Washington Real Estate Fundamentals Lesson 11: Applying for a Residential Loan © 2011 Rockwell...

Washington Real Estate Fundamentals

Lesson 11:

Applying for a Residential Loan

© 2011 Rockwell Publishing

Applying for a Residential Loan

This lesson will cover five main topics:Choosing a lenderLoan application processBasic loan featuresResidential financing programsPredatory lending


Choosing a LenderTypes of lenders

Major sources of residential financing:Commercial banksThrift institutionsCredit unionsMortgage companies

Many of the original distinctions between these types of lenders have been lost.


Types of LendersCommercial banks

Commercial banks are either national banks (federally chartered) or state banks (state-chartered).

Traditionally:accepted only short-term (demand) depositsmade primarily short-term business loans

Later diversified their business, and now have significant share of residential mortgage market.


Types of LendersThrift institutions

Savings and loans and savings banks are grouped together as thrifts.

Have either federal or state charter.Emphasize home purchase loans.

Once dominated mortgage market.No longer dominant, because of

greater involvement of commercial banks and mortgage companies.


Types of LendersCredit unions

Credit unions often serve only members of a particular group.

Examples: members of union or other association, employees of large company.

Traditionally specialized in small personal loans.

Now also make home loans (home equity and home purchase loans).


Types of LendersMortgage companies

Unlike other lenders, mortgage companies aren’t depository institutions.

Therefore can’t use depositors’ funds to make loans.

Instead, mortgage companies:act as loan correspondents, and/orengage in warehousing.



Loan correspondent: Local intermediary between large investors and home buyers.Makes and services home loans on behalf of

insurance companies, pension funds.

Warehousing: Borrowing from banks on short-term basis, using funds to originate loans to buyers.Loans then sold on secondary market, not

kept in portfolio.© 2011 Rockwell Publishing


Mortgage companies are sometimes called mortgage bankers. Traditional distinction:

Mortgage banker: Lender that originates and services loans.

Mortgage broker: Not a lender; only negotiates or arranges loans.

Distinction no longer clear-cut. Mortgage company may play either role.



Number of mortgage companies increased sharply in 1990s.

Companies played major role in subprime lending boom.

Subprime foreclosures have affected them more than other types of lenders.


Types of LendersSeller financing

In addition to institutional lenders, private sources of residential financing. Most important is seller financing.

Seller financing: When property seller extends credit to buyer.

Seller financing especially important when:institutional loans scarcemarket interest rates high


Types of LendersSeller financing

Buyer makes downpayment and gives seller mortgage, deed of trust, or land contract for rest of price.

Alternatively, seller may provide secondary financing:Buyer finances most of purchase price

through institutional lender, finances rest through seller.


SummaryTypes of Lenders

• Commercial bank• Thrift institution• Credit union• Mortgage company• Loan correspondent• Warehousing• Mortgage banker• Mortgage broker• Seller financing


Choosing a LenderLoan costs

For most buyers, cost of loan is primary consideration when choosing a lender.

Loan costs include:interest chargesorigination feesdiscount pointsmiscellaneous other charges, such as

document preparation fees


Loan CostsOrigination fees

Loan origination: Processing loan applications and making loans.

Origination fee: Charge to cover lender’s administrative costs in making loan. Also called loan fee.

Percentage of loan amount (1% to 3%).Charged for almost every institutional loan.Paid by buyer unless otherwise agreed.


Loan CostsPoints

Origination fee may be grouped together with discount points under general term points.

One point = 1% of loan amountExample:

On $200,000 loan, one point = $2,000When someone quotes points for a loan,

clarify whether both origination fee and discount points included, or just discount points.


Loan CostsDiscount points

Discount points: Fee paid to lender at closing to increase lender’s upfront yield (profit) on loan.

Percentage of loan amount.Generally, the more discount points paid,

the lower the buyer’s interest rate will be.

Buydown: Seller agrees to pay discount points to lower buyer’s interest rate, make loan more affordable.


Loan CostsTruth in Lending Act

Truth in Lending Act (TILA): Federal consumer protection law that requires lenders to disclose full cost of obtaining a loan to borrowers.

Helps borrowers compare loans offered by competing lenders.

Implemented through Fed’s Regulation Z.


Truth in Lending ActConsumer loans

TILA applies to consumer loans.

