Real Estate Financing: The Primary and Secondary Market

ESCROW 190 (Escrow I) Spring Term 2016Day 5

Chapter 6: Real Estate Financing • Key to the real estate transaction • Without financing options, every potential purchaser would need to pay cash • Where does it all come from?

The Primary Market • The original source of funds in the primary market comes from savings of individuals and businesses in the local area. • The primary market would include any individual or institution the borrower has direct access to: • Savings and Loan • Commercial Banks • Savings Banks • Mortgage Companies • Credit Unions

The Primary Market: Savings and Loan Associations • “S&Ls” • Originally created in the early 1900’s to provide financing for single family homes • Prior to 1970’s they were the largest source of residential lending capital in the U.S. • Obtained funds to lend from their own depositors • Serviced their own loans (30 years) and serviced their local community • Charged higher interest than it paid on deposit accounts • The resulting “spread”, less operation costs hopefully resulted in profit

The Primary Market: Commercial Banks • Oriented toward commercial lending activity • Largest source of investment funds in the U.S. • Prior to the 1970’s government regulation restricted commercial banks’ long term investment activity in the real estate lending market • Today, as much as 20% of a commercial bank’s assets may be tied up in long term mortgage loans

The Primary Market: Savings Banks • Similar to S&Ls • Created to serve their local community • Obtained funds to lend from their depositors and maintained servicing • Savings Banks tended to focus on making small personal loans, not large residential loans • 1982: Congress passed the Garn St. Germain Act allowing Savings Banks to nationally charter • Created option of going public and selling stock • Resulting revenue boosted assets & diversity of lending activity including residential lending

The Primary Market: Mortgage Companies • Mortgage Companies (Mortgage Bankers) do not maintain deposit accounts • Make loans by borrowing capital from other banks, or by representing larger investors (insurance companies, pensions funds) who don’t have resources to research local real estate markets • Mortgage Companies serve as intermediaries, rather than a source of lending capital • They use their capital to originate loans, but sell the loans quickly to the secondary market

The Primary Market: Mortgage Companies (continued) • Mortgage Bankers are not Mortgage Brokers • The Mortgage Broker: • Never originates a loan with own funds • Has access to a wide variety of lenders, loan rates and loan programs • “Shops” the market for best rate and program for the client • Takes the loan application and required documentation from client to qualify them • Submits loan package to the selected lender • Upon loan approval, steps out of the loop

The Primary Market: Mortgage Companies (continued) • Mortgage Bankers are not Mortgage Brokers • The Mortgage Banker: • Works for a bank or similar lending institution which actually provides you the money for the loan. • Is a direct lender.

The Secondary Market • Sets the standards for the Primary Market • National market where mortgages secured by real estate are bought and sold • Creation of the Secondary Market helped regulate economically disruptive cycles of local real estate markets by moving lending capital from areas of excess to areas of need • Investors (such as banks), are more willing to buy mortgage loans on the Secondary Market because uniform lending standards ensure relatively “safe” loans

The Secondary Market: Three Major Players • Fannie Mae: • Federal National Mortgage Association • FNMA • Ginnie Mae • Government National Mortgage Association • GNMA • Freddie Mac • Federal Home Loan Mortgage Corporation • FHLMC

Player 1: Fannie Mae • Formed in 1938, its purpose was to provide a market to buy and sell government loans • FHA-Insured • VA-guaranteed loans • Reorganized in 1968 by Congress as a private corporation in which the general public could purchase stock • FMNA pledged to purchase ANY residential loans that met certain standards (“guidelines”) as provided by FNMA • FNMA acted as a conduit for packaging and selling loans to other investors around the country

Player 2: Ginnie Mae • As Congress re-organized FNMA, they created the Government National Mortgage Association to take over the previous responsibilities of FNMA • Presently, GNMA provides government securities for large blocks of FHA and VA loans • GNMA also purchases loans that aren’t attractive to private investors but are socially beneficial • Low income housing loans • Loans for urban renewal projects

