Financing Real Estate

Financing Real Estate - Intended Learning Outcomes

· Distinguish between a mortgage and a note and list the essential elements of each

· Describe Florida's statutory foreclosure process

· Understand mortgage priorities and the concept of subordination

· Understand the characteristics of a conventional mortgage and calculate a mortgage payment on a new loan using financial tables and/or a financial calculator

· Understand the provisions of FHA-insured mortgage loans and Veterans Affairs (VA) loans and calculate the maximum loan amount and required investment for an FHA residential mortgage loan

· Explain the calculation of the interest rate on an adjustable-rate mortgage (ARM) and describe the features of graduated payment, reduction option, early payment, 15-year and 3 percent down mortgages

· Understand the characteristics of the purchase money, participation, blanket, and package mortgages

· Describe the types of discrimination prohibited by the Equal Credit Opportunity Act (ECOA) and understand the provisions of the Truth-in-Lending Act and Regulation Z

· Calculate the minimum qualifying ratios for conventional and FHA mortgages and estimate the approximate yield to the lender based on the number of points charged

Mortgage Concepts and Practices

Promissory Note

There are two parts to a mortgage loan: a pledge (or promise to pay) and the collateral.

The promissory note is the promise to repay the debt. This is similar to an IOU and it is the primary evidence that there is a loan between the lender and the borrower. The promissory note defines the payment terms, including the interest rate, the date of repayment, prepayment penalties if any, purchase price, and penalty if there is a default.

The promissory note is the lender's personal property and it is a readily negotiable item. The note can be sold to another financing company either on the primary or secondary market. The note can be included in the financing process as either a separate document or included in the mortgage or deed of trust. The note makes the borrower personally liable for the loan.

Mortgage

Buying a home is one of the largest investments a family makes today. Most people are unable to pay cash; therefore, the need to borrow money is critical in making such a large purchase.

When a person borrows money to purchase a home, the lender will require him or her to sign a promissory NOTE which is a personal acknowledgment of the debt with a promise to repay the debt created. The promissory note contains all the loan details such as the principal debt, interest rate, amount of each periodic payment, and the number of periodic payments. Anyone who witnesses a promissory note is a “co-signor” and jointly liable for the debt, also. Therefore, promissory notes are not witnessed.

Although the lender has the borrower’s personal guarantee that payments will be made and the loan will be repaid, there are still many things that could happen which might lead to a default by the borrower. Sickness or a loss of employment could be disastrous. For this reason, most lenders will require some type of collateral to secure the loan.

A MORTGAGE is a security instrument that the borrower signs voluntarily to pledge the real property as collateral. The borrower is known as the MORTGAGOR, while the lender is known as the MORTGAGEE. The lender will record the mortgage in the public records, which gives constructive notice that there is a debt outstanding and the property has been pledged as security. Typically only the mortgage is recorded, not the promissory note.

Essential elements of a mortgage

The mortgage document typically contains the following items:

The promise to repay the debt by making payments according to the note
The promise to pay all taxes and keep the property insured
The promise to maintain the property in good repair and condition
A prepayment clause in a mortgage outlines the mortgagor's rights, if any, to repay some or all of the existing debt ahead of schedule. Most mortgages allow prepayment without any penalties required. There are some situations, however, in which lenders do not want the debt to be paid early and will insist on a prepayment penalty.

In Florida, if the mortgage does not contain a provision of the right to make prepayments (silent), the borrower has the right to prepay some or all of the principal debt in advance without penalty.

The ACCELERATION CLAUSE allows the mortgagee, upon default, to call the entire debt due and payable. Banks do not like to foreclose; however, in order to protect their position, foreclosure is a necessary remedy. The foreclosure process cannot begin unless the entire debt is delinquent. Once the acceleration of the entire debt has been demanded, the mortgagor has thirty days to pay the debt in full. If not, the borrower is considered to be in default of the entire debt and foreclosure can begin.

The Due-on-Sale Clause prevents owners from selling mortgaged property without the lender’s permission. This prevents unauthorized transfers of title to unqualified buyers

Mortgage theory
For many years, when a person borrowed money to buy a home, the lender required the borrower to relinquish title to the lender until the debt was repaid. This practice is followed in states that adhere to the TITLE THEORY of mortgages.