Consumer loan: Loan used for personal, family, or household purposes that:

has more than four installments or is subject to finance charges, and

is for $51,800 or less, or is secured by real property.


Truth in Lending ActExemptions

TILA does NOT apply to:loans made to corporations or

organizationsloans made for business, commercial, or

agricultural purposesloans over maximum amount, unless

secured by real propertyseller-financed transactions


Truth in Lending ActDisclosure requirements

If loan covered by TILA, lender must disclose detailed information about loan costs.

Includes two key disclosures:total finance chargeannual percentage rate (APR)


TILA Disclosure RequirementsTotal finance charge

Total finance charge: Sum of all loan-related charges borrower will have to pay, including:

interestorigination feediscount points (if paid by borrower)finder’s feemortgage broker’s feeservice feesmortgage insurance premiums


TILA Disclosure RequirementsTotal finance charge

In real estate loan transaction, these costs are NOT included in total finance charge:

appraisal feecredit report feeinspection feestitle feescosts paid by someone other than

borrower (such as points paid by seller)


TILA Disclosure RequirementsAnnual percentage rate

Annual percentage rate (APR): Total cost of loan expressed as annual percentage of loan amount. Also called effective interest rate.

Comparing APRs shows relative cost of loans more accurately than comparing nominal interest rates.Nominal rate: Interest rate stated in

promissory note.


TILA Disclosure RequirementsOther disclosures

In addition to total finance charge and APR, lender must disclose:

amount financedtotal of all paymentsnumber of paymentspayment amount(s)any prepayment penalty


TILA Disclosure RequirementsTiming of disclosures

For loan secured by borrower’s dwelling, disclosure statement with estimated costs:

delivered or sent within 3 days after loan application

received at least 7 business days before closing

Lender may not charge any fees before borrower receives disclosure statement.

Exception: Credit report fee© 2011 Rockwell Publishing

TILA Disclosure RequirementsTiming of disclosures: amendments

If significant changes to original estimates: Lender must give borrower amended

disclosures at least 3 business days before closing.


Truth in Lending ActRight of rescission

For loan secured by existing principal residence, borrower may rescind loan agreement within 3 days after:

signing agreementreceiving disclosure statementreceiving notice of right to rescind

(whichever comes latest)

If notice or disclosure statement never given, right of rescission lasts for 3 years.


Truth in Lending ActRight of rescission

Right of rescission generally applies only to:home equity loanrefinancing with new lender

Does not apply to:home purchase loanconstruction loanrefinancing with same lender, unless

lender advancing additional funds


Truth in Lending ActAdvertising rules

TILA also has rules concerning advertising.Apply not just to lenders, but to anyone

who advertises consumer credit.Example: Real estate agent

advertising financing terms for listed home.



Ad can always state cash price or APR.If APR stated, interest rate also OK.

But other specific information triggers full disclosure requirement.

Triggering terms:downpayment amount or percentageloan term or number of paymentsamount of any paymentamount of any finance charge



If ad states triggering term, then it must also include:

APRany required downpaymentrepayment schedule, with number, timing,

and amount of payments

General statements (“easy terms”) do not trigger full disclosure requirement.


Loan CostsLocking in the interest rate

Borrower may ask lender to lock in quoted interest rate for certain period.

Otherwise lender can change rate at any time until transaction closes.If rate increases, borrower might no

longer qualify for loan.Lender usually charges lock-in fee.

Applied to borrower’s closing costs if transaction closes.


SummaryChoosing a Lender: Loan Costs

• Origination fee• Discount points• Truth in Lending Act• Regulation Z• Total finance charge• Annual percentage rate• Right of rescission• Advertising requirements• Locking in interest rate


Applying for a Residential LoanLoan application process

After comparing loan costs and choosing lender, buyer fills out loan application.

Traditionally, buyers would find house first and then apply for loan.

Now getting preapproved (before house-hunting) is standard practice.Lender approves buyer for up to

specified maximum loan amount.


Loan Application ProcessRequired information

Fannie Mae/Freddie Mac residential loan application requires buyer to provide:

personal information (age, education, etc.)current monthly housing expenseemployment informationincome from various sourcesassets and liabilities

Lender verifies information provided.


Loan Application ProcessUnderwriting

Loan underwriting: Evaluating application to decide if loan should be approved.