By 1980: Savings and Loans fell into trouble • Competition in the mortgage lending space led many S&Ls to making speculative investments which often did not pay off • S&Ls had most of their assets tied up in long-term mortgage loans at fixed rates • The Federal Government deregulated interest rates on deposit accounts resulting in deposit rates skyrocketing • Thus, the S&Ls were paying more money on deposit accounts than they were making in income on mortgage loans • Many S&Ls faced bankruptcy

Enter Player 3: Freddie Mac • Freddie Mac was created in 1980 to help the failing S&Ls by purchasing their conventional loans • Today, FHLMC is authorized to purchase conventional loans from any type of lender

Big Mac

The Secondary Market: New lending regulations • July 2010: Dodd-Frank Wall Street Reform and Consumer Protection Act passed • In response to the recession of the late 2000s • Consumer Financial Protection Bureau (CFPB) originally proposed in 2007 by then Harvard Law School professor, Elizabeth Warren • Proposed CFPB supported by Americans for Financial Reform* • *Umbrella of 250+ consumer, labor, and civil rights organizations

The Secondary Market: New lending regulations (continued) • September 17, 2010 President Obama appoints Warren as Assistant to the President and Special Advisor to the Secretary of the Treasury, to set up the new agency • CFPB formally began operation July 21,2011, with Richard Cordray appointed as the Director of the agency • October 3, 2015 • Parties applying for a new loan for purchase or refinance of a home now subject to new disclosures required by the CFPB • Consumer Disclosure Form replaces the Good Faith Estimate and Truth in Lending. • Impact on the Escrow Agent will be discussed in Chapter 7

Conventional Loans • Most common type of home financing • Common term is LTV (Loan to Value) • Percentage of loan to property value • Traditionally, the mortgage and banking industry considers 80% LTV to be secure • 20% equity (personal investment) makes it unlikely the borrower will not stop making payments or abandon the property • If a foreclosure were necessary, the property would likely sell for a price that would cover the loan balance and foreclosure expenses incurred by the lender

Conventional Loans: Processing and approval of the loan • Basic documentation required by an underwriter for loan approval may include the following, and is collected by the loan processor: • A loan application by the borrower • Credit report for all borrowers • Verification of employment • Verification of the source of down payment • Appraisal of the property

Conventional Loans: Processing and approval of the loan (cont.) • Loan processor submits the documentation to underwriter for approval • Underwriter will approve a borrower and determine the final loan amount by considering the following qualifications: • Character • Capacity • Capital • Collateral

Conventional Loans: Processing and approval of the loan (cont.) • Character: • Refers to a borrower’s projected willingness to make loan payments responsibly (on time) • The credit report is used by the underwriter to evaluate the borrower’s character • Good payment history is considered good character making the borrower a good credit risk

Conventional Loans: Processing and approval of the loan (cont.) • Capacity: • Borrower’s ability or means to make loan payments • Underwriter evaluates the borrower’s monthly income to debt ratios Example: An underwriter may not approve a loan if the loan payment is more than 30% of the borrower’s monthly income, and, when combined monthly debt us more than 38% of monthly income (loan payments, taxes, insurance child support are all considered)

Conventional Loans: Processing and approval of the loan (cont.) • Capital • Refers to the amount of down payment a borrower is willing to invest in the property at the time of purchase • The mortgage and banking industry has found a direct correlation between equity invested and probability of the borrower abandoning the property.

Conventional Loans: Processing and approval of the loan (cont.) • Collateral • Refers to the property the loan will be secured against • Lender relies on an appraisal to determine property value and to highlight any defects • i.e. no power or or water = no conventional financing • can the lender sell the house if foreclosure were necessary?