In most states (including Florida), the borrower keeps the title to the property while at the same time providing the lender with a mortgage (lien) to secure the debt. This practice is known as the LIEN THEORY of mortgages.

Mortgage Assumption
There are situations when buyers have the opportunity to assume an existing first mortgage. If this occurs, the lender will require the buyer to qualify for the assumption and sign a promissory note. The seller is still responsible for the debt unless the lender is willing to release them from liability. This is known as NOVATION. In some rare situations, the loan is non-qualifying to assume. The buyer will be taking title subject to the existing mortgage and is not required to sign a note. Sometimes commercial banks and life insurance companies provide an EXCULPATORY CLAUSE. The borrower signs a mortgage and note but is not responsible for a deficiency in the event of foreclosure.

Mortgage priorities
The general rule is that the time and date of recording a mortgage lien determines its priority in relationship to liens. Many lenders will not accept a junior position in lien priority but rather insist upon being the first lien of record. In some cases (usually seller financing), a mortgagee might agree to step down in priority in order to allow another mortgagee to take a higher position. This is known as subordination.

Example: Dave purchased a lot to build his house and got the seller to finance the purchase. Before the lender would approve the construction loan, the seller had to first allow the bank to take a superior position in lien priority.

Rights of Mortgage Lenders
Right to foreclose

If the borrower fails to meet the terms and conditions of the note, the mortgage provides that the lender may file suit to have the collateral sold at public auction to pay the outstanding debt in a process known as foreclosure. To avoid foreclosure, the mortgagor has to make timely principal and interest payments, timely pay the property taxes, and keep the property insured.

Foreclosure is a judicial process whereby the lender sues in court requesting a judgment to have the property sold by the courts to pay outstanding debt. As part of the preliminary legal steps, the lender's attorney will also file a Lis Pendens (litigation pending) which is public notice of the lawsuit. After a court determines that the mortgage lien is in default and how much money the lender is owed (including interest, court costs, and attorney fees), a date for the public auction is set, typically thirty days later. During that 30-day period, the lender must advertise the foreclosure sale in the legal notice section of a local newspaper.

From the commencement of the lawsuit through the foreclosure sale, the mortgagor has the right to redeem the collateral by paying the debt in full prior to the foreclosure sale. This is known as EQUITY OF REDEMPTION. At the public auction, however, the mortgagor’s rights in the property will be extinguished, and a new owner will take the title. Until the foreclosure auction is completed, the mortgagor still maintains the right to possess the subject property. If the foreclosure sale takes place, the clerk of court starts the auction with the first bid typically placed by the lender for the amount of money that is owed (including costs and fees). Anyone present at the auction may bid over that amount with the property being sold to the highest bidder. The proceeds from the auction sale are then used to pay all mortgages (and other liens) in their order of priority, unpaid property taxes always being paid first. If there is any money left over after satisfying the liens, the excess money is given to the mortgagor. If, however, the foreclosure auction does not generate enough money to pay the amounts owed, any creditor with a lien on the property has the right to obtain a deficiency judgment for that amount.

In a foreclosure, the lienholder foreclosing is paid (or receives title to the subject property) and any lien of lesser priority (known as a junior lienholder) is either paid, partially paid, or the lien is eliminated (if there are no remaining monies for disbursement). Any lien or interest in a superior position will not be eliminated; rather, the new owner will take title subject to the superior lien still attached to the property.

Rights of Mortgage Lenders
Right to transfer (assign) the mortgage

The assignor/buyer transfers any and all rights as a buyer under the subject purchase agreement to the assignee, usually in exchange for payment or other consideration given by the assignee to the assignor. As a result, the initial “buyer” is making its profit as of or prior to the closing of the sale rather than having to take ownership and resell the property to a new buyer. This practice is often referred to as “wholesaling” and is growing more and more prevalent, including in “short sale” transactions in which the existing mortgage holders agree to accept less than the full amount owed on the mortgage(s) and the seller does not receive any proceeds from the sale (other than those funds paid toward commissions, closing costs and the mortgage(s)).

Rights of Borrowers

Right of possession

The borrower has a right of possession that may not be taken away except by foreclosure.

Equity of redemption

In every state there is a specified time period of notice to the borrower. The lender determines the loan is in default and proper notice, such as notice in the legal paper of the county, is given, and notice to the borrower at the address is given. The borrower has a time period to make up any deficiencies.