Underwriter applies qualifying standards to assess whether loan is acceptable investment risk.Lender may apply own standards.But most lenders use standards set by

Fannie Mae or Freddie Mac (or FHA or VA, for those loans).


UnderwritingQualifying the buyer

Underwriters focus on three main considerations to qualify buyer:

Credit historyIncomeNet worth


Qualifying the Buyer Credit history

Underwriter evaluates applicant’s credit history based on credit reports and credit scores from reporting agencies.

Late payments on debtsBankruptcyForeclosure

Applicant should explain any extenuating circumstances (such as divorce) to lender.


Qualifying the BuyerIncome

Underwriter checks whether applicant has enough stable monthly income to make payments on proposed loan.

Considers quality and durability of income as well as quantity.Quality – dependability of source

Established company vs. new oneDurability – how long it’s expected to last

Permanent job vs. temporary job


Qualifying the Buyer Income

Underwriter uses income ratios to determine if applicant’s stable monthly income is enough.

Two main types of ratios:housing expense to income ratiodebt to income ratio

Housing expense includes principal, interest, taxes, and insurance (PITI).


Qualifying the Buyer Net worth

Net worth: Total assets minus total liabilities.

Evidence of financial management skills.

Applicant also needs enough cash for:downpaymentclosing costs

May be required to have cash reserves sufficient to meet mortgage payments for several months.


Underwriting Qualifying the property

Underwriter also evaluates property that applicant plans to buy.

Is it worth enough to provide adequate collateral for loan amount?Otherwise, foreclosure could result in

financial loss for lender.

Underwriter relies on appraisal report for estimate of property’s value.


Underwriting Automated underwriting

Automated underwriting (AU): Computer program performs preliminary analysis of loan application and makes recommendation for or against approval.

Human underwriter evaluates AU recommendation.

AU analysis based on performance statistics from millions of loans.


Underwriting Subprime lending

Subprime lending: Making riskier loans than standard lenders, including loans to buyers who:

have poor creditcan’t or don’t want to meet

documentation requirementswant to buy nonstandard properties

More flexible underwriting standards.Higher interest rates and fees.


Underwriting Subprime lending

Subprime boom enabled many to buy homes who otherwise could not have.

But many loans turned out to be bad risks, causing foreclosure crisis.

Subprime lending now much less common.Recent federal and state legislation

intended to curb abuses.


Underwriting Mortgage fraud

Examples of mortgage fraud:loan applicants lying about employment,

assets, or liabilitiesinvestors falsely claiming to be buying

property as principal residencelenders overstating quality of loans when

selling them to secondary market


Underwriting Mortgage fraud

Recent laws aimed at mortgage fraud:Fraud Enforcement and Recovery Act

(federal)Mortgage Lending and Homeownership

statute (Washington)

Both laws provide significant jail time and fines for violation.


SummaryLoan Application Process

• Preapproval• Underwriting• Qualifying standards• Credit reports and credit scores• Stable monthly income• Income ratios• Net worth• Cash reserves• Automated underwriting• Subprime lending


Applying for a Residential LoanBasic loan features

Basic features of mortgage loan include:loan termamortizationloan-to-value ratiosecondary financingfixed or adjustable interest rate


Basic Loan FeaturesLoan term

Loan term: Period of time borrower has for repaying loan. Also called repayment period.

The longer the loan term:the lower the monthly paymentthe more interest paid over life of loan



30-year term:standard term for home purchase loanlow monthly payment

15-year term:larger monthly paymentlower interest rateloan paid off in half the timemuch less interest paid overall



Larger payment for 15-year loan generally means buyer can’t buy nearly as expensive a home as 30-year loan would allow.

Buyer may consider 20-year loan instead, as compromise.

Some programs allow 40-year term, to maximize purchasing power.


Basic Loan FeaturesAmortization

Amortized loan: Installment payments include both principal and interest.

Fully amortized loan: Monthly payments will pay off entire debt by end of term.

Partially amortized loan: Monthly payments not enough to pay off entire debt, so balloon payment required at end of term.


Basic Loan FeaturesAmortization

Interest-only loan:payments during loan term cover only

interest accruing, so entire principal amount is due at end of term; or

payments are interest-only for specified number of years at beginning of term, with amortized payments after that.


