Lesson 10:

1. Lesson 10: Conventional Financing

2. Introduction • In this lesson we will cover: • conforming and nonconforming loans, • characteristics of conventional loans, • qualifying standards for conventional loans, and • special programs and payment plans.

3. Introduction • Loans made by mortgage lenders can be divided into two main categories: • conventional loans • government-sponsored loans

4. Introduction • Conventional loan Any institutional loan that isn’t insured or guaranteed by a government agency.

5. Conforming & Nonconforming Loans • Most conventional loans comply with underwriting guidelines set by Fannie Mae and Freddie Mac. • Conforming loan:complies with those guidelines. • Nonconforming loan:doesn’t comply.

6. Conventional Loan Characteristics • Fannie Mae/Freddie Mac underwriting guidelines are widely followed in the mortgage industry because lenders want to be able to sell their loans on secondary market. • Many of the rules covered here are based on their guidelines.

7. Conventional Loan Characteristics Topics: • Property types and owner-occupancy • Loan amounts • Repayment periods • Amortization • Loan-to-value ratios • Risk-based loan fees • Private mortgage insurance • Secondary financing

8. Conventional Loan Characteristics Property types and owner-occupancy • Fannie Mae and Freddie Mac buy loans secured by residential property: • detached site-built houses • townhouses • condominium units • cooperative units • manufactured homes

9. Conventional Loan Characteristics Property types and owner-occupancy • Fannie Mae and Freddie Mac don’t require owner-occupancy, but different (generally stricter) underwriting rules apply to investor loans. Investor loan: Borrower purchasing property doesn’t intend to occupy it.

10. Conventional Loan Characteristics Property types and owner-occupancy • Conventional loan may be secured by: • Principal residence • Up to 4 dwelling units • Second home • No more than 1 dwelling unit • Investment property • Up to 4 dwelling units

11. Conventional Loan Characteristics Loan amounts • Conforming loan limits are set annually by Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac. • If loan amount exceeds applicable limit, the agencies won’t purchase the loan. • Different loan limits for different areas, based on area median home prices. • Different limits for one-, two-, three-, and four-unit dwellings.

12. Conventional Loan Characteristics Loan amounts • 2009 conforming loan limits for one-unit dwellings • In most areas: $417,000 • In high-cost areas: 125% of area median house price, up to a maximum of $729,750. • Higher limits for Alaska, Hawaii, Guam, and Virgin Islands.

13. Conventional Loan Characteristics Loan amounts • Loan that exceeds conforming loan limit is called a jumbo loan. • Typically, jumbo loans: • have higher interest rates and loan fees than conforming loans, and • are underwritten using stricter standards. • For example, lower maximum LTV, higher credit score requirements.

14. Conventional Loan Characteristics Repayment periods • Repayment periods can range from 10 to 40 years. • 30-year loans are standard. • 15-year loans also popular.

15. Conventional Loan Characteristics Amortization • Standard conventional loan is fully amortized. • Partially amortized and interest-only loans also available.

16. Conventional Loan Characteristics Loan-to-value ratios • Traditional standard conventional LTV: 80% • Loans with LTVs up to 95% also available. • During subprime boom, higher LTVs were available: 97% or even 100%. Now uncommon. • Also, loans with LTVs of 90% or 95% are less easily obtained than they were a few years ago.

17. Conventional Loan Characteristics Loan-to-value ratios • Conventional loans may be categorized by LTV ratio, with different underwriting rules applied to each category. • Fannie Mae and Freddie Mac require any conventional loan with LTV over 80% to have private mortgage insurance.

18. Conventional Loan Characteristics Loan-to-value ratios • High-LTV loans also usually have: • higher interest rates and fees, and • stricter underwriting rules.

19. Conventional Loan Characteristics Combined loan-to-value ratios • If there are other mortgages against a property, lender will be concerned with the combined loan-to-value ratio (CLTV). • CLTV generally should not exceed usual LTV limit, but in some cases a higher CLTV is allowed.

20. Conventional Loan Characteristics Risk-based loan fees • Fannie Mae and Freddie Mac require most borrowers to pay risk-based loan fees called loan-level price adjustments (LLPAs).

21. Conventional Loan Characteristics Risk-based loan fees • Loan-level price adjustments shift some of the risk (cost) of mortgage defaults onto borrowers. • Generally, the riskier the loan, the more the borrower will have to pay in LLPAs.

22. Conventional Loan Characteristics Risk-based loan fees • Nearly all loans sold to Fannie Mae and Freddie Mac are subject to an LLPA that varies based on borrower’s credit score and loan-to-value ratio. • Example: • Borrower with 650 credit score and 80% LTV might be charged LLPA of 2.75% of loan amount. • But borrower with 710 credit score and 90% LTV might be charged only 0.5%.

23. Conventional Loan Characteristics Risk-based loan fees • One or more additional LLPAs may be charged because loan is ARM, investor loan, interest-only loan, or some other relatively risky type of loan. • Fannie Mae and Freddie Mac also levy a flat fee called an adverse market delivery charge on every borrower to help agencies recover losses caused by poor market conditions.

24. Conventional Loan Characteristics Private mortgage insurance • Private mortgage insurance (PMI) helps protect lenders from risk of high-LTV loans. • Required for convention loans if LTV over 80%. • Makes up for reduced borrower equity.

