REAL ESTATE FINANCE Ninth Edition

1. REAL ESTATE FINANCE Ninth Edition John P. Wiedemer and J. Keith Baker

2. Chapter 9 Borrower Qualification

3. LEARNING OBJECTIVES At the conclusion of this chapter, students will be able to: • Understand the difference between a Veterans Administration mortgage loan and the primary FHA mortgage loan programs. • Describe how the components of an FHA loan must be compiled, including how their unique features of Mortgage Insurance function as part of closing costs and continuing mortgagor obligations. • Understand the development of private mortgage insurance products and their current features. • Describe how a home equity revolving line of credit mortgage works. • Explain the function and costs of a reverse annuity mortgage.

4. Introduction • Mortgage loans may be divided into two categories: those made to buy homes and those made to acquire commercial properties. • For a home loan, the analysis focuses first on the applicant’s income. • For a commercial loan, the analysis focuses on the income produced by the property. • Residential loans comprise over two-thirds of the mortgage loan market and may be classed in four major categories: • (1) insured by a government agency such as HUD/FHA • (2) guaranteed by a government agency such as VA or RHS • (3) conventional conforming • (4) conventional non-conforming

5. Equal Credit Opportunity Act • ECOA limits information that may be required in an application. • Questions that could lead to discrimination have been eliminated and new questions added that need only be answered on a voluntary basis. • The act prohibits discrimination in the granting of credit on the basis of sex, marital status, race, color, religion, national origin, age, receipt of public assistance income, and the exercise of rights under the Consumer Credit Protection Act. • The restrictions covering information on sources of an applicant’s income do not apply if the applicant expects to use that income as a means of repaying the loan. • No discounting of income is allowed because of sex or marital status or because income is derived from part-time employment. • If credit is denied, the lender must provide the reasons.

6. The Loan Application • A loan application offers information on the borrower andthe property. • If the loan is residential, the application must conform to the ECOA. • The Fannie Mae and Freddie Mac application (FNMA 1003 and FHLMC 65, respectively) and is used by all lenders with all residential loans. • The latest revision appears in the Appendix. • The information required may be summarized as follows. • 1. Identification of borrower (and co-borrower) • 2. Cost of house, down payment, financing requested • 3. Employment and income data • 4. Anticipated monthly housing expenses • 5. List of assets and liabilities • 6. Permission to obtain a credit report • 7. Details of the transaction including an estimate of cash needed • 8. Applicant’s certification as to accuracy of information

7. Commercial Loan • If a loan is for commercial property, the lender is more likely to use its own application form. • Federal laws regarding the application do not apply to commercial. • Since most commercial loans are expected to be repaid from the property income rather than from the borrower’s personal income, specific information is needed on that property. • An appraisal, market information with a review of competition, and substantial financial data on anticipated operations would be required. • More detailed information on commercial loans will be considered after the examination of residential loan qualification next.

8. Financial Evaluation of the Borrower • The high loan-to-value ratios (LTVR) often found in residential loans place a premium on an accurate examination of the borrower. • Analysis of a borrower can be handled two different ways: • 1. by a human underwriter, called manual underwriting. • 2. by a computer, called automatic underwriting. • The “Three Cs” of good underwriting are commonly followed. • 1. Capability – a borrower’s capacity to make the required payments. • 2. Credit – the borrower’s credit reputation (willingness to pay). • 3. Collateral –determining that the property is adequate collateral. • The underwriter must consider the three basic questions: • 1. What is the applicant’s ability to pay? • 2. What is the applicant’s willingness to pay? • 3. Does the property provide enough collateral?

9. Financial Evaluation of the Borrower Ability to Pay The residential lender looks to a family’s income as the basic resource for repayment. A careful review of the employment record, present income, and future potential is important. Types of Income Lenders make a distinction between production-related and assured income. Production-related income means commissions, bonuses, and piecework pays. It does not have the certainty of assured income such as wages or salary and requires a longer record of earnings to qualify. Review the list of income types in your book. Stability of Income Along with the size of an applicant’s income, the assurance that it will be continued must be investigated. Two measures are most commonly used: (1) time on the job and (2) type of work performed.

