Topic 4: Underwriting Mortgage Loans

1. Topic 4: Underwriting Mortgage Loans

2. Underwriting Mortgage Loans • As we have stated,mortgage lenders face two types of risk or uncertainty: • Interest rate risk • Default risk. • Lenders control interest rate risk by using Asset-Liability Management techniques. • They control default risk through the underwriting process.

3. Underwriting Mortgage Loans • Underwriting is the process through which a lender decides to issue a loan and at what terms. • Underwriting is done at one of several levels depending upon the lender and the nature of the loan: • Loan committee • Loan officer • Automated underwriting process

4. Underwriting Mortgage Loans • Underwriting is one of the more expensive aspects of issuing a loan. Lenders are constantly attempting to control or reduce those costs. • Although in hindsight it is clear that it is expensive not to underwrite effectively.

5. Underwriting Mortgage Loans • The underwriting process largely considers: • The creditworthiness of the borrower • The value of the underlying collateral • Market credit conditions. • Typically the underwriting decision is made based on information from: • The loan application • A property appraisal • Credit reporting agencies.

6. Underwriting Mortgage Loans • A major consideration in the underwriting process is whether to require the borrower to purchase default insurance. • This is a policy which the borrower purchases that protects, to varying degrees, the lender in the event the borrower defaults on the loan.

7. Underwriting Mortgage Loans • There are two main variables used in the underwriting decision.

8. Underwriting Mortgage Loans • There are seven major types of mortgages today. They are: • Conventional mortgages • Insured conventional mortgages • Jumbo Loans • FHA Insured Loans • VA Guaranteed Loans • 125% LTV Loans • Sub-Prime Loans

9. Conventional Mortgages • Generally to be considered a conventional mortgage, the loan must be made • To a creditworthy borrower • No outstanding bad debts. • PTI ratio within normal limits. • For no more than 80% LTV • Default risk is relatively low. • Cheapest loan from the borrower’s standpoint. • Usually will be sold to Freddie Mac or Fannie Mae.

10. Private Mortgage Insurance • Insured Conventional Mortgages • This is a standard conventional loan that has a higher Loan to Value ratio. It is most commonly under 95% LTV, but can reach as high as 97%. • It is insured against default by a private company (PMI). • The amount of insurance will vary depending upon the down payment amount. • These are typically purchased by FHLMC or FNMA. • They are riskier than non-insured conventional loans.

11. Private Mortgage Insurance • PMI typically covers the first 25 to 30% of the mortgage amount. • The theory is that the borrower will default on the loan, but the insurer will pay take the first hit on the loan. The lender can then sell the house to recover their losses on the remaining 70-75%. • By only covering 25-30%, the cost of the insurance is minimized. • Premium is typically .5% of balance or less.

12. Private Mortgage Insurance • Some of the largest mortgage insurers are: • Mortgage Guaranty Insurance Corporation, MGIC, (“Magic”) • GE Capital • GMAC • Rates for mortgage insurance are typically on the order of:

13. Jumbo Loans • FHLMC and FNMA cannot securitize loans of more than $418,000. • If you wish to borrow more than that, you will have to go through the “jumbo” market. • Rates are higher in this market, due to the lack of FNMA/FHLMC liquidity. • Depending on the LTV, the risks to the lender are roughly comparable to conventional loans.

14. FHA Insured Loans • FHA Insured Loans • These are loans issued by banks, which FHA insures against default. • These homes can have less than a 3% down payment (>97% LTV). • GNMA, FNMA, and FHLMC are all involved in remarketing these loans. • Lenders generally view these as riskier loans.

15. FHA Insured Loans • The insurance premium is paid in two pieces: • An initial 2.25% “up front” premium. • An annual premium is usually .5% of “average outstanding balance”, and can be built into the monthly payment. • The Maximum loan that can be insured by FHA is 144,336 in general, but in high cost areas can be higher. • In Charlotte/Mecklenburg and in Cabarrus it is 156,655.00 • In Iredell it is 144,336.

16. FHA Insured Loans from FHA Web-page

17. FHA Insured Loans • The amount in any particular case that you can insure varies depending upon the size of the loan and whether the borrower chooses to finance the up-front 2.25% insurance premium. • Rules: • If loan<$50,000 – 97% • If loan>50,000: take the minimum of: • A. 97.75% of house value • B. 97% of first 25,000 of house value plus 95% of the remaining house value plus allowed closing costs.

18. FHA Insured Loans • This works out to be:for loans greater than $50,000 • And • .97*H for loans less than $50,00. • After determining the max loan amount, you add back in the financed premium (if borrower finances the premium) total loan = max loan amount *1.0225

19. VA Loans • VA directly guarantees loan made to qualified veterans, up to 25% of the loan amount. • The maximum loan that can have a guarantee is usually $203,000.

20. Riskier Loans • Within the past 5 years two new products have come on the market in a big way. • 125% loans – generally made to people with good credit, it is in some ways a “combination” loan – i.e. a mortgage combined with a personal loan. • Sub-prime loans – for people with bad credit histories. Many sub-prime loans go to minority and underrepresented groups.

21. Underwriting Process • All underwriting, be it manual or automated, comes down to verifying adequate income and house value. • The basic idea is to establish the • PTI ratio • LTV ratio

22. Borrower Income Estimation • The idea is to confirm: • Employment • Wages • Expected future wages. • This can be difficult to verify for the self-employed. • Tax returns are used as “proof” of income. • Other obligations (debts) will also determine eligibility.

23. General Underwriting Standards • For FRMs: • 28% Payment to Gross Income • 36% Total Obligations to Income • 80% LTV for no insurance. • Up to 97% with PMI or FHA insurance • >=620 FICO credit score • For ARMs: • Same as above except sometimes 25% payments to gross income and 33% total obligations to income.

24. General Underwriting Standards • Note that all of the “payments” we refer to here are “PITI”: • Principal • Interest • Taxes • Insurance (include PMI/FHA)

25. FHA Underwriting Standards • In addition to the loan limits discussed earlier, FHA also sets their own debt ratios: • Housing expense ratio: • PITI/Gross Income <=.29 • Total obligations ratio: • (PITI + Installment + credit card)/Gross Income<.41

26. Appraisal • Once we have established that the borrower is creditworthy, we can move on to determine how much the property is worth. This will let us determine the loan to value ratio. • The big trend in this field is to move away from using appraisers and move toward using automated underwriting systems with automated valuation systems.

27. Real Estate Appraisal • Appraisal is the process of estimating the value of real estate. • The appraisal industry is very large, with well over a hundred thousand appraisers in the US. • The big trend, however, is for appraisals to become automated.