Chapter 13 (Types of Mortgages and Sources of Financing) Flashcards
Conventional Mortgages
- Conventional Loan
A real estate loan that is neither FHA-insured nor VA-guaranteed.
- A conventional loan is one that is not insured or guaranteed by a government agency. The lender assumes the full risk of default in a conventional loan.
1. Nonconventional Loan
A mortgage loan that is insured or guaranteed by the federal government (FHA or VA).
*Nonconventional loans typically require a smaller down payment compared with conventional loans, because with nonconventional loans, the government provides some risk protection to the lender.
Interest Rate
Private lenders make conventional mortgage loans. Interest rates for conventional mortgages reflect market conditions and are negotiated between the lender and the borrower.
Assumption
Fixed-rate conventional mortgages typically contain a due-on-sale clause, meaning that they are not assumable.
Prepayment
Fixed-rate conventional mortgages contain a prepayment clause that allows borrowers to prepay the mortgage principal.
Down Payment and Loan-to-Value Ratio
Conventional loans usually have a lower loan-to-value ratio (LTV) than either FHA or VA loans. In other words, conventional loans require a larger down payment (equity) as compared with FHA and VA. Lenders typically require a 20% down payment for conventional loans.
Borrowers are sometimes approved for conventional mortgages with less than 20% down. Loans for more than 80% (20% down) LTV require borrowers to buy private mortgage insurance (PMI).
PMI insures that portion of the mortgage loan that exceeds the 80% of value. Conventional loans are available for 90% or 95% LTV if the borrower buys PMI insurance.
Qualifying for a Conventional Mortgage
Mortgage lenders use income ratios to qualify potential borrowers. For a lender to be able to sell mortgages in the secondary market (described later in this chapter), the mortgages must meet designated expense/income ratio requirements.
Conventional lenders use gross monthly income to calculate qualifying ratios for borrowers. Lenders also want to know what percentage of total monthly income is already obligated to pay other debt.
The total obligations ratio (TOR) is a measure of a borrower’s total monthly installment debt divided by monthly gross income. The TOR includes monthly expenses found on the borrower’s credit report, such as credit card payments, auto payments, student loan payments, and child support payments, in addition to the PITI.
To qualify for a conventional mortgage, the borrower’s TOR must not exceed 36%.
total monthly obligations ÷ monthly gross income = TOR
EXAMPLE 1: A potential buyer’s monthly housing expenses total $1,470, and monthly gross income is $5,880. What is the buyer’s housing expense ratio?
$1,470 monthly housing expense ÷ $5,880 monthly gross income = .25 or 25%
EXAMPLE 2: The buyer’s total monthly obligations are $2,058, and the buyer’s monthly gross income is $5,880. What is the buyer’s total obligations ratio (TOR)?
$2,058 total monthly obligations ÷ $5,880 monthly gross income = .35 or 35% TOR
Amortized Mortgage
A loan characterized by payment of a debt by regular installment payments.
Today, the most popular loan payment plan is the fully amortized, level-payment plan mortgage. Webster’s defines the word amortize as meaning to extinguish or deaden.
An amortized mortgage is gradually and systematically killed or extinguished by equal regular periodic payments.
Each monthly payment includes both interest and principal.
Although the borrower pays the same amount each month, on a fixed-rate mortgage, the portion used to pay interest decreases each month, while the portion used to repay principal increases each month.
- Constant (Level) Monthly Payment
Mortgages used to purchase residential property usually call for regular, equal payments that include both interest payments and payments on the unpaid balance of the debt (principal).
This type of mortgage is called the level-payment plan (A method for amortizing a mortgage whereby the borrower pays the same amount each month) or, more commonly, a fixed-rate amortized mortgage, because the regular, periodic payments remain the same.
However, the amount of the payment that goes for interest gradually decreases, and the amount assigned to amortizing the debt (principal) gradually increases. On a 30-year fixed-rate mortgage, the payments during the first few years are used almost entirely to pay interest; payments during the last few years are almost entirely principal repayment (see below).
- 30-Year and 15-Year Terms
Conventional mortgage loans typically feature either a 30-year term or a 15-year term.
- Amortizing a Level-Payment Plan Mortgage
To calculate how much money is to be regarded as interest and how much is to be paid on the principal, three facts are needed:
- The outstanding amount of the debt (principal)
- The rate of interest
- The amount of the payment per period (usually monthly)
Interest rates for mortgages are expressed as annual interest rates.
Thus, a $60,000 mortgage at 10% simply means that the interest rate is 10% per year. To find the monthly interest actually paid, first determine what 10% of $60,000 will amount to for the entire year.