Types of Mortgage Loans
Conventional Loans

Conventional loans are neither guaranteed nor insured by the federal government. Loans are made by local lenders through savings and loans, mortgage brokers, mortgage bankers, banks and credit unions.

A minimum down payment of 20% must be made for a conventional loan. Most loans are packaged by the lenders and sold in the secondary market to the Federal Home Loan Mortgage Corporation. Assumptions of these loans are rarely allowed; almost all of the loans contain an alienation clause. Prepayment clauses in the loans will depend on what type of loan is used: adjustable, fixed, etc. Nonconforming loans do not have to follow these criteria as they are not sold on the secondary market but are held by the local lender.

Conventional Insured Loans

Unlike the conventional loans listed above, these loans require less than 20% down payment, but they also require mortgage insurance, which protects the lender (not the home buyer!). PMI (Private Mortgage Insurance) is charged at the beginning of the loan and may be part of the monthly payment; so the payment becomes PITI. Borrowers will have to qualify for this payment, which includes the extra cost of the insurance payment. Mortgage insurance is purchased from a private company, not the federal government.

Typical payment of Conventional Insured:

Principal and interest payment $700

Taxes $150

Insurance $ 70

PMI $60

Total $980 per month

Assumption of conventional mortgages

The relationship between the supply and demand of lendable funds ultimately creates the price that the consumer pays to borrow. The interest rate on conventional mortgages is set by the market and is negotiated between the lender and the borrower. Most fixed-rate mortgages are non-assumable while adjustable-rate mortgages can be assumed with pre-determined qualification criteria. Typically, there are no prepayment penalties involved. Some adjustable-rate loans, however, have a lower-than-market starting rate (teaser rate) and will have a prepayment penalty required during the early stages of the loan.

Private Mortgage Insurance (PMI)

is insurance provided by a private insurer that protects the lender against loss in the event of a foreclosure and deficiency. Insurance is required for all loans with less than 20% down payment.

The amount a lender will loan is generally based on the appraised value for loan purposes or the sale price, whichever is lower.

Remember, whether an FHA, VA or conventional loan is made to a consumer, the lender and/or investor, all are concerned:

With the current and future value of the property.
With the income and income potential of the loan applicant.
With the attractiveness of other investments that could be made for a better return.
A lender or investor is really not interested or concerned with the loan applicant's need of financial assistance.

Governmental originated, insured or guaranteed mortgage loans
FHA Loans

The Federal Housing Administration (FHA) insures loans for lenders of real property made by qualified or approved lending institutions. The Department of Housing and Urban Development (HUD) oversees the FHA. If a buyer wants to obtain an FHA loan, a licensee should send him or her to a qualified lender, such as a savings & loan or a mortgage broker.

The borrower is charged a one-time insurance premium by the lender, which provides security to the lender in addition to the real estate in case of borrower default. The one-time charge is paid at closing by the borrower or some other party (seller). The insurance is called MIP or Mortgage Insurance Policy.

The lender can charge points, and either the borrower or the seller or both can pay them. Each point is 1% of the loan amount. Lenders charge points to increase the yield on the loan.

No prepayment penalties are allowed on FHA loans.

Loans are assumable under certain qualifying conditions depending upon when the original loan was obtained. The mortgaged real estate must be appraised by an approved FHA appraiser.

FHA regulations set minimum standards for the type and construction of buildings and credit-worthiness of borrowers. FHA does NOT build homes nor does it lend money itself. The term "FHA Loan" refers to a loan that is insured by the Federal Housing Administration.

The ratios that FHA uses are different than that of conventional lenders. FHA uses a Housing Expense Ratio (HER) to determine if a buyer is qualified for the loan. The gross monthly income times 29% is for the housing payment and 41% is for all obligations. Because this is a federal program, the ratios, rules and interest rates change often. The real estate professional is advised to check with local lenders on the ratios and the maximum sale price.

Because these are government-insured loans, the FHA programs and rules change frequently. The real estate professional should check with local lenders about current programs, rules, ratios and interest rates.

Governmental originated, insured or guaranteed mortgage loans
Some commonly used programs are:

Section 203 (b) is a fixed rate program. It is the most widely used of all FHA programs. It requires a minimum down payment and closing costs.

234 (c) - For loans on condominiums

245 - Graduated Payment Plan Mortgage

203K - Allows the purchaser to borrow enough money to rehabilitate a property.

