Common Mortgage Types Flashcards
Mortgages are either government insured or government guaranteed, or they are conventional loans.
Government-Backed Loans
Government-backed loans include FHA, VA, and USDA, which we will talk about in later chapters. These programs do not provide money for loans. The money comes from private lenders. However, the loans are insured or guaranteed by special government programs.
Borrowers pay for the insurance or guarantees that protect the lender on these government-backed loans.
The insurance to protect the lender that is provided by the Federal Housing Agency (FHA) is called mortgage insurance premium (MIP).
VA loans are guaranteed by the Veterans Administration.
The U.S. Department of Agriculture (USDA) makes loans to low-income buyers that are guaranteed through government-backed programs.
Borrowers pay for the insurance or guarantees that protect the lender on these FHA, USDA, and VA loans.
Conventional Loans
The money for conventional loans also comes from private lenders. However, they are not insured by the government at all. You’re on your own, conventional loan holders!
With conventional loans, the lender will ask for a 20% down payment since they are not protected by the government. But, if the borrower can only make a smaller down payment, the borrower can purchase private mortgage insurance called PMI. (There’s a chapter on PMI later!).
Conventional loans are the most common type of loan. Recall that conventional loans are divided into two types – conforming if they adhere to the underwriting guidelines of government-sponsored enterprises such as Fannie Mae and Freddie Mac, and nonconforming if they do not adhere to those guidelines. Because these loans are not backed by the government, conventional loans are considered a higher risk for lenders.
Approval for a Conventional Loan
In considering approving a loan, lenders will look closely at the property via the appraisal because that is the primary security for making the loan. The lenders will also look closely at the buyer’s credit report, which is an indication of credit reliability, the source of steady income, and the amount of money available for down payment and closing costs.
Conventional loans generally have more stringent credit and income requirements than FHA and VA loans. Conventional loans are typically faster to obtain, have fewer eligibility requirements, and often have no mortgage insurance requirements. Additionally, the interest rates may be lower than government-backed loans.
Some of the items the conventional lender will consider in making a loan are:
Total monthly expenses
Total gross income per month
Employment history
Credit score and payment history
Assets (checking, savings, and retirement accounts)
Here’s a helpful chart to help you keep your ducks (or in this case, loans) in a row:
A chart which compares conventional loans to government-backed loans.
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Government-Backed Loans vs. Conventional Loans
As you may recall from the level 15, conventional loans are divided into two categories: conforming loans and non-conforming loans.
Conforming Loans
Conventional conforming loans are loans that conform to the guidelines set by Fannie Mae and Freddie Mac and, thus, can be sold on the secondary market to government-sponsored enterprises (GSEs).
Conforming loans are made using the Uniform Residential Loan Application (Fannie Mae Form 1003 or Freddie Mac Form 65).
Loan Limits
The amount of money a buyer can borrow is not just limited to how much they qualify for with the lender. The government also limits how big a conforming conventional mortgage can be. The Federal Housing Finance Agency (FHFA) sets maximum limits on conforming loans. In recent years, the loan limits for single-family residences have come in excess of $450,000. For homes in high-cost areas, the limit has been in excess of $675,000.
FHFA annually publishes these limits by state and county. Head to their website if you want to see the limits for your county. 💸
High-Cost Area
In 2016, the Housing and Economic Recovery Act (HERA) provisions set loan limits as a function of local-area median home values. This is why the maximum conventional loan limit is different in some cities than in others.
In areas where 115% of the local median home value exceeds the baseline loan limit, the local loan limit is set at 115% of the median home value. The local limit cannot, however, be more than 50% above the baseline limit.
Non-Conforming Loans
Conventional non-conforming loans are loans that do not follow Fannie Mae and Freddie Mac guidelines and, thus, will not be purchased by Fannie and Freddie on the secondary market (although other secondary market buyers may choose to purchase them).
Jumbo Loan
A loan that is above the conventional loan limit is known as a jumbo loan and faces a somewhat higher interest rate because larger loans imply more lender risk.
Jumbo loans still belong in the category of conventional loans (they’re not insured or guaranteed by the government). But since they exceed the Fannie Mae and Freddie Mac loan limits, jumbo loans are considered non-conforming.
Nonconforming Conventional Loan Advantages
Here are two advantages of nonconforming conventional loans:
The Advantage of Time: Processing a conventional loan usually takes less time. Loan approval from a conventional lender can take 30 days or less, while approval on a government-backed loan seldom, if ever, can be done in less than 30 days. (Increased regulations have lengthened closing times to where 30 days is somewhat rare even for conventional loans. Nevertheless, conventional loans still tend to close more quickly than their government-backed counterparts.)
The Advantage of No Limits: There is usually no legal limit on loan amounts with conventional loans, whereas government-backed loans have dollar limits that vary by agency.