Dividing this amount by 12 (the number of months) gives the amount of interest for one month.
When the principal amount changes, the calculation must be done over again, based on the new principal balance.
The new balance must be treated as though it were to be applied to the entire 12 months.
Principal
The party employing the services of a real estate broker; amount of money borrowed in a mortgage loan, excluding interest and other charges.
Level-Payment Plan
A method for amortizing a mortgage whereby the borrower pays the same amount each month.
Amortizing a Mortgage
Step 1: principal balance × annual interest ÷ 12 = first month’s interest
Step 2: monthly mortgage payment – first month’s interest = payment on principal
Step 3: beginning principal balance – principal payment = new principal balance
EXAMPLE: A home for sale has a mortgage of $30,000 at 8% interest. Your buyer wants to know how much of the $220.13 monthly payment will go for interest and how much for principal during the first three months.
Step 1: $30,000 unpaid balance × .08 rate = $2,400 interest ÷ 12 months= $200 first month's interest Step 2: $220.13 monthly payment – $200 interest = $20.13 payment on principal
So the first month’s interest was $200, and the principal reduction in month one was $20.13.
However, the buyer wanted to know about the first three months, so take credit for the $20.13 paid on the principal by subtracting that amount from the $30,000.
Step 3: $30,000 – $20.13 principal paid first month = 29,979.87 new principal balance
Now repeat the previous steps to determine the answers for the second and third months, beginning with:
Step 4: $29,979.87 new principal balance × .08 rate = $2,398.3896 ÷ 12 months = $199.87 interest
Repeat steps 2 and 3 to determine the unpaid balance remaining after payment of the second month’s principal. Begin with this new principal balance at the end of the second month and repeat steps 1, 2, and 3 to find the amount paid for interest and principal during the third month. Thus, the answer to your buyer’s question is:
First month: principal = $20.13; interest = $200.00
Second month: principal = $20.26; interest = $199.87
Third month: principal = $20.40; interest = $199.73
If the amount paid for interest from the first month’s mortgage payment is given along with the interest rate and loan-to-value ratio (LTV), the sale price of the property for which payment was made can be found.
EXAMPLE: The interest portion of the first month’s mortgage payment is $770, the interest rate is 10.5%, and the LTV is 80%. Calculate the sale price of the property.
$770 × 12 months = $9,240 interest per annum
$9,240 ÷ 10.5% = $9,240 ÷ .105 = $88,000 mortgage amount
$88,000 ÷ 80% or .80 LTV = $110,000 sale price
Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage (ARM) is a loan characterized by a fluctuating interest rate over the term of the loan.
The ARM is originated at the initial interest rate.
The rate can then increase or decrease, based on an objective economic indicator called an index.
As the index changes, the interest rate on the loan changes at preset intervals.
Index
Lenders legally are allowed to link the interest rate of an ARM with any recognized index (for example, U.S. treasury securities).
The index moves up and down with fluctuations in the nation’s economy.
The index must not be controlled by the lender, and it must be verifiable by the borrower.
Margin
The fixed component that is added to the index to calculate the interest rate in an adjustable rate mortgage.
The margin (or spread) is the percentage added to the index.
The margin represents the lender’s cost of doing business plus profit. The margin percentage remains constant over the life of the loan.
Calculated Interest Rate
The calculated interest rate is arrived at by adding the index to the lender’s margin:
index + margin = calculated interest rate
Assume the borrower has an ARM tied to the one-year T-bill rate with a margin of 2.25. If the T-bill rate is 4%, the calculated interest rate is:
4% index + 2.25% margin = 6.25% calculated interest rate
Adjustment Period
The interest rate on an ARM adjusts periodically based on the adjustment period established in the mortgage loan documents.
For example, the interest rate may adjust annually or for a longer term, such as three years or seven years.
Rate Caps
ARMs typically include rate caps to limit how much the interest rate may change.
A periodic rate cap limits the amount the rate may increase at any one time.
For example, the interest rate may be capped to not increase more than 2% during an adjustment period.
ARMs typically also cap the total amount the interest rate may increase over the life of the loan.
For example, the loan might have a life-time cap or ceiling of 6% over the life of the loan.
Payment Cap
A payment cap limits the amount the monthly payments can increase during any year. If interest rates rise sharply but the payments do not because of a payment cap, the unpaid interest is added to the loan balance.
Negative Amortization:
A financing arrangement whereby monthly mortgage payments are less than required to pay both interest and principal. The unpaid amount is added to the loan balance.
Negative amortization occurs when the mortgage payments are not large enough to cover the interest expense. The result is the unpaid principal balance of the mortgage loan increases.