FHA also has 251 - An adjustable Rate Mortgage Program (ARM).

Veterans Administration (VA) loan
The Veterans Administration (VA) will guarantee that a loan made by an approved lending institution will be paid. The following are requirements to receive a VA loan:

The veteran must have served 181 days of active service in the military since 1940.
A veteran's basic entitlement is $36,000 (or up to $60,000 for certain loans over $144,000). Lenders will generally lend up to 4 times the available entitlement without requiring a down payment, provided the veteran's income and credit qualify and the property appraises for the asking price. There will be a VA funding fee charged for the origination of the loan.
There is no maximum VA loan, but lenders will generally limit VA loans to $240,000. This is because lenders sell VA loans in the secondary market, which currently places a $240,000 limit on the loans. For loans up to $240,000, it is usually possible for qualified veterans to obtain no down payment financing. (These numbers change from time to time.)
VA will guarantee real property, mobile homes and plots for the mobile home.
The VA requires that a veteran assumes liability for the loan. If a veteran does not pay the mortgage as agreed there will be a foreclosure.
The property must be owner-occupied for at least one year.
A qualified veteran may borrow up to 100% of the loan with no down payment.
The veteran must first apply for a Certificate of Eligibility in order to obtain a VA loan.
The house must qualify with an appraisal and be issued a Certificate of Reasonable Value.
The amount of the loan is limited to the amount shown on the Certificate of Reasonable Value.
Loans may be assumed by non-veterans, but the veteran is still liable.
VA will lend money in rural areas where there is no financial institution available.
Points can be paid by either the seller or the buyer.
VA does not allow prepayment penalties to be charged if a veteran pays off a loan early.
If a veteran has died, his/her widow or widower may be eligible for a VA loan. In order to be eligible for a VA loan, the widow or widower may not be married again at the time of application.
If a loan is assumed by another veteran and the seller has used all of his/her eligibility, the seller cannot use his/her eligibility again, unless he is given a novation* because he/she will still be liable for the loan.
FHA and VA will allow the buyer to pay more than appraised value, if the buyer pays the difference in cash.

* Novation - a term used in contract law and business law to describe the act of either replacing an obligation to perform with a new obligation, or replacing a party to an agreement with a new party.

Rural Housing Services Administration Loans

Section 502 loans are primarily used to help low-income individuals or households purchase homes in rural areas. Funds can be used to build, repair, renovate or relocate a home, or to purchase and prepare sites, including providing water and sewage facilities.

Eligibility: Applicants for loans may have an income of up to 115% of the median income for the area. Area income limits for this program apply. For example, the median income for a family of four in the Jacksonville metro area is $69,350, with low income being $48,250. Families must be without adequate housing, but be able to afford the mortgage payments, including taxes and insurance. In addition, applicants must have reasonable credit histories.

Approved lenders under the Single Family Housing Guaranteed Loan program include:

Any State housing agency;

Lenders approved by:

HUD for submission of applications for Federal Housing Mortgage Insurance or as an issuer of Government National Mortgage Association (Ginnie Mae or GNMA) mortgage-backed securities;

The U.S. Veterans Administration as a qualified mortgagee;

Fannie Mae for participation in family mortgage loans;

Freddie Mac for participation in family mortgage loans;

Any FCS (Farm Credit System) institution with direct lending authority;

Any lender participating in other USDA Rural Development and/or Farm Service Agency guaranteed loan programs.

Terms: Loans are for 30 years. The promissory note interest rate is set by the lender.

Mortgages by the method of payment

Fully Amortized:

Full amortization is a systematic payment method that retires the principal loan amount at the end of a specified period. The mortgage payment remains constant; however, the principal and interest change each payment (LEVEL PAYMENT PLAN). The interest portion of the payment is based upon the principal balance of the loan. As the principal balance gets smaller, the corresponding interest payment gets smaller. Over the life of the loan, the interest part of the payment gets smaller while the principal part of the payment gets larger.

There are several mortgage loan terms that are available. The most common is the thirty-year term. The monthly payments are lower with more interest paid over the life of the loan. The fifteen-year mortgage has a larger monthly payment but builds equity faster and pays less interest over the life of the loan.