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Conforming vs. Non-Conforming
In the last level, we talked quite a bit about amortization. Mortgage loans can be talked about in terms of their amortization, whether the loan is fully amortized, partially amortized, or is subject to negative amortization.
Fully Amortized Loans
Mortgage loans that are fully amortized will include equal monthly payments that contribute to both principal and interest until the entire loan is paid. The payments will be credited first to the interest when due, with any remainder credited to the principal.
What’s unique about fully amortized loans is that if the borrower makes all their monthly payments in full and on time, the loan will be completely paid off with the last scheduled payment.
Fully amortized loans usually have higher payment amounts than other types (interest-only, partially amortized) but are consistent in the amount that has to be paid.
Red balloon letters spelling out LOAN.
Partially Amortized Loans
A loan might also be partially amortized. This means that even though there are equal payments going towards the principal and interest, the loan will not be fully paid off with the last scheduled payment.
A partially amortized loan might be designed to include a larger payment at the end of the loan’s terms. This larger payment is called a balloon payment and would effectively pay off the balance of the loan.
Negative Amortized Loans
Remember that with amortized loans, the interest is paid in arrears. This means that the borrower is paying for borrowing the money after they have already been “using” it for a period of time.
If a borrower’s payments are not large enough to cover the interest due on a loan, the unpaid interest is added to the principal balance. This is known as negative amortization or deferred interest. This is not a good situation for a borrower to be in!
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Amortization
In fully amortized, fixed-rate loans, the interest rate remains the same for the life of the loan and the monthly payments remain the same. The only thing that changes is how much of each monthly payment is applied to interest vs. principal — and even that is laid out on a predetermined schedule. With a fully amortized, fixed-rate loan, you can see exactly how much you’ll be paying in principal or interest in any month of the loan!
Potential for Refinancing
If the borrower wants to get a fixed-rate mortgage, even if the rate isn’t the best it could be, they could refinance in a few years if interest rates go down. This might be a better option for them than an adjustable-rate mortgage.
Otherwise, if rates are on their way up, the rate they’re getting at the moment they sign the contract is what they’ll have for the foreseeable future.
Fixed-Rate and Fully Amortized
In order to help your client, it might be good to know the benefits and drawbacks of both fixed-rate and adjustable-rate mortgages. Here are the pros and cons of taking out a fixed-rate mortgage.
Advantages
Fixed-rate mortgages are good in a few ways:
The payments are always going to be the same. Whatever the interest rate might be in the world, the borrower is protected.
Because of the stability, the borrower will be able to create a monthly budget and not have to worry about it changing because of the house payment.
Disadvantages
Here’s how fixed-rate mortgages can be not so great:
If the interest rate is high when the borrower is trying to get a mortgage, their interest rate will stay high for the life of the loan. The only way the borrower would be able to change their interest rate is to refinance, which can be helpful, but can also be a hassle.
If the interest rate drops by a lot, the borrower won’t be able to take advantage of the drop. Again, their only option would be to refinance.
A lot of the time, fixed-rate mortgages are sold to the secondary market, while ARMs stay within the lender’s institution. This means that ARMs can usually be more customizable than fixed-rate.
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Fixed-Rate Advantages and Disadvantages
As opposed to a fixed-rate loan, an adjustable-rate mortgage (ARM) is a loan with an interest rate that can increase and decrease periodically throughout the life of the loan, often based on a market index. An ARM typically has an introductory interest rate that is lower than the market rate.
An ARM’s initial interest rate is locked for a certain amount of time—this is called the initial rate period. After the initial rate period ends, the loan’s rate adjusts based on the index the loan is tied to.
Adjustable-Rate Mortgages
ARMs have a vocabulary of their own. You should understand the following concepts, as related to ARMs.
The Index Rate
The index rate is a benchmark used by investors to compare how the mortgage is doing compared to other similar types of mortgages.
The index rate is the number that adjusts after the fixed-rate period of the ARM. It’s the adjustable in adjustable rate.
Index Links
Most mortgages are linked to one of three potential indexes: the London Interbank Offered Rate (LIBOR), the 11th District cost of funds, or the maturity yield on one-year Treasury bills. Based on one of these three indexes, the index rate of the ARM will move up or down (like your own arm can move up and down!).
You’ll probably never really need to know how ARMs are indexed, but if you have an investor client who knows their stuff, throwing around terms like “LIBOR” will make you look smart. 😉
ARM Margin The margin (also known as the spread) is a fixed percentage above the index which the borrower will pay. For example, if the margin on a loan is 3%, then the borrower will always pay 3% above whatever the index is at the last adjustment. The rate you get when you add the index and the margin is called the fully indexed rate.
Remember that while the index may move up and down, the margin is fixed. That margin ain’t changin’, baby. It’s set in stone.
Your client should know that the margin is, most of the time, negotiable. They can speak with the lender to try and negotiate this number as low as possible.