10. Financial Evaluation of the Borrower Length of Time on Job Length of time on the same job is a measure of stability. The former three-year standard has changed to a more common one-year. Have they “job-hopped without improvement in income? Is the new job of greater responsibility and growth potential? Has the applicant stayed in a chosen field of work, or is the new job an entirely new type of work? Type of Work Persons with salaried jobs employed by major companies rate very well. So do professional people. Hourly workers, especially with union contracts, can be more stable (and more highly paid) than lower level management and clerical staff workers. Government employees, teachers, police officers, and other service workers are very stable. On the lower side of the scale, new sales representatives, entertainers, and seasonal workers give poor evidence of continued stable income. To some lenders, socially unacceptable types of work carry unduly low ratings.

11. Financial Evaluation of the Borrower Liabilities Fixed liabilities must be reported on the application. Not all liabilities are included, for instance, cost of food, clothing, transportation, and income taxes need not be listed even though they are all essential. Monthly obligations should not exceed guideline percentages of the applicant’s income. The obligations that fall under this criterion are the monthly mortgage payment plus other fixed obligations such as installment payments and revolving account payments. Caution should be taken before incurring other debt prior to qualifying for a mortgage loan. Assets Residential applicants need not show substantial assets to qualify. However, there is an advantage if assets other than a home are held by an applicant. Stocks, bonds, real estate, savings, and other assets does indicate an ability to live prudently. If this is the case, the applicant should find qualification of income much easier, as the percentage guidelines that limit the amount of obligations will most likely be relaxed a bit.

12. Financial Evaluation of the Borrower Willingness to Pay The most common source of information to make this determination comes from credit reports. Information is also obtained from public records covering litigation, judgments, or criminal actions. Credit Reports Most adults in this country have credit reports. Information in credit files is classed as proprietary, available only to approved credit bureau members. Those who pay bills only in cash are approved on the basis of timely cash payments showing proof of sound payment practices. Keepers of Credit Records Before applying for any loan, it is wise to review one’s credit report. The Fair Credit Reporting Act grants individuals the right to do this. Three major national credit data companies hold credit information. They are Equifax (equifax.com), Experian (experian.com) and Transunion (transunion.com).

13. Financial Evaluation of the Borrower Credit Information Reports cover the past seven years (ten for bankruptcy). If an individual files a complaint against a credit reporting company, the law requires an answer be provided within 30 days. Disputed information may be removed during investigation. If accurate, it is returned to the record. If inaccurate, the information must be deleted. The individual can instruct the credit bureau to send a correction to all creditors who reviewed the file in the previous six months. If there are mitigating circumstances an individual can file a statement up to 100 words. Responsible Federal Agency Consumers’ rights stem from the Fair Credit Reporting Act, administered by the Federal Trade Commission. In addition, the Fair and Accurate Credit Transactions Act (FACT) was passed to protect consumers from inaccurate credit information. Requirements include disclosure of reasons for loan denial. The necessity for compliance with these privacy policy rules stems from the new Red Flag Rules that require financial institutions to implement identity theft prevention programs.

14. Financial Evaluation of the Borrower The Privacy Act Requires that lenders provide an initial privacy notice as soon as the customer relationship is established. Possession of any means of identification for the purpose of knowingly transferring or using it without lawful authority is a federal crime. Credit Reporting Problems Problems remain in the confusion of persons with similar names and changes of married names, and just plain errors in the recording of data. Confusion over names is not always simplified by the use of Social Security numbers because creditors may not demand a Social Security number when considering granting credit. Credit Scoring Credit scores continue to have a rising influence by residential mortgage. Credit scoring is calculated by credit bureaus using information from one or more of the three major credit repositories.