Partial Amortization:

A PARTIALLY AMORTIZED MORTGAGE is one in which principal and interest are made, but not enough is paid by the end of the loan term to pay the loan amount in full. A partially amortized mortgage usually requires a BALLOON PAYMENT for the unpaid balance.

Mortgages by payment or yield variability
Adjustable Rate Mortgage:

An ADJUSTABLE RATE MORTGAGE (ARM) is one in which the monthly payments may change on a periodic basis based on a pre-determined INDEX. The adjustable rate mortgage is made up of the index and the margin. The index is set by a monitory policy such as the one-year T-Bill or the Cost of Funds Index published by the Federal Reserve Board. Once the index is set, it is beyond the control of either the mortgagee or the mortgagor. MARGIN is simply profit. Although the index may adjust up or down depending on the movement of a market, the margin is fixed and remains constant throughout the life of the loan. The index plus the margin equals the loan’s calculated interest rate.

The adjustable rate mortgage is designed to ease market risk in that, as interest rates go up, the adjustable rate goes up. As interest rates go down, the adjustable rate goes down. The adjustments have caps. The most common is the 2/6 cap. That is to say, the adjustments cannot go up more than 2% each year with a 6% adjustment increase over the life of the loan (LIFETIME CAP). If the payment caps are less than the index, the result could be a NEGATIVE AMORTIZATION(instead of reducing the principal balance of a loan, the loan balance actually gets larger).

A TEASER RATE is a below-market interest rate offered by the lender to sell the loan. There is normally a pre-payment penalty during the first year or two because of the below-market rate. Most homebuyers keep a home for an average of seven years, and the lender is able to make up the deficit over that time.

Mortgages by payment or yield variability
Graduated Payment Mortgage:

In a graduate payment mortgage, the payments are at a lower amount compared to a standard mortgage. Eventually, the payments rise periodically to an amount greater than the payments in a standard mortgage. Typically, in the early years of a Graduate Payment Mortgage, interest accrues at a higher rate than the amount actually paid (negative amortization). The interest deficit amount is added to the principal debt. GPM’s are attractive to borrowers who believe their income will rise significantly in the future.

Reduction Option Mortgage:

In a Reduction Option Mortgage, the borrower and lender agree to refinancing terms in advance. Usually between 1 and 5 years, the borrower has the option to receive the prevailing interest rate available at the time of refinancing. This type of mortgage is advantageous when interest rates are expected to decline in the near future.

Early Payment Mortgage:

This type of mortgage provides the borrower with an opportunity to pay principal payments in advance which will reduce the loan’s payback term.

15-year Mortgage: With a 15-year mortgage, the borrower saves money by paying less interest over the lifetime of the loan, typically receiving a lower interest rate than a 30-year loan but the monthly payments are larger.

Buydown: This program allows a buyer to pay additional discount points in exchange for receiving a lower interest rate on a mortgage.

Other Techniques Used in Financing Real Estate
Besides traditional financing, other alternatives exist for buyers who need to borrow money to purchase real estate:

Time-Sharing

A hybrid form of ownership. A time share is the right to occupy a unit of real estate property, such as a condominium or vacation home, during a specified number of separate time periods. Each time period is for a certain duration, such as one or two weeks. Time-sharing allows multiple purchasers to buy interests in the same real estate. Time-sharing is a popular form of real estate ownership where a single property is jointly owned by individuals who agree to use the property at different times. Frequently, time-sharing occurs at resorts or in popular vacation destinations, such as ocean-front properties, where the outright cost of ownership would be cost-prohibitive. Chapter 721, F.S shall be known and may be cited as the “Florida Vacation Plan and Timesharing Act.

This chapter applies to all timeshare plans consisting of more than seven timeshare periods over a period of at least 3 years in which the accommodations and facilities, if any, are located within this state or offered within this state. The purposes of this chapter are to:

• Give statutory recognition to real property timeshare plans and personal property timeshare plans in this state.
• Establish procedures for the creation, sale, exchange, promotion, and operation of timeshare plans.
• Provide full and fair disclosure to the purchasers and prospective purchasers of timeshare plans.
• Require every timeshare plan offered for sale or created and existing in this state to be subjected to the provisions of this chapter.
• Require full and fair disclosure of terms, conditions, and services by resale service providers acting on behalf of consumer timeshare resellers or on behalf of prospective consumer resale purchasers, regardless of the business model employed by the resale service provider.