Choosing an Index and Margin
Generally, the higher the margin, the lower the index level, and vice versa. That is, if the chosen index has a generally low rate not prone to large variations, the margin will likely be higher.
There may be a few margin/indexes available for the borrower to choose from, so they should figure out which will work best for them before choosing a loan.
EXAMPLE
If the margin on a loan is 3% and the index rate is 5%, the interest rate will be 8%.
If the index rate goes down to 3% at the next index reset period, the interest rate on the mortgage will be 6% (margin + index).
When the margin and the index are combined you get the fully indexed interest rate.
ARM Terms
ARMs written in a unique way. They look like a wonky fraction. You’ll see things like 2/28 or 4/1.
The First Number
The first number will always be the number of years that the interest rate remains fixed. So, a 2/28 ARM has a fixed rate for two years. A 4/1 ARM has a fixed rate for four years.
The Second Number
The second number doesn’t always mean the same thing.
In the first example of 2/28, the second number probably means that the interest rate floats (changes alongside the index) for the remaining 28 years after the initial two-year fixed period.
For the second example of 4/1, the 1 means that the rate will adjust every year. But, you could also see 4/6, which might mean that the rate could change every six years or every six months.
Critical Thinking Required
To decipher the ARM’s terms from its name requires a bit of critical thinking. It would be strange for a loan to adjust every six years (the market could change dramatically in that time), so you can assume that the “6” in a 4/6 ARM is probably talking about months, not years.
Similarly, if you saw a 2/28 or 3/27 ARM, you could safely assume that the loan won’t be adjusting every 27 or 28 years, or months for that matter (because that would just be an odd number to choose). The large number lets you know it’s probably referring to a floating interest rate after the initial fixed-rate period.
To Be Clear
But even if you can figure out what an ARMs terms are by its name, it’s always important to make sure your client understands exactly what the lender means by this number.
How ARMs Are Written
You may be wondering, “Wait, so the interest of an adjustable-rate mortgage can just go up and up and up without stopping?” Fortunately, no.
The stopping point for the interest on an ARM is called a rate cap. These can limit how high the interest rate can go and also how big the difference can be between old and new rates.
A homeowner wouldn’t like waking up to find out that their mortgage payment was thousands of dollars higher than what they expected — this is what the rate cap helps to avoid.
The Average Rate Cap
A typical rate cap might be 1% or 2%. If the loan had a really long fixed-rate period, then the first rate adjustment after the fixed-rate period might be higher—maybe around 5% (the rate cap would probably drop down to 1% or 2% after the first year).
Types of Caps
A periodic rate cap limits the change in interest rate between adjustment periods.
A lifetime cap, or, ceiling, limits the increase of interest over the life of the loan.
Also, payment caps limit the amount of the monthly loan payment for the borrower, which is stated in dollars and not in percentage points.
Below is an example of the difference a rate cap can make on monthly loan payment. As you can see, having a rate cap in place can keep the monthly payments much more reasonable over time compared with not having a cap.A chart showing the difference a rate cap can make on monthly loan payment.
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Rate Caps
Make sure you tell your client about ARM loans, in case it’s something they’re not aware of. If they do the math, they might see that this type of mortgage could potentially save them money.
Also, if they only plan on staying in their house for, say, 12 years or less, it makes sense to try to get a 10 to 15 year introductory interest rate. That way they pay a lower rate for the fixed-rate period and then sell the home before the adjustment period.
Caveat Emptor
Before a borrower takes out an ARM, they should consider what the maximum possible monthly payment over the life of the loan could be.
If the borrower doesn’t think they will be comfortable with the increased monthly payment, they should probably keep exploring loan options. When taking out a mortgage, it’s important to understand the worst-case scenarios. This ensures that the borrower is ready for whatever happens and greatly reduces the likelihood of foreclosure.
ARM’d and Dangerous
Now let’s talk about the pros and cons of adjustable-rate mortgages.
Advantages
Here are the advantages:
The big draw toward ARMs is the fact that they offer introductory interest rates that will be lower than fixed interest rates.
If interest rates are dropping, ARM borrowers don’t have to refinance to take advantage of lower interest rates.
If the borrower is able to sell before the adjustment, they won’t have to worry about payment increases.
Disadvantages
Here are the disadvantages, which should be taken very seriously:
ARMs are less predictable than fixed-rate loans. Interest rates change. If interest rates go way up, the borrower will end up paying way more than they began paying in the introductory interest period. The borrower might not be able to afford higher payments, and they could default on their loan.
The borrower will have to be careful because sometimes the rate caps don’t apply to the first adjustment. Yikes! This is something they’ll definitely want to discuss/negotiate with their lender.
If a borrower isn’t super knowledgable about ARMs, they might have trouble negotiating with the lender because there’s so much that goes into them. Lenders might use the borrower’s lack of knowledge to sign them up for something that isn’t very beneficial to them.
And finally, prepayment penalties.
Adjustable-Rate Advantages and Disadvantages