Teaser Rate
Sometimes, a lender will offer borrowers an initial below-market interest rate or teaser.
The low rate is usually offered for the first year of the loan, with a sharp annual rate increase at the next rate-adjustment period to bring the loan in line with the agreed-upon index.
Partially Amortized Mortgage
With a partially amortized mortgage, the buyer makes regular payments smaller than what is required to completely pay off the loan by its date of termination.
In other words, the payments do not fully amortize the loan.
A single large final payment, including accrued interest and all unpaid principal, then becomes due on the loan maturity date (called a balloon payment).
Balloon Payment:
A single, large payment made at maturity of a partially amortized mortgage to pay off the debt in full.
In Florida, a partially amortized mortgage must be clearly identified as such on the face of the mortgage, with the amount of the final balloon payment disclosed.
Biweekly Mortgage
A biweekly mortgage loan is amortized the same way as other loans with monthly payments, except the borrower makes a payment every two weeks.
The amount paid is equal to one-half the normal monthly payment. Because there are 52 weeks in the year, the borrower makes 26 biweekly payments.
Therefore, the borrower makes the equivalent of an extra month’s payment each year (26 half-size payments equal 13 full-month payments instead of 12).
This saves the borrower considerable interest, and the loan is paid off sooner.
Package Mortgage
A package mortgage loan includes both real and personal property as security for the debt.
A buyer uses a package mortgage, for example, when purchasing a restaurant complete with cooking equipment and other personal property that serve as a part of the collateral for the debt.
Home Equity Loan
A mortgage secured by a personal residence. It provides a line of credit available for draws when needed by the homeowner. It is sometimes used as a home improvement loan.
Homeowners use home equity loans to finance consumer purchases; consolidate existing credit card debt; and pay for college tuition, medical expenses, or home improvements. Because the interest on most home equity loans is tax deductible, they are more popular than other types of consumer credit.
Home equity loans are secured by the borrower’s residence. The original mortgage remains in place. The home equity is usually a second mortgage (junior to the original mortgage).
The dollar amount of a home equity loan is based on the amount of equity. The borrower may take a lump-sum amount or access a line of credit.
The interest rate usually is adjustable and is based on the lender’s prime rate.
The LTV of both mortgages combined is typically limited to 80% of the property’s value.
Purchase Money Mortgage (PMM)
Any new mortgage taken as part of the purchase price of real property by the seller.
A purchase money mortgage (PMM) is a mortgage given as part of the buyer’s consideration for the purchase of real property.
The PMM is delivered when the deed is transferred as a simultaneous part of the transaction.
It is usually a mortgage taken back by a seller from a buyer in lieu of purchase money.
A purchase money mortgage is used to fill a gap between the buyer’s down payment and a new first mortgage or an assumed mortgage.
Title passes to the buyer, and the seller retains a vendor’s lien right as security for the debt.
Home Equity Conversion Mortgage (HERM) or Reverse Mortgage
Homeowners age 62 and older who have paid off their mortgage or have only a small mortgage balance remaining are eligible to participate in HUD’s reverse mortgage program (A form of mortgage that enables elderly homeowners to borrow against the equity in their homes so they can receive monthly payments needed to help meet living expenses).
The only reverse mortgage insured by the U.S. Federal Government is called a Home Equity Conversion Mortgage (HECM), and is only available through an FHA approved lender.
The program allows homeowners to borrow against the equity in their homes. Homeowners can receive payments in a lump sum, on a monthly basis (for a fixed term or for as long as they live in the home), or on an occasional basis as a line of credit.
The size of reverse mortgage loans is determined by the borrower’s age, the interest rate, and the home’s value.
Unlike ordinary home equity loans, a HUD reverse mortgage does not require repayment as long as the borrower lives in the home.
Lenders recover the principal and interest when the home is sold. The remaining value of the home goes to the homeowner or to the homeowner’s survivors.
If the sale proceeds are insufficient to pay the amount owed, HUD will pay the lender the amount of the shortfall.
The Federal Housing Administration, which is part of HUD, collects an insurance premium from the borrower to provide this coverage.
Land Development Loans
Developers commonly purchase land for development by securing seller financing. The developer usually requests that the seller agree to a subordination clause.
This arrangement allows the developer to secure a construction loan from a traditional lending institution.
Blanket mortgages cover a number of parcels, usually building lots. The developer uses proceeds from the sale of individual lots to pay off the blanket mortgage.
A partial release clause commonly used in blanket mortgages provides for the release of individual parcels from the blanket mortgage upon payment of a specified amount.