15. FHA Borrower Qualification • HUD/FHA Borrower Income Qualification – Percentage Guideline Method • The percentage guideline method considers an applicant’s monthly liabilities in two separate categories and measures each amount against the applicant’s effective income. • The two categories and limits applied are as follows. • Housing expense should not exceed 31 percent of the applicant’s effective income. • Housing expense plus other recurring charges are identified and should not exceed 43 percent of effective income. • Taxes, maintenance, and utilities are considered payable from income remaining after the required mandatory expenses has been deducted. FHA uses 31/43

16. FHA Borrower Qualification Effective Income Gross income from all sources and expected to continue for 3 years. Housing Expense Principal, interest, taxes, hazard /flood insurance, FHA premium, HOA fee. Recurring Obligations Extending ten months or more, such as installment accounts, child support, separate maintenance, revolving accounts, and alimony. Fixed Payment The sum of the housing expense and recurring charges. Residual Income This is gross effective income minus fixed payment. Ratios Housing expenses should not exceed 31% of income and recurring obligations should not exceed 43%.

17. FHA Borrower Qualification FHA Institutes Minimum Credit Scores and Loan-to-Value Ratios • Borrowers with a credit score 580+ are eligible for maximum financing. • Borrowers with a credit score between 500 & 579 are limited to 90% LTV. • Borrowers with a credit score of less than 500 are not eligible for FHA. • Borrowers using 203(h), Mortgage Insurance for Disaster Victims, are eligible for 100% financing and no down payment is required, provided that the borrowers have a minimum credit score of 500.

18. VA Borrower Qualification VA requires two separate calculations, residual method & income ratios. Residual Method of Income Qualification Start with gross monthly income, then deduct tax liabilities, shelter expenses, and other fixed obligations. What remains is residual income. Gross Income Income of borrower & spouse with reasonable expectation of continuing. Tax Liabilities Federal and state income taxes, Social Security, and any other tax due. Shelter Expenses PITI, special assessments, and estimated cost of maintenance & utilities. Other Monthly Obligations Installment obligations with six+ monthly payments still due, revolving accounts, alimony, child support, job-related expenses, other state and local taxes, and life insurance premiums.

19. VA Borrower Qualification Residual Income After deducting taxes, shelter expenses, and other monthly obligations, what remains is residual income. The residual must be sufficient to cover the required minimum residual income. The minimum residual income is a cost-of-living amount that varies by region, family size, and loan amount. Cost of Living Expense The VA uses a calculated figure for determining the cost of living. These costs include food, clothing, transportation, personal and medical care, and other consumption items. The residual income must be sufficient to cover the applicable cost of living amount. Excess Residual Income Whatever remains after total obligations and cost of living expenses are deducted is called “excess”. Divide the excess residual by the minimum required residual. If the ratio is 20% or greater, the applicant may still qualify even though the income ratio guidelines are not met.

20. VA Borrower Qualification VA Income Ratio Method of Qualification Used in conjunction with the residual method. Shelter Expenses The same expenses apply for the income ratio method as for the residual method, except for utility &maintenance costs which are not included. Other Monthly Payments Same as that used with the residual method. Income Ratio Shelter expense plus other monthly payments is compared to gross income. The total expenses should not exceed 41% of gross income. Comparison with Residual Guideline If the income ratio exceeds the 41% limit, the underwriter reviews the excess residual ratio and if the ratio is 20% or greater, the applicant may still qualify.

21. VA Borrower Qualification • Other Qualification Considerations • While the VA considers the income available for family support a significant factor, it is not the sole criterion for approving a loan. • Other important considerations include. • Applicant’s demonstrated ability to accumulate liquid assets such as cash and securities. • Applicant’s ability to use credit wisely and refrain from incurring excessive debt. • Relationship between proposed housing expenses and the amount applicant is accustomed to paying. • The number and ages of applicant’s dependents. • The likelihood of increases or decreases in income. • Applicant’s work experience and history. • Applicant’s credit record with other obligations. • The amount of any down payment made.