Basic Loan FeaturesLoan-to-value ratio

Loan-to-value ratio (LTV): Relationship between loan amount and value of security property, expressed as percentage.

Example: $80,000 loan on $100,000 property. LTV = 80%

LTV calculated using sales price or appraised value, whichever is less.

The lower the LTV, the greater the buyer’s equity in the property.


Basic Loan FeaturesLoan-to-value ratio

Lenders prefer a lower LTV for two reasons:Borrower who makes larger investment

will try harder to avoid foreclosure.If there is a foreclosure, lender more

likely to recover full amount owed.

Lenders use loan-to-value ratios in setting maximum loan amount for a transaction.


Basic Loan FeaturesSecondary financing

Secondary financing: Second mortgage loan to pay for part of downpayment and closing costs required for first loan.

Source of secondary financing may be:institutional lenderproperty sellerprivate investor


Basic Loan FeaturesSecondary financing

Primary lender usually places restrictions on terms of secondary financing. For example:

Borrower must qualify for combined payment for both loans.

Borrower may still have to make a minimum downpayment out of own funds.

Second loan may have to be payable at any time without penalty.


Basic Loan FeaturesInterest rates

Interest rate for mortgage loan may be either fixed or adjustable.

Fixed-rate: Rate remains same throughout loan term.

Adjustable-rate: Rate adjusted periodically throughout loan term to reflect current market interest rates.


Interest RatesAdjustable-rate mortgages

Adjustable-rate mortgage (ARM): Initial interest rate set at current market rate, with possibility of future rate increases or decreases.

Rate tied to a market index.Also called variable-rate loan.May have lower rate than fixed-rate loan.


Adjustable-rate MortgagesHow an ARM works

Key elements of an ARM:indexmarginadjustment periodscapspossibility of negative amortization


How an ARM WorksIndex

Index: Published statistical report that indicates changes in cost of money.

ARM’s interest rate tied to index selected by lender when loan made.After ARM’s initial rate set, rate

adjusted periodically, up or down, based on changes in selected index.


How an ARM Works Margin

Margin: Difference between index rate and interest rate charged to ARM borrower.

Lender adds margin to index rate to cover lender’s expenses and profit.For example, margin might be 2

percentage points.

Margin stays same throughout loan term.


How an ARM Works Adjustment periods

ARM has two adjustment periods.Rate adjustment period: How often loan’s

interest rate may change.Not changed every time index changes.Most common: one-year intervals.

Payment adjustment period: How often monthly payment amount may change.Usually matches rate adjustment period.


How an ARM WorksCaps

ARM may have rate cap and/or payment cap.Interest rate cap: Limits how much lender

may increase loan’s interest rate.Payment cap: Limits how much lender

may increase monthly payment amount.

Caps help prevent payment shock: sudden increase in payment so large that borrower defaults.


How an ARM Works Potential for negative amortization

Negative amortization: When unpaid interest is added to principal, so loan balance goes up.

Occurs if increases in ARM’s monthly payment amount don’t keep up with increases in its interest rate.

Most ARMs now structured to prevent negative amortization.


Adjustable-rate MortgagesHybrid ARMs

Hybrid ARMs: Interest rate is fixed for certain number of years at beginning of loan term, then becomes adjustable.

Example: 5/1 ARM has five-year fixed rate, then annual adjustments.

Generally, longer fixed period = higher initial interest rate.


SummaryBasic Loan Features

• Loan term• Amortization• Loan-to-value ratio• Secondary financing • Fixed-rate mortgage• Adjustable-rate mortgage• Index and margin• Rate and payment adjustment periods• Rate and payment caps• Negative amortization


Applying for a Residential LoanResidential financing programs

Major types of residential financing include:conventional loansFHA-insured loansVA-guaranteed loansRural Housing Service loans


Residential Financing Programs Conventional loans

Conventional loan: Any institutional mortgage not backed by a government program.

Lenders can make conventional loans according to their own rules.

But most follow Fannie Mae and Freddie Mac qualifying standards so the loans can easily be sold on the secondary market.


Residential Financing Programs Conventional loans

Nonconforming loan: A conventional loan that doesn’t meet Fannie Mae or Freddie Mac standards.

Not as easy to sell nonconforming loan on secondary market, so lender may keep loan in its own portfolio.