Recognize that the tourism industry in this state is a vital part of the state’s economy; that the sale, promotion, and use of timeshare plans is an emerging, dynamic segment of the tourism industry; that this segment of the tourism industry continues to grow, both in volume of sales and in complexity and variety of product structure; and that a uniform and consistent method of regulation is necessary in order to safeguard Florida’s tourism industry and the state’s economic well-being.

In order to protect the quality of Florida timeshare plans and the consumers who purchase them, it is the intent of the Legislature that this chapter be interpreted broadly in order to encompass all forms of timeshare plans with a duration of at least 3 years that are created with respect to accommodations and facilities that are located in the state or that are offered for sale in the state as provided herein, including, but not limited to, condominiums, cooperatives, undivided interest campgrounds, cruise ships, vessels, houseboats, and recreational vehicles and other motor vehicles, and including vacation clubs, multisite vacation plans, and multiyear vacation and lodging certificates.

Each seller shall utilize and furnish each purchaser a fully completed and executed copy of a contract pertaining to the sale, which contract shall include the following information:

A purchaser has the right to cancel the contract until midnight of the 10th calendar day following whichever of the following days occurs later the execution date; or the day on which the purchaser received the last of all documents required to be provided to him or her, including the notice required by s. 721.07(2)(d)2., if applicable:

You may cancel this contract without any penalty or obligation within 10 days after the date you sign this contract. If you decide to cancel this contract, you must notify the seller in writing of your intent to cancel. Your notice of cancellation shall be effective upon the date sent and shall be sent to the seller at (address) . Any attempt to obtain a waiver of your cancellation right is void and of no effect. While you may execute all closing documents in advance, the closing, as evidenced by delivery of the deed or other document, before expiration of your 10-day cancellation period, is prohibited.

The purchase of a time-share period should be based on its value as a vacation experience or as a place to spend leisure time and should not be considered for the purpose of acquiring an appreciating investment or with an expectation that you will resell the time-share period.

Contract for Deed
Also known as a land contract is the sale of property with seller financing that has a slight twist at closing. At closing, the seller retains legal title with a promise to transfer legal title to the buyer at a later date. The buyer is said to receive equitable title which is an interest in real estate with the expectation of future title.

Some contracts for deeds are prohibited from being recorded, making it easier for a seller to take the property back in the event of default. Buyers are in a vulnerable position because title remains in the seller's name and is subject to liens incurred by the seller.

Sale and Leaseback
A Sale and Leaseback arrangement involves two simultaneous transactions: the sale of real property coupled with a lease agreement whereby the seller becomes the rental tenant after the closing. By selling the real property followed by renting the location, businesses can improve their financial position by using the sale assets to reduce the companies’ debts.

Federal Consumer Protection Legislation
Equal Credit Opportunity Act:

The Equal Credit Opportunity Act was created in 1974 to prohibit discrimination by lenders based upon race, religion, age, sex, marital status, national origin, or receipt of money from public assistance programs.

Consumer Credit Protection Act (Truth in Lending Act)
The Truth in Lending Act was created to provide disclosure to borrowers of the cost of borrowing. The cost of borrowing includes the interest rate charged plus other costs involved in borrowing. These costs are expressed as a percentage and are known as the Annual Percentage Rate (APR). The Consumer Credit Protection Act applies to all federally related residential loans. This disclosure must be made within three business days from application.

The Truth in Lending Act also provides that if a lender advertises any detail of a loan, such as interest rate, the lender is required to disclose the annual percentage rate. This is designed to prevent “bait and switch” tactics that a lender may employ in an effort to entice new borrowers.

The Truth in Lending Act is implemented by the Federal Reserve Regulation “Z." This law governs consumer loans (residential property) made by institutional lenders.

Real Estate Settlement Procedures Act (RESPA)
RESPA was created primarily to provide disclosure to borrowers of closing costs that might be incurred while buying a home. Lenders are required to provide applicants:

1. An information booklet on borrowing within three business days of application

2. A good-faith estimate of closing costs within three business days of application

3. A uniform settlement statement (HUD-1) no later than closing. If the borrower wishes to review the settlement statement prior to closing, the lender/closing agent must provide at least one day for such a review.

RESPA prohibits lenders from receiving referrals or kickbacks from closing-related businesses unless an actual service was provided. The Real Estate Settlement Procedures Act applies to all federally related residential loans.