The partial release clause stipulates the conditions under which the mortgagee will grant a release of lots, free and clear of the mortgage.
Purpose of the FHA
The National Housing Act of 1934 created the Federal Housing Administration (FHA). A major focus of FHA is to stimulate homeownership.
The FHA is a government agency within the Department of Housing and Urban Development (HUD). The FHA functions as an insurance company, insuring mortgage loans made by approved lenders.
The FHA insures mortgages for various types of properties. Common FHA loan programs include a mortgage program for condominium units and an adjustable rate loan program.
Section 203(b) is the most popular home mortgage program of the National Housing Act.
Section 203(b) fixed-rate mortgage loans require a small down payment for the purchase or construction of one-family to four-family residences.
Characteristics of FHA Mortgage Loans
- Loan Insurance
FHA loans are a type of nonconventional loan because they are insured by the FHA up to certain limits. The FHA insures mortgage loans to protect lenders in the event that borrowers default. The cost of the mortgage insurance is passed on to the borrower.
- Lending Source
FHA loans are made by FHA-approved lenders. The FHA does not make loans to borrowers. The FHA does not process loans or build houses.
- Discount Points
FHA-approved lenders may charge discount points on FHA-insured mortgage loans. Discount points may be paid by either the seller or the buyer.
- Down Payment
A major benefit of FHA-insured loans is that the down payment is much smaller than the amount required for conventional mortgage loans.
A borrower can obtain an FHA-insured loan with a down payment as low as 3.5% of the purchase price or the appraised value, whichever is less.
FHA refers to the required down payment as the minimum cash investment. Closing costs may not be used to meet the minimum 3.5% down payment requirement. Borrowers must have a good credit history to qualify for maximum financing.
- Loan Limit
FHA sets limits on the amount that can be borrowed. The limits vary significantly, depending on the average cost of housing in different regions of the country.
For example, the maximum FHA loan for a one unit residence is greater in Fort Lauderdale and Miami than in Gainesville or Tallahassee, Florida, because the average cost of housing is greater in the Fort Lauderdale and Miami markets.
Lenders make FHA-insured loans in even $50 increments.
- Insurance Premium
Borrowers are charged a one-time mortgage insurance fee at closing.
This fee is called the up-front mortgage insurance premium (UFMIP).
(A one-time mortgage insurance premium on FHA mortgage loans that is paid at closing)
The percentage of the UFMIP is based on the type (new or refinance) and term (15-year or 30-year) of the mortgage. The UFMIP is paid at closing and can be financed into the mortgage amount.
In addition to the UFMIP, the borrower is also charged an annual mortgage insurance premium (MIP).
“Fee paid by FHA borrowers to obtain a loan (up-front and annual).”
The annual MIP is paid monthly (annual premium divided by 12) as part of the monthly mortgage payment. The MIP must be included in the proposed monthly expenses when calculating the buyer’s qualifying ratios. The monthly MIP is paid for the life of the FHA loan when the borrower receives maximum financing. UFMIP and MIP go into an FHA fund for repaying lenders if borrowers default.
- Qualifying Ratios
FHA lenders use gross monthly income to calculate two qualifying ratios for loan applicants.
a. The housing expense ratio (HER) is calculated by taking monthly housing expenses for principal, interest, property taxes, and hazard insurance (PITI) and the monthly mortgage insurance premium (MIP) and dividing by the applicant’s monthly gross income.
monthly housing expenses (PITI and MIP) ÷ monthly gross income = HER
b. Lenders also use the total obligations ratio (TOR) to qualify applicants for FHA-insured mortgage loans. The TOR cannot exceed 43%. Total obligations includes PITI, MIP, and recurring expenses (also see Qualifying for a conventional mortgage).
total monthly obligations ÷ monthly gross income = TOR
- Assumption
FHA mortgage loans do not have a due-on-sale clause in the mortgage. The FHA requires complete qualification of the buyer assuming the loan.
All assumed loans (and new FHA loans) are for owner-occupied use only (no investor loans). The lender must release the original mortgagor from liability if the assuming mortgagor is found creditworthy and executes an agreement to assume and pay the mortgage debt.
By law, FHA loans cannot charge prepayment penalties; the loan may be paid off early without penalty.
- Interest Rate
The interest rate on FHA mortgages is not set by the FHA or HUD. The interest rate is allowed to fluctuate with the market and is negotiable between the lender and the borrower.
- Appraisal
The home must be appraised by an FHA-approved appraiser.
HUD requires the appraiser to confirm the property meets HUD’s minimum property standards.
However, the FHA does not warrant the condition of the property. The FHA encourages buyers to have a home inspection conducted.
