, called principal. The word amortize comes from the Latin word amorte, which means to kill. The amortization, then, is the principal portion of the payment used to repay the loan. Most conventional, FHA and VA loans are amortized loans.
Most amortized loans are fully amortizing, which means the payment is sufficient to repay the interest owed and the loan amount in full over the life of the loan. Loan terms are commonly 15 or 30 years.
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The availability of shorter-term mortgage loans
allows a borrower to save a substantial amount of interest compared to a longer-term loan. However, the monthly payments are obviously higher for a 15-year mortgage loan than those for a 30-year loan are. Lenders will usually make a 15-year loan at an interest rate slightly lower than a long-term loan due to the reduced risk.
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Partially Amortized/ Balloon Payment Mortgage
Some amortizing loans are partially amortized, which means the payment is not sufficient to pay all of the interest due and repay the loan in full. Referred to as a balloon payment mortgage, the balance of the original loan remaining unpaid at the end of a partially amortizing loan term is called a balloon payment. Other amortizing loans may be structured so that a balloon payment is due after a certain number of years, such as five or seven years. This would allow the payment to remain the same as a fully amortizing loan, but the borrower would have to be in a position to pay the balloon amount when it becomes due.
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Negative Amortization
Occurs when loan payments fail to cover the interest due and the remaining amount of interest is added to the loan’s principal. Negative amortization increases the loan balance, which causes the borrower to owe more money.
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Fixed Rate or Level Payment Loan
If the monthly mortgage payment remains the same over the term of the loan, the loan is a fixed rate or level payment loan. In each succeeding monthly payment, the amount applied to pay interest on the loan is reduced and the amount applied to repay the loan principal is increased. The principal amount originally borrowed will be completely repaid at the end of the loan term.
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The monthly payment for an amortized loan consists of
Interest portion + Principal portion = Monthly mortgage payment
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Amortizing Loan Payments
If the monthly payment for a level payment mortgage is known, it is possible to calculate the amount of the payment that is applied to pay interest and the amount that is applied to principal. The balance of the loan that remains unpaid after the principal reduction can then be determined.
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The formula for calculating the interest portion of the loan payment
I = P x R x T
The letters in the formula represent values as follows:
I = Interest portion amount of the monthly payment ($)
P = Principal amount of the loan (loan balance)
R = Rate of annual interest charged on the loan (%)
T = Time expressed in fractions of a year (i.e. one month is 1/12)
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Characteristics of an Amortized Loan
Amortized loans with level monthly payments have the following characteristics:
o The interest portion paid each month is less than the amount paid in the previous month.
o The principal portion paid each month is more than the amount paid in the previous month.
o The principal balance of the loan decreases each month, thereby resulting in a zero balance at the end of the loan term.
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Adjustable Rate Mortgage
is an amortized loan in which the interest rate fluctuates over the term of the loan. Payment adjustments are made at set intervals. The lender’s risk associated with making fixed-rate loans is reduced by using an adjustable rate mortgage. Since interest rates can rise, the lender may receive additional income on the loan as the market changes. Important elements of an ARM loan include an index and a margin. A teaser rate may also be included.
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Index
The index is a foundation rate for the loan that must be published and is beyond the control of the lender. Two index rates often used by lenders are the weekly average yield on U.S. Treasury Securities called the one-year T-bill rate, and the eleventh district cost of funds. Of the two, the eleventh district cost of funds tends to be less volatile, thereby resulting in less dramatic changes in the borrower’s payment. In the ten-year period from June 1982 until June 1992, the one-year T-bill index ranged from a 4% low to a 14% high. The lender does not control the fluctuation of interest rates charged in an ARM. The marketplace composed of investors who buy one-year T-bills set the index rate in an ARM.
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Margin
A Margin is a percentage that is added to the index rate by the lender to cover the lender’s overhead and provide a profit on the loan. The margin does not change for the life of the loan. The margin aged to the index determines the note rate that is the rate the borrower will pay on the loan. This rate can change for future loans based on changes in the index. Federal law requires the lender to lower the rate when the index goes down. Increases are at the option of the lender. the rate is sometimes expressed in basis points with 100 basis points equal to 1% of interest.
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Teaser Rate
A teaser rate is an initial interest rate that is stated in the promissory note that is lower than the fully indexed rate. A teaser rate is intended to encourage mortgage loan borrowers to obtain an ARM instead of a fixed-rate loan. Teaser rates usually apply only to the first year of the loan.
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Rate Adjustment
the date when interest rates can change in an ARM. The amount of time between rate adjustment dates is called the rate adjustment period, or interval. An ARM with a rate adjustment period every 12 months is called a one-year ARM, every 36 months is a three-year ARM, and every 60 months is a five-year ARM.
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Periodic Cap or Periodic Rate Cap
o A periodic cap, or periodic rate cap, limits how much the rate can change at any one time. Periodic caps are usually annual, or caps that prevent the rate from rising more than a certain number of percentage points in any given year. The change date for the borrower’s monthly mortgage payment must be disclosed to the borrower in advance. Typically, the payment adjustment is made on the same date as the interest rate.