Upon loan approval… • The funder will prepare documents which are forwarded to the Escrow Agent • Borrower signs the documents • Signed loan documents are returned to the funder for review • Security documents are sent to title company to be held for recording

Closing loans for the purposes other than purchase • Conventional Loans are also given to borrower when they already own the property (Refinance) • Refinancing for better terms • Pulling out equity for home improvement of debt consolidation • RESPA (Real Estate Settlement Procedures Act) Reg Z provides that the borrower is entitled to additional disclosure time when borrowing against their principal residence • This is a “Notice of Right to Cancel” and is three business days from the date of signing.

Typical Conventional Loan Costs • Loan fees: • Range between 1 and 3.5 points (percentage of the loan amount) • Fee can be broken into Origination and Discount Fees • “Origination” fee refers to cost to obtain the loan • “Discount” fee refers to the cost for the borrower to buy down the interest rate

Typical Conventional Loan Costs (cont.) Example: Mr. Jones is applying for an $80,000 loan. ABC Bank quotes Mr. Jones a 7% interest rate for a total of 1 point (which is 1% or $800). Mr. Jones decides he would prefer to “buy the rate down” to 6.75%. Therefore, the loan will cost Mr. Jones a total of 2 points ($1,600), the loan origination fee, plus an additional 1% discount

Credit Report FeeAppraisal FeeTax Service Fee • Fees for these three items generally have a base rate this is considered a usual fee • These fees can increase depending on circumstances • Out of town purchases • Additional inspections, etc

Document Preparation FeeUnderwriting FeeProcessing Fee • These will vary depending on the lender • Sometimes included in the loan fee

First year hazard insurance premium • This can be paid directly to the insurance agent by the borrower if the borrower can provide evidence of payment to the lender • Usually paid through closing

Interim Interest on the New Loan • Calculated by multiplying the loan amount by the interest rate and dividing by 365 (or 360) to come up with a daily interest figure (per diem). • Interest is always paid in arrears (backwards) so interest is paid from the day of loan disbursement to 30 days prior to the first payment on the new loan

Interim Interest on the New Loan (cont.) Example: Susie is obtaining a loan for $100,000 at 8% interest. Loan disbursement will occur on August 28th with first payment due on October 1st Since interest is paid in arrears the October 1st loan payment will cover interest from September 1st to October 1st. Therefore, Susie owes interim interest on the new loan from August 28th to September 1st

Sellers need to be reminded that interest is paid in arrears • Sellers will typically owe interim interest on a loan payoff • If closing is August 28th and the seller’s next payment is due September 1, the seller will still owe interim interest on the loan from August 1st to the date the payoff funds are receiving by the underlying lender • This assumes all prior payments have been made

Reserve Accounts (aka Escrow Accounts or Impound Account) • Reserves are required by the lender in accordance with their lending policy • Reserves are for the purpose of establishing a separate account to accumulate funds to pay property taxes and/or home owner’s insurance when they come due each year • Some lenders only require property tax reserves • Others, like FHA and VA, require both property tax and home owner’s insurance reserves

Reserve Requirements • Tax Reserves • In Washington State, taxes are due April 30 and October 31 • Lender calculates how many months in advance deposit is required: • How many months payments will be made before the next tax payment is due • The subtracts 6 months • The difference is the number of months to be collected in advance • Its typical for a lender to collect 2 additional months of reserves at closing so there are sufficient funds in the account should taxes or insurance

Reserve Requirements (cont.) Example: Susie’s loan will close on August 28th. Her first payment on the new loan is due October 1st. Since second half taxes are due October 31st, Susie will have made one payment by the time taxes are due. The lender will collect at least 5 months of tax reserves at the time of closing. Most likely the lender will also collect an additional 2 months “buffer”, bringing the total to 7 months of tax reserves collected at closing

Hazard Insurance Reserves (aka Home Owners Insurance or Fire Insurance) • For a new home purchase the lender usually requires the first year be paid at closing plus 2 months. Example: Susie’s insurance premium is $400 per year. The first year premium is paid in full at closing and 2 months insurance reserve will be deposited into a reserve account to pay next year’s insurance premium in full when it comes due Therefore, the lender will collect a hazard insurance reserve deposit of $66.66 at closing