22. Conventional/Conforming Loan Qualification • A conforming loan meets the requirements of Fannie Mae/Freddie Mac. • Both are subject to HUD oversight and Congress set the maximum loan these agencies may purchase at $417,000 for 2012 on a single dwelling. • Loans that do not exceed the limit are more readily salable. • Fannie Mae and Freddie Mac use the same basic loan documents. • There are no restrictions on who is eligible other than the minimum standards and originators may set requirements more stringent. • The mortgage payment cannot exceed 28% of gross income, and other obligations plus mortgage payment cannot exceed 36%. Fannie/freddie uses 28/36

23. Conventional/Conforming Loan Qualification Mortgage Payment For a conforming loan, the mortgage payment amount is defined as principal, interest, taxes, and insurance (PITI), plus any special assessments that may hold a lien on the property. Other Monthly Payments Installment debt that extends for six months or longer, revolving accounts, and other payments that represent a fixed claim on the applicant’s income. Many demands on income, such as food, clothing and taxes, are not included. It is simply that these costs are expected to be paid from the 64% of an applicant’s income that is not designated for mandatory payments. Fannie/freddie uses 28/36

24. Affordable Housing Loans • One result of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) is the creation of a new category of conventional loan that targets low- and moderate-income people. • The generally accepted definition of low income is 80% of the local area’s median income and 115% for moderate income. • Some programs limit the maximum purchase price of the house and all include an education course for home buyers. • Fannie Mae and Freddie Mac both have a variety of affordable housing programs. • The purpose is not to make risky loans to unworthy borrowers, but to recognize that many people simply follow different living practices.

25. Temporary “Making Homes Affordable” Programs • These programs only apply to mortgages owned or guaranteed by Fannie Mae/Freddie Mac or serviced by servicers participating in HAMP. • These programs can be broken down into the following categories: • Lowering borrower payments • Lowering borrower mortgage interest rates • Assistance for unemployed borrowers • Assistance for borrowers with poorly constructed 2nd mortgage • Assistance for borrowers with negative equity • Foreclosure alternative programs for borrowers • Each program has unique eligibility requirements and provisions and many are under sunset provisions that are set to expire within a year. • Examples include HAMP, HARP, HHF, and HAFA.

26. Commercial Loans • Repayment of the loan is expected from the property’s income rather than from the borrower’s personal income. • A creditworthy borrower is still important, but greater emphasis is placed on the property. • Commercial loans are made primarily to businesses, not individuals. • Detailed financial statements are normally required. • These are scrutinized as to profitability and the accumulation of assets. • Information is submitted on the principal owners, officers & directors. • A loan agreement is usually required that spells out certain limitations on the company’s operations during the term of the loan.

27. Commercial Loan Application • Lenders develop their own commercial loan applications. • Depending on the kind of property and business operation involved. • The general information in a commercial loan application include: • 1. Company name, address, and business structure • 2. Information on owners or corporate officers and directors • 3. Name of contact person • 4. Purpose of the loan requested • 5. Financial statements for past three to five years: • Balance sheet • Profit and loss statement • Pro forma statement showing impact of loan on profitability • 6. Names of suppliers and banks for credit references • 7. Appraisal of property to be pledged as collateral • 8. An environmental assessment of the property • 9. Possibly a feasibility study if project is new construction

28. Commercial Loan Application • The listed information would suffice for a preliminaryreview. • It is normal for a lender to require an upfront fee to review the app. • Some set a rather high fee to discourage frivolous requests. • All costs of information are paid by the borrower. • The review covers management, sales, production, purchasing, research, planning, personnel, policies, physical plant, and equipment. • The underwriter expects current, audited, financial statements. • An audited statement is one in which all data are verified by a CPA. • The underwriter looks for at least $2 of assets for every $1 of liabilities. • Creditworthiness is determined references along with credit reporting agencies such as Dun & Bradstreet.

29. Commercial Loan Application • A pro forma balance sheet and P&L statement is prepared and projects what the loan will do for the borrower. • The long-range ability to operate profitably is the real key to repayment. • A separate agreement is usually a part of the loan commitment that states how the loan is to be used and penalties for noncompliance. • Certain restrictive covenants are often added that limit company policies during the term of the loan. • These would include loans or advances to officers or employees, amount of salary increases, dividends, and limits on other borrowing. • The agreement might require lender approval before any major assets, patents, or leasehold interests could be sold. • All terms of a loan agreement are negotiable.