Conventional LoansLoan-to-value ratios

Traditional LTV for conventional loan is 80%, but conventional loans often have higher LTVs.

Lenders generally allow LTV up to 95%.97% LTV sometimes available, though

no longer common.

Lenders tend to have stricter rules for higher-LTV loans, especially if LTV is over 90%.


Conventional LoansOwner-occupancy

Owner-occupancy not required for conventional loan.

But lenders tend to impose stricter requirements on borrowers who are investors.Investor will be renting out house

instead of living in it.Owner-occupants considered less likely

to default.


Conventional LoansPrivate mortgage insurance

Private mortgage insurance (PMI): Designed to protect lenders from greater risk of high-LTV loans.

Insurance provided by private companies (not federal government).

PMI generally required for any conventional loan with LTV over 80%.



PMI typically covers only top 20% to 25% of loan amount.

If borrower defaults on loan with PMI, lender can:

sell the property or relinquish it to insurerfile claim for covered losses suffered, up

to policy amount



As borrower pays off loan, LTV decreases, and eventually PMI has fulfilled its purpose.

Federal Homeowner’s Protection Act requires lenders to cancel PMI once loan paid down to 80% of property’s original value, if requested by borrower.

Once balance reaches 78%, lender must cancel PMI even without formal request.


Conventional LoansQualifying standards

Fannie Mae and Freddie Mac have detailed standards regarding credit history, income, and net worth.

Depending on lender, underwriter may apply:both housing expense to income ratio

and debt to income ratio, oronly debt to income ratio

Borrower may be required to have reserves to cover two or three months of payments.


Conventional LoansAssumption

Most conventional loans have an alienation clause.

Prevents borrower from selling property and arranging assumption of loan without lender’s permission.

Buyer in assumption usually must meet same qualifying standards lender uses for ordinary loan approval.


SummaryConventional Loans

• Conventional loan• Nonconforming loan• Loan-to-value ratio• Owner-occupant• Investor• Private mortgage insurance• Qualifying standards• Assumption


Residential Financing Programs FHA-insured loans

Federal Housing Administration (FHA) created in 1934 to promote home sales and financing for low- and middle-income buyers.

FHA’s main function: insuring mortgages.Mutual Mortgage Insurance Plan

FHA is agency within Department of Housing and Urban Development (HUD).


Residential Financing Programs FHA-insured loans

Buyers apply to FHA-approved lender.FHA does not accept loan applications

from buyers.Lender must comply with FHA qualifying

standards and other rules to have loans insured.

If borrower defaults, FHA covers lender’s losses.


FHA-Insured LoansCharacteristics

Term typically 30 years, but can be shorter. Property must be borrower’s primary

residence, but may have up to 4 units. FHA must have first lien position. Required downpayment less than for

conventional loan. Mortgage insurance always required. No prepayment penalty allowed.


FHA-Insured LoansLoan amount

Every area has local maximum FHA loan amount based on median housing prices.

There’s also a ceiling that applies nationwide.

Local limit can’t exceed ceiling, no matter how high local prices are.


FHA-Insured LoansLoan amount

In addition, loan amount for transaction limited by FHA loan-to-value rules.

Maximum LTV for FHA loan: 96.5% (90% for borrower with low credit score).

If LTV is 96.5%, borrower must make minimum cash investment of 3.5%.


FHA-Insured LoansQualifying standards

FHA qualifying standards less strict than conventional standards.

For example, FHA has higher maximum income ratios.So FHA borrower’s mortgage payment

can be higher percentage of income than conventional borrower’s payment.

Easier to qualify for FHA loan.


FHA-Insured LoansQualifying standards

No maximum income limits.Buyer at any income level could qualify,

as long as loan amount didn’t exceed local maximum.

FHA borrower needs sufficient funds for minimum cash investment and closing costs, but not required to have reserves.

Secondary financing generally can’t be used for minimum cash investment.


FHA-Insured Loans Mortgage insurance premiums

Most FHA loans require both:one-time mortgage insurance premium

paid at closing or financedannual mortgage insurance premiums

paid in monthly installments


FHA-Insured LoansAssumption

FHA loans closed before 1990 may be assumed without lender’s approval, if seller does not need release of liability.