Reserve Analysis • RESPA’s “Regulation X” went into affect in 1995 • Lenders are now required to perform an aggregate account analysis on all reserve accounts monthly to ensure the are not over-collecting reserve deposits • The analysis ensures the lender is in compliance with the regulation, and not collecting too much or too little for taxes and/or insurance

Closing Insured Loans • Some borrowers do not have a 20% down payment, so other financial options are available to them, such as: • They may qualify for a Conventional Loan of they obtain Private Mortgage Insurance (PMI) • Secondary Financing • Government insured loan such as FHA or VA financing

Private Mortgage Insurance (PMI) • Protects the lender against loss if the borrower defaults on their loan • As a rule, the less capital a borrower puts down, the greater the risk of default • Therefore, the less capital a borrower puts down, the more expensive the PMI premium • In terms of reserves, if the borrower chooses to pay monthly the lender may require a year of PMI be paid at closing, or just 1 month • The difference between closing an insured loan (PMI) versus an uninsured loan (no PMI), is the borrowers need to be approved by the lender and the mortgage insurance company

FHA Insured Loans • The Federal Housing Administration (FHA) is a government agency within the Department of Housing and Urban Development (HUD) • Funded by Congress to enable home purchasers to acquire homes with small down payments • Through FHA, a qualified purchaser can pay as little as 3% down (subject to maximum loan restrictions) • The terms of the Purchase and Sale Agreement and the Lender’s Instructions to escrow will identify what loan costs are to be paid by the seller and buyer • Payoffs are calculated differently on an FHA loan • (instructor to describe)

Mortgage Insurance (MI) • Purchaser must pay for FHA mortgage insurance • FHA insurance guarantees the loan will be paid in full if the borrower should default on the loan • Except for condo units, the mortgage insurance premium for the life of the loan is paid at the time of closing • If the loan amount plus the mortgage insurance premium does not exceed the maximum amount allowed, the mortgage insurance premium can be financed

VA Guaranteed Loans • The Veteran’s Administration (VA) is a government department created for the purpose of providing benefits to veterans. • On a VA loan the purchaser can’t pay certain fees, such as: • Loans closing or settlement • Document preparation • Preparation of loan documents • Conveyance documents • Attorney’s services (except title work) • Photographs • Interest rate lock-in fee • Postage/Mailing • Membership fees • Escrow fee • Notary fee • Loan processing fee • Tax Service Fee

VA Guaranteed Loans (cont.) • In the case of a refinance, the lender will generally pay the escrow fee and the Escrow Agent will confirm that before closing a VA refinance • The VA Funding fee is mandatory and is based on the loan amount • Interest rate and discount pints can be negotiated among the buyer, seller and lender but cannot be added to the loan amount of VA Funding Fee • Seller may credit up to 4% of the purchase price for funding fee, discount points, down payment and prepaid cost, without adjustment of the down payment

VA Guaranteed Loans (cont.) • The VA program includes a guaranty for the down payment, so the Veteran can purchase property with no down payment on their principal residence all costs paid by the seller • This is called a “VA zero down” or “VA double zero” • VA zero down • Veteran still pays for insurance and prepaid closing costs • VA double zero down • Seller pays for everything including insurance and prepaid closing costs • The veteran can only have one VA loan at a time

Seller Financed Transactions • Financing for the buyer comes from the seller and not an institutional lender • The purchaser and seller may use a Real Estate Contract, a Note and Deed of Trust, or a Note and Mortgage to outline the terms of the loan and secure the financing

Real Estate Contract • A form of financing where the seller remains on title to the property until all or a certain part of the purchase price is paid by the purchaser • Often used when the down payment is very small • Once the purchaser has paid all sums owing under the contract, the seller records a Statutory Warranty Fulfillment Deed to transfer title into the name of the purchaser

Real Estate Financing: The Primary and Secondary Market