Residential Loan Underwriting
Initial Interview and Loan Application

Whenever a person is required to obtain a loan to purchase property, the lender will want to qualify both the borrower and the property. Most lenders use an application form which allows general information to be obtained about the borrower’s ability to repay a loan as well as his or her willingness in the past to repay. The Uniform Residential Loan Application (FNMA form 1003) is the most common; however, modern technology allows “on-line” processing and approval with ease and speed.

Borrower analysis
1. Credit History: A borrower’s credit rating (or credit score) is an indication of the borrower’s willingness and attitude about paying debts timely. Amounts previously borrowed and the repayment history is the primary factors in determining an applicant’s credit score.

2. Assets and Liabilities: Lenders want an understanding of a borrower’s net worth which is calculated by subtracting assets from liabilities. By definition, an asset is something of value while a liability is something that is owed.

3. Quality of Income: Not only are borrowers interested in the amount of a borrower’s income, but the lender also wants to know the likelihood that the income will continue in the future. Length of employment (including self-employment), whether the income was salary, bonuses, or both, and the likelihood of continued employment affect the lender's attitude toward the borrower’s quality of income.

4. Expense Ratios: Conventional lenders use qualifying guidelines to assist in determining if a borrower qualifies. The Housing Expense Ratio (PITI divided by monthly gross income) should not be more than 28%. The Total Obligation Ratio (PITI + other debt divided by monthly gross income) should not be more than 36%. These are only guidelines, and lenders have latitude, depending on credit scores. The credit score becomes critical because this single item reflects the borrower’s willingness in the past to repay a debt. Past payment patterns usually don’t change; therefore, poor payment patterns will probably continue.

The FHA insurance has established qualifying ratios that allow the borrower easier access to financing. The housing expense ratio (PITI divided by monthly gross income) cannot exceed 31% while the borrower’s total obligations (PITI + other payments divided by monthly gross income) cannot exceed 43%.

The qualifying ratio for a VA loan requires the borrower's total obligations ratio not to exceed 41%. There is no housing expense ratio for VA guaranteed loans.

Property Analysis
The lender will require an appraisal to be performed by a state certified appraiser. The appraiser’s job is to verify the value of the collateral offered for the loan

Loan Analysis

Loan to Value Ratio: The LOAN TO VALUE RATIO is the percentage of the loan (mortgage) as it relates to the value of the property. The definition of value is either the contract price or the appraised value, whichever is less. Most loans to value ratios for residential mortgages range from 70% to 100%, depending on the borrower’s ability (income) and willingness (credit) to repay.

Most mortgage lenders require the borrower to invest some of his or her own money before qualifying for financing. A borrower’s down payment is known as EQUITY. Equity is the difference between the purchase price and the loan amount.

Interest rate and discount points
Discount Points are pre-paid interest charged by the lender at the time of closing to receive a lower interest rate; a discount point is equal to 1% of the loan amount. Buyers and sellers frequently pay discount or loan origination points to obtain the loan.

When discount points are paid, the lender gives the borrower the loan amount minus the discount points, but the full loan amount must be repaid. Discount points are paid to the lender to lower the interest rate, where each discount point on a 30-year loan will typically lower the interest rate by 0.125%. However, it may not make sense to pay discount points for a loan of shorter duration or if the buyer intends to sell within a few years. Naturally, it would make sense to compare the cost of the discount points with a higher interest rate over the expected term of the loan. Sometimes, the seller will pay the points in exchange for a higher selling price.

Loan term
With a 15-year mortgage, the borrower saves money by paying less interest over the lifetime of the loan typically receiving a lower interest rate than a 30-year loan, but the monthly payments are larger.

Availability of mortgage insurance
Private Mortgage Insurance (PMI) is insurance provided by a private insurer that protects the lender against loss in the event of a foreclosure and deficiency. Insurance is required for all loans with less than 20% down payment. The amount a lender will loan is generally based on the appraised value for loan purposes or the sale price, whichever is lower. The FHA insurance has established qualifying ratios that allow the borrower easier access to financing. The housing expense ratio (PITI divided by monthly gross income) cannot exceed 31% while the borrower’s total obligations (PITI + other payments divided by monthly gross income) cannot exceed 43%.