30. Private Mortgage Insurance (PMI) • History of Private Mortgage Insurance • The idea of writing an insurance policy to protect a lender against loss in the event of loan default began with the creation of FHA in 1934. • It was not until the 1950s that several entrepreneurs began testing the market for private default insurance coverage for conventional loans. • In 1971 PMI became a requirement for higher-ratio conventional loans. • In that year, regulatory authorities expanded lending limits for conventional residential loans and required the use of PMI. • The new limits allowed loans up to 95% of the appraised value. • The result was a tremendous growth in PMI. • Until the recent financial crisis, when all private mortgage insurers failed.

31. Private Mortgage Insurance (PMI) Private Mortgage Insurance Companies The nature of default risk has limited the number of companies offering PMI. Loan originators must obtain the necessary qualifying information from a loan applicant for submission to the PMI underwriter. Qualifying Information Required A request for coverage includes submitting a copy of the loan application, a property appraisal, a credit report on the borrower, several verifications, and any other data helpful. Amount of Coverage Offered FHA insures 100% of the loan while VA guarantees only a portion of the loan. PMI carriers issue a variety of policies for residential loans that range from 12% of the loan to 35%. Term of PMI Insurance FHA and VA commitments are for the life of a loan, while PMI varies from 3 to 15 years.

32. Private Mortgage Insurance (PMI) Types of Property That Can Be Covered Residential primary residences, second or leisure homes, multifamily properties, mobile homes, and modular housing. Commercial hotels, motels, shopping centers, office buildings, warehouses, and others. Premiums Charged Premiums on PMI may be paid as a single premium at time of closing or in installments as an annual premium plan. The premium amount is expressed in points. It has been customary to require two months’ worth of premiums to be paid at closing, plus the cost for one year placed in escrow. Several companies began offering to drop the one-year escrow requirement and make charges only on a monthly basis. Cancellation of PMI Coverage Lenders are required to notify consumers of their right to cancel PMI when the equity in their home reaches 20%, if requested by the borrower, and automatic cancellation when the loan reaches 78% of the original LTVR.

33. Private Mortgage Insurance (PMI) Who Determines the Need for PMI? The answer is lenders, not borrowers. The need is based on risk; the larger the down payment, the lower the risk. A general rule of lenders is that loans with 20% or more down payment are not required to carry PMI. PMI Obligations in the Event of Foreclosure Even though PMI coverage is limited to a percentage of the loan amount, insurance companies have generally reimbursed the lender in full should foreclosure become necessary. As foreclosure problems escalated, many insurers were forced to reimburse the lender for the amount of the loan actually covered. Indemnification Clause If the insurance company suffers a loss in the settlement of a claim with a lender (when the loan balance due exceeds the value of the property), the borrower is liable for reimbursement of the loss. Remember, the insurance protects the lender against loss.

34. A Final Note On Borrower Qualification Fha uses 31/43 VA uses Residual/41 Conventional uses 28/36 So if borrowers qualify conventional they qualify for fha or va! So use 28/36 as a rule of thumb!

35. Questions for Discussion How does the Equal Credit Opportunity Act reduce discrimination? List the essential information that a prospective borrower must provide in a residential loan application, and in a commercial loan. Discuss “ability to repay” a loan as may be indicated by type of income and stability of income. What are the major rights of borrowers as they relate to how their credit is reported, protected, and accessed? Define willingness to pay and how it can be evaluated. What information is normally obtained from a credit report? In analyzing corporate credit, what further investigation would an underwriter employ beyond a careful study of the company’s financial statements? What is the risk insured by private mortgage insurance? What are the principal features of an affordable housing loan qualification, and how are they different from those of recent temporary “Making Homes Affordable” programs? How are liabilities usually measured in the analysis of an applicant seeking a home loan?