VA Loan Guarantee Program
The Servicemen’s Readjustment Act (GI Bill of Rights) was passed to aid returning World War II veterans.
This act and subsequent acts gave the Department of Veterans Affairs (VA) the authority to partially guarantee mortgage loans made to veterans by private lenders.
The partial guarantee covers the top portion of the loan.
The VA issues rules and regulations that set the qualifications, limitations, and conditions under which a loan may be guaranteed. The VA loan guarantee differs from the FHA program that insures loans (see below).
VA Mortgage Loan Characteristics
- Qualifications for Program
Only veterans, unremarried surviving spouses of veterans, and active military personnel may apply for a VA loan.
- Eligibility Requirements
Specific eligibility requirements are based on the period of active duty or the period of continuous service, as applicable. Real estate licensees should rely on a VA lender to determine an applicant’s eligibility for a VA loan.
- Lending Source
VA loans are made by VA-approved lenders. However, the VA does have the power to make direct loans to veterans in areas where VA loans are not available. The VA loan program may be used to purchase, refinance, or construct one to four-unit properties provided the veteran resides in one of the units. The maximum loan term is 30 years. The interest rate on VA loans varies based on market conditions and is negotiated between the borrower and the lender.
- Loan Guarantee
The VA establishes loan guarantee limits called the VA loan guarantee or the maximum “entitlement”. The 2014 maximum entitlement (guarantee) is $104,250. A veteran’s entitlement is the maximum amount the government guarantees the lender will be paid in the event the borrower defaults.
A veteran begins by applying to the VA for a certificate of eligibility. The certificate of eligibility states the amount of entitlement available to the veteran borrower. The VA loan guarantee program uses a scale that establishes each veteran’s entitlement based on the loan amount. A veteran who has used the entitlement in the past may only now be eligible for a portion of the entitlement. The unused portion is available to the veteran borrower up to the maximum guarantee. When a VA loan is paid off, the veteran’s maximum entitlement is reinstated.
- Loan Limits
The VA does not set loan limits. The amount that a veteran may borrow depends on the value of the real estate. The loan may not exceed the amount stated in the certificate of reasonable value (CRV). The CRV is based on the property value estimated by a VA-approved appraiser. The other limiting factor is the veteran’s income and ability to make the monthly mortgage payments.
- VA Funding Fee
The VA requires a funding fee or user’s fee to help the government defray the cost of foreclosures. Currently, the funding fee is 2.15% of the loan amount, with no down payment for first-time users.
Funding fee expenses may be added to the maximum loan amount and financed over the life of the loan. If a veteran has a service-connected disability, the funding fee is waived. VA loans do not require mortgage insurance premiums (MIP).
- Discount Points
Lenders may charge discount points on VA guaranteed loans. The veteran buyer or the seller may pay the points.
- Qualifying Ratio
To qualify loan applicants, the VA uses a total obligations ratio (TOR) and a table of residual incomes calculated for different regions in the United States. The veteran borrower’s total monthly obligations may not exceed 41% of the total monthly gross income.
- Closing Costs
The lender may charge reasonable closing costs. However, these costs may not be included in the VA loan. Closing costs vary among lenders. The veteran borrower or the seller may pay the following closing costs or the closing costs may be shared:
VA appraisal Credit report Loan origination fee (usually 1% of the loan) Discount points Title search and title insurance Recording fees State transfer fees Survey
- Assumption
Because they do not have due-on-sale clauses, VA loans are assumable (even by nonveterans). VA loans made prior to March 1, 1988, are assumable without a credit check of the new mortgagor.
However, both seller and buyer will be liable in case of default, unless the buyer qualifies and completes all substitution documents.
For VA loans made on or after March 1, 1988, the buyer must qualify. The buyer must pay an assumption or transfer fee to the lender plus an assumption fee to the VA.
The seller is then released from liability for the VA loan.
- Prepayment
VA mortgage loans do not contain a prepayment penalty clause. Therefore, veterans may prepay all or a portion of the mortgage loan ahead of schedule without penalty.
Qualifying for a Loan
The constantly changing real estate financing market requires that licensees keep up with the various mortgage types and formats available in their local areas.
Before attempting to qualify a buyer, licensees should make sure that required written brokerage relationship disclosures have been made.
Brokerage relationship disclosure is important because licensees need to obtain confidential information to help determine appropriate loan amounts, financing plans, and affordable income-expense ratios. Qualifying a buyer involves two separate but important processes:
- Determining the potential buyer’s real property needs (housing objectives)
- Determining the potential buyer’s economic capability to satisfy those needs (financial abilities)