FHA insurance is committed to providing quality housing. In that regard, the lending standards of FHA are generally higher than that of conventional lending standards. The FHA will not insure loans on obsolete homes or on properties poorly located with respect to vital community services and adequate transportation. The appraisal that is done for FHA insured loans has strict guidelines that insure these standards. Prior to December 1, 1986, all FHA loans could be assumed without qualification. Today all FHA loans require the same qualifications of the buyer who is assuming the mortgage as they would of a new borrower. In addition, FHA assumptions do not allow prepayment penalties.

Loan fees and calculations
The cost to finance a loan is flexible depending on which loan product the buyer chooses. There may be points involved or not, depending on the market and the buyer's choices. Many lenders offer either an online loan quote or a quote by phone that the sales associate can use to write the contract. Once a contract is written, the costs to finance the loan will be shown in the good faith estimate. The buyer will have a good idea at that time of the amount of cash that will be required at closing.

Underwriting decision and loan commitment
Firm Commitment: This is a commitment without contingencies from a lender to fund a loan.

Conditional Commitment: This is a commitment from a lender to fund a loan, but the commitment is contingent upon certain matters that must be fulfilled (e.g. verification of the applicant’s tax returns).

Automated underwriting
Most loan underwriting is done through a sophisticated process of computer-generated information that analyzes and provides data sufficient to determine if a person is qualified for a loan. The Federal National Mortgage Association’s “Desktop Underwriting” is the most popular program used by lenders. If this computer program approves the loan applicant, then FNMA has agreed to purchase the note and mortgage at the time of, or after, the closing.

SUMMARY

A promissory note is evidence of the debt and primarily states the amount of the loan, the interest rate, the amount of each periodic payment, and the number of periodic payments. The mortgage pledges the real property as collateral to secure repayment of the promissory note. The essential elements of the mortgage include the promise to pay the note, to keep the premises insured, and to maintain the premises in good condition.

Foreclosure is a judicial process in which the collateral is sold at public auction with the proceeds being disbursed to satisfy debts and liens against the property. If there are not enough funds to pay all liens, those unpaid lienholders receive a deficiency judgment. Property owners can exercise their rights of redemption and end the foreclosures before the auction by paying the mortgage holders all monies that are owed, including interest, attorney’s fees, and costs.

Most mortgages establish their priority position based upon the date of recording. If a mortgage contains a subordination clause, however, a mortgage recorded later in time can obtain a higher priority position, even though it was chronologically recorded at a later date.
Conventional mortgages do not involve any governmental agency programs of assured repayment. If a borrower has a loan to value ratio greater than 80%, the conventional lender requires the borrower to obtain private mortgage insurance (PMI) to protect the lender in the event of a deficiency judgment after a foreclosure auction.

A purchase money mortgage involves seller financing in which a seller will hold a mortgage for all or part of the purchase price instead of receiving the full purchase price proceeds. In a participation mortgage, the lender receives mortgage loan interest plus a portion of the profits generated by a business venture. A blanket mortgage is a loan secured by more than one item of real property. A package mortgage accepts both real and personal property as security (collateral) for a loan.

Under the Equal Credit Opportunity Act, lenders are prohibited from discriminating based on race, religion, color, sex, age, national origin, prior receipt of public assistance, or occupation. Under the Consumer Credit Protection Act (also known as Truth in Lending Act), lenders are required to disclose the true cost of borrowing, including interest rate, points, and other lender charges. Under the Real Estate Settlement Procedures Act (RESPA), lenders must provide loan applicants with a pamphlet and a good faith estimate of closing costs, and use the standardized HUD-1 settlement statement.

To qualify for a conventional loan, an applicant must have a housing expense ratio that does not exceed 28% and a total obligation ratio that does not exceed 36%. To qualify for an FHA loan, an applicant must have a housing expense ratio that does not exceed 31% and a total obligation ratio that does not exceed 43%. To qualify for a VA loan, the applicant must have a total obligation ratio that does not exceed 41%
Every point charged to a borrower adds one-eighth of a percent to the lender’s yield (APR).

Vocabulary List: buy down, conforming loan, contract for deed, discount points, Florida Real Estate Time-Share Act, fully amortized mortgage, home equity loan, lien theory, nonconforming loan, partially amortized mortgage, reverse annuity mortgage, sale and leaseback financing, a secured note, term mortgage, title theory, unsecured note, yield