Newer loans may be assumed only if buyer:meets FHA underwriting standardsintends to occupy the home as primary

residence


SummaryFHA-Insured Loans

• Federal Housing Administration• Mutual Mortgage Insurance Plan• Primary residence• Local maximum loan amount• Minimum cash investment• FHA qualifying standards• One-time premium and annual premiums• Assumption


Residential Financing Programs VA-guaranteed loans

VA-guaranteed loan: Home loan made to U.S. military veteran and guaranteed by federal government.

If borrower defaults, U.S. Department of Veterans Affairs (the VA) will reimburse lender for all or part of its loss.


VA-Guaranteed Loans Eligibility

To be eligible for VA loan, borrower must have served period of active duty in the U.S. armed forces.

Also eligible:spouses of deceased or missing

veteranslong-term members of National Guard or

reserves


VA-Guaranteed LoansApplication process

Veteran applies to lender for loan, not to VA.VA issues Certificate of Eligibility to

eligible veteran.Property must be appraised according to

VA guidelines.Appraised value set forth in Notice of

Value (also called Certificate of Reasonable Value).


VA-Guaranteed LoansCharacteristics

No downpayment required (100% LTV). VA doesn’t set a maximum loan amount. VA qualifying standards much less strict

than conventional standards. No mortgage insurance required; instead,

veteran pays funding fee. Applicant must intend to occupy property,

which may have up to 4 units. No prepayment penalty allowed.


VA-Guaranteed LoansVA guaranty

Although VA doesn’t set a maximum loan amount, there is a maximum guaranty amount.

So if loan amount very large, lender typically requires small downpayment.

Usual limit for no-downpayment loan: loan amount no more than four times guaranty amount.


VA-Guaranteed LoansRestoration of entitlement

If a veteran pays off a VA loan:veteran’s full guaranty entitlement is

restoredveteran can obtain another VA loan with

maximum guaranty

Restoration of entitlement is also called reinstatement.


VA-Guaranteed LoansSubstitution of entitlement

If VA loan assumed, seller’s entitlement restored only if buyer is eligible veteran willing to substitute her entitlement for seller’s

VA loan can be assumed by non-veteran, but seller’s entitlement won’t be restored.

With or without substitution of entitlement, buyer must be creditworthy to assume VA loan.


VA-Guaranteed LoansQualifying standards

Only one income ratio (total debt to income ratio) applied in underwriting VA loan.

Acceptable ratio much higher than conventional debt to income ratio.

Underwriter also considers VA’s residual income requirements.

Borrower must have at least minimum income left over after paying all monthly tax and debt obligations.


Residential Financing ProgramsRural Housing Service Loans

Rural Housing Service: Federal agency within Department of Agriculture that makes and guarantees loans used to buy, build, or rehabilitate homes in rural areas.

Aka RD (rural development) loans.RHS:

makes direct loansguarantees loans made by approved

lenders© 2011 Rockwell Publishing

Residential Financing ProgramsRural Housing Service Loans

For RHS financing, borrower must:not currently have adequate housingbe able to afford the mortgage paymentshave a reasonable credit historychoose a house that is modest in size

and design


SummaryVA Loans and RHS

• VA-guaranteed loan• Certificate of Eligibility• Notice of Value• VA guaranty• Restoration of entitlement• Substitution of entitlement• Total debt to income ratio• Minimum residual income requirements• Rural Housing Service loans


Applying for a Residential LoanPredatory lending

Predatory lending: Making loans that take advantage of unsophisticated borrowers.

Often targets the elderly, the poor, or people with limited English.

Especially common in subprime market.May involve:

unscrupulous lender, mortgage broker, appraiser, and/or real estate agent

buyer or seller (deceiving other party)© 2011 Rockwell Publishing

Predatory LendingPredatory practices

Examples of predatory lending practices:predatory steeringfee packingloan flippingdisregarding borrower’s ability to repayballoon payment abusesexcessive or unfair prepayment penaltiesfraud regarding fees, loan terms, etc.


SummaryPredatory Lending

• Predatory lending• Targeted borrowers• Predatory steering• Fee packing• Loan flipping• Disregarding ability to repay• Balloon payment abuses• Excessive prepayment penalties


Washington Real Estate Fundamentals Lesson 11: Applying for a Residential Loan © 2011 Rockwell...

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