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Negative Amortization
if the ARM payment does not change on the same date as the interest rate. This is due to the fact that the monthly payment may be lower than the payment required for principal plus the amount of interest due. If the interest rate is adjusted monthly, but the payment is only changed once each year, negative amortization can occur. When negative amortization occurs, the unpaid interest is added to the loan balance and no reduction in the principal occurs.
Some ARM loans have both a payment cap and a lifetime cap. Caps create an upper and a lower limit on the adjustments that can be made to the loan.
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Payment Caps
set the limit for any single adjustment to the payment amount. for example, with a 7% payment cap, a payment of $100 could increase to no more that $107.00 in the first adjustment period and to no more than $114.49 in the second adjustment period. Payment caps can cause negative amortization if the interest rate increases and the payment cap holds the payment at an amount that does not cover the full interest portion of the monthly payment. If this happens, the unpaid monthly interest is deferred and added to the principal balance, creating negative amortization.
Lifetime Caps set the upper and lower interest rate that can be charged over the life of the loan. Interest rate caps are another way of protecting the borrower from sharp increases in interest rates.
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Biweekly Mortgage
requires that one-half of the mortgage payment be paid every 2 weeks instead of one payment per month. This is essentially the same as making 13 monthly payments each year and reduces the time necessary to amortize the loan. By making payments every two weeks, a loan that would take 30 years to amortize will be paid off in approximately 21 years, thereby saving a substantial amount of interest.
The disadvantage of this type of loan is that the payments are usually required to be automatically withdrawn from the borrower’s checking account. Closer attention to the account balance is necessary to avoid charges for insufficient funds. Virtually the same interest savings can be achieved by making one additional monthly mortgage payment each year.
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Blanket Mortgage
is a single mortgage given by a borrower that pledges two or more parcels as a security for a loan. Builders and developers when constructing several properties in the same area commonly use blanket mortgages.
A blanket mortgage typically contains a release clause, thereby allowing the borrower to pay a specified amount to release a single lot from the blanket so it can be sold to a buyer upon completion of construction.
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Home Equity Loan
is a loan secured by the equity in the home. Home equity loans are commonly used by homeowners to finance major expenses, such as home remodeling. Interest on a home equity loan may be tax deductible.
Home equity loans generally must be repaid over a fixed period and may have fixed or variable interest rates. Like other mortgages, lenders also charge points or other fees.
A home equity loan is secured by the equity in the home and creates a lien on the borrower’s home, which reduces the overall equity. If the borrower defaults, the lender may foreclose on the home.
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A home equity loan is not the same as a
home equity line of credit (HELOC). A home equity loan is a single, lump-sum loan. A HELOC is a revolving line of credit with an adjustable interest rate that allows the borrower to choose when and how to borrow against the equity of their house.
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Purchase Money Mortgage (PMM)
is any mortgage loan obtained from the seller when the proceeds of the loan are used to purchase real property. Also referred to as seller financing, a PMM is typically used in situations where the buyer cannot qualify for a mortgage through other lending channels.
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Package Mortgage
includes both real and personal property as security for a loan. The purchase of a home often includes personal property items such as a refrigerator, range, dishwasher, and so on. If these items are a part of the security offered in the mortgage, it creates a package mortgage. A chattel mortgage uses only personal property as security for a loan.
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Reverse Mortgage
also called a reverse equity mortgage or a reverse annuity mortgage, allows a homeowner to receive a lump sum or a monthly advance on a line of credit based on the equity in their home.
The lender is repaid when the property is sold, when the owner dies, or when the owner ceases to be a permanent resident. If funds are insufficient to repay the lender, the Home Equity Conversion Guarantee Fund makes a reimbursement to the lender.
The most popular reverse mortgage program is the FHA Home Equity Conversion Mortgage (HECM) for seniors who are age 62 or older and own their property outright or have paid-down a considerable amount. passed in 1988.
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Term Mortgage
also called a straight-term mortgage, provides for payments of interest only during the term of the mortgage.
The principal amount borrowed is repaid in a lump sum payment called a balloon payment at the end of the term.
The amount of a balloon payment must be stated in the mortgage.
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Money in the Marketplace
Money is bought and sold in the marketplace like any other commodity. The interest paid on borrowed money is the price of money and can be thought of as rent paid for its use. Any commodity in short supply is expected to have a higher price and a lower price when the commodity is plentiful. The same is true for the price of money. Interest rates move up or down based on the supply available and the demand for its use.
The supply of money available for mortgage lending has historically been linked to the activities of local lenders and local borrowers. This process has been modified in recent years with the advent of interstate banking. However, mortgage money supply and the price of money are still very much influenced by the same forces that have traditionally been at work in the marketplace.
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Intermediation
is the term used to describe the flow of deposits into lending institutions, thereby creating a mortgage money supply. When individuals deposit funds into banks, savings and loan associations, and credit unions, the money becomes available for lending purposes. It follows that high levels of intermediation increase the mortgage money supply and interest rates are typically reduced.
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Disintermediation
occurs when depositors bypass traditional depository institutions and withdraw from accounts with low fixed interest rates, transferring those funds to alternative investments with higher interest rates (yields) such as the stock market, mutual funds, artwork, and so on. Large-scale disintermediation can reduce the mortgage money supply and cause interest rates to rise.