25. Private Mortgage Insurance How PMI works • Private mortgage insurance company assumes only a portion of risk of default and foreclosure loss. • PMI covers upper portion of loan. • Typically 25% to 30% of loan amount.

26. Private Mortgage Insurance How PMI works • Upon default and foreclosure, lender makes claim for reimbursement of actual losses. • Or may relinquish property to insurer.

27. Private Mortgage Insurance How PMI works • Insurers have own underwriting standards, which have been influential in mortgage industry.

28. Private Mortgage Insurance PMI premiums • Mortgage insurance company charges risk-based premiums for coverage. • Variety of payment plans, including: • flat monthly premium; • initial premium at closing, plus renewal premiums; or • financed one-time premium.

29. Private Mortgage Insurance PMI premiums • With some plans, borrower who pays off loan early is entitled to partial refund of initial premium or financed one-time premium. • But plans that don’t provide for refunds are less expensive.

30. Private Mortgage Insurance Deductibility of PMI premiums • PMI premiums are currently tax-deductible. • No deduction if family income is over $109,000. • Deductibility set to expire in 2010.

31. Private Mortgage Insurance Cancellation of PMI • Under federal Homeowners Protection Act, lenders must cancel loan’s PMI under certain conditions: • once loan has been paid down to 80% of property’s original value (upon borrower request); or • once loan reaches 78% of property’s original value (automatic cancellation).

32. Private Mortgage Insurance Cancellation of PMI • Homeowners Protection Act applies only to loans on single-family dwellings occupied as borrower’s primary residence. • Depending on payment plan, cancellation of PMI may reduce monthly mortgage payment.

33. Secondary Financing • Lenders generally allow secondary financing in conjunction with a conventional loan. • Most impose some restrictions to minimize increased risk that borrower will default on primary loan.

34. Secondary Financing Restrictions • Examples of restrictions lenders may impose: • Borrower must qualify for payments on both first and second mortgages.

35. Secondary Financing Restrictions • Examples of restrictions lenders may impose: • Borrower must qualify for payments on both first and second mortgages. • Borrower must make 5% downpayment.

36. Secondary Financing Restrictions • Examples of restrictions lenders may impose: • Borrower must qualify for payments on both first and second mortgages. • Borrower must make 5% downpayment. • Scheduled payments must be due on regular basis.

37. Secondary Financing Restrictions • Second mortgage can’t require balloon payment less than 5 years after closing.

38. Secondary Financing Restrictions • Second mortgage can’t require balloon payment less than 5 years after closing. • If first mortgage has variable payments, second mortgage must have fixed payments.

39. Secondary Financing Restrictions • Second mortgage can’t require balloon payment less than 5 years after closing. • If first mortgage has variable payments, second mortgage must have fixed payments. • No negative amortization.

40. Secondary Financing Restrictions • Second mortgage can’t require balloon payment less than 5 years after closing. • If first mortgage has variable payments, second mortgage must have fixed payments. • No negative amortization. • No prepayment penalty.

41. Secondary Financing Piggyback loans • Secondary financing is sometimes referred to as a piggyback loan, especially when it is used to either: • avoid paying private mortgage insurance, or • avoid jumbo loan treatment.

42. Secondary Financing Piggyback loans • With piggyback loan, LTV of primary loan isn’t over 80%. • So PMI requirement doesn’t apply. • With piggyback loan, loan amount for primary loan doesn’t exceed conforming loan limit. • So higher costs and stricter rules for jumbo loans don’t apply.

43. Secondary Financing Piggyback loans • Piggybacking was popular during subprime boom, but is no longer widely used. • Advantages of piggybacking reduced by: • tax deductibility of PMI premiums • loan-level price adjustments imposed on secondary financing

44. Conventional Loan Characteristics Conventional loan Conforming loan Nonconforming loan Conforming loan limits Jumbo loan Loan-level price adjustment (LLPA) Adverse market delivery charge PMI Piggyback loan

45. Conventional Qualifying Standards Evaluating risk factors • Fannie Mae and Freddie Mac have changed how they evaluate creditworthiness of applicants. • Newer methods influenced by automated underwriting systems and computer analysis.

46. Conventional Qualifying Standards Evaluating risk factors • Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors. • Two primary risk factors: • applicant’s credit reputation, and • the loan-to-value ratio.

47. Conventional Qualifying Standards Evaluating risk factors • Fannie Mae uses “comprehensive risk assessment” to evaluate risk factors. • Two primary risk factors: • applicant’s credit reputation, and • the loan-to-value ratio. • Loans ranked as low, moderate, or high primary risk.

48. Conventional Qualifying Standards Evaluating risk factors • Fannie Mae treats other aspects of application, such as debt to income ratio and cash reserves, as contributory risk factors. • Each factor assigned value depending on whether it: • satisfies basic risk tolerances, • increases risk, or • decreases risk.

49. Conventional Qualifying Standards Evaluating risk factors • Freddie Mac’s underwriting guidelines call for separate evaluation of each component of creditworthiness: credit reputation, income, net worth. • Underwriter then considers overall layering of risk. • Weakness in one component can be outweighed by strength in another.

50. Conventional Qualifying Standards Evaluating risk factors • Difference between Fannie Mae’s approach and Freddie Mac’s approach is mainly a difference in terminology. • Both agencies consider the borrower’s overall financial picture, with positive factors offsetting negative ones and vice versa.