Mortgage Loan Programs: The Full Monty

There is a great deal of misunderstanding surrounding the abundance of different loan programs available.

This seminar is not meant to be an all encompassing education in residential lending, but rather to familiarize you with residential lending programs. Our hope is to equip you with enough information to prevent you from getting into a loan program that may not work for your situation. First, we will discuss the most basic and common loan types. Later, I will show you how the more exotic loans work. Some of what we discuss will already be known to you. We will try to move through those portions of the presentation quickly, but please let me know if there is something that you would like me to further explain.

At a basic level all loans have some fundamental requirements. Banks are happy to lend you money and collect the interest on the loan, but this represents a risk on their part. Banks will try everything possible to minimize risk. In order to receive a loan you will typically have to prove a certain level of creditworthiness, ability to repay the loan, and collateral in the form of the value your home. Additionally, all loans have to be paid back, but there are many different options when it comes to the terms of how to repay the loan. This is where residential financing can get confusing.

Credit

Turn on any TV, radio, or go onto the internet and you can’t help but hear someone talking about credit, offering you a free credit report, etc. Credit scores have gotten a lot of press in recent years and rightly so since they can have a substantial impact on a number of financial transactions. It is important, however, to know that the score itself is only one portion of what is required to qualify for a loan. You may have a high score and still not qualify for a certain loan because of something that is on your credit report. Likewise, a low score does not always mean that you won’t get a good loan with a low rate.

Ability to Repay

Different loan programs have different requirements when it comes to proving your ability to repay a loan. Some are more intense than others when it comes to documenting your income and assets. Most programs check your Employment, Income, and Assets. This is the most traditional documentation type. It is called full documentation, or Full Doc. for short. Other documentation types allow a person to state (but not verify) their income or assets or both. These are called stated income programs. You might hear Stated Income Verified Assets or SIVA, or Stated Income Stated Asset known as SISA. Still there are some programs that are called No Documentation or No Doc loans. In these programs a borrower doesn’t disclose their income, assets, and even their employment. This could be for people who recently started their own business and do not have a two year history of self-employment, but have great credit. It stands to reason that the more documentation you provide the better your likelihood of receiving a competitive rate.

Collateral; Home Value

The home that you finance is your collateral for the loan. Should you default on the loan the bank will own your house. Banks don’t like owning houses. They like owning money. Therefore a bank isn’t going to loan you more than the value of your home. There are very rare exceptions to this rule. Equity is the dollar value of your house, minus the amount of money owed against the home. So, a home worth $200,000 where the borrower owes $100,000 on his or her mortgage represents $100,000 or 50% equity. The more equity you have in a home, or the more money that you put down, the less risk this presents to the bank.

ARM’s, Hybrid’s, and Fixed Rates

ARM’s are mortgages that lack the security of a fixed rate but typically offer a lower introductory rate. ARM Rates are determined by an Index and a Margin which is usually a mark up above the index. The interest rate itself fluctuates according to the index to which it is tied. Some indices are more volatile than others and are more prone to dramatic fluctuations. The most common indices are the LIBOR (London Interbank Offered Rate), COSI (Cost of Savings Index), COFI (Cost of Funds Index), and MTA (Monthly Treasury Average). The LIBOR ARM is a very common mortgage that offers a low rate but is rather volatile. It fluctuates with the market. On the other hand, the COSI, COFI, and MTA indices are averages of the preceding 12 months rates.

There are ARMs that are tied to the Prime rate as well. This rate only adjusts when the Federal Reserve Chairman initiates a rate change such as he has done recently. Typically, Home equity lines of credit (HELOCs) and land purchase loans are tied to the Prime rate.

Fixed Rate mortgages have interest rates that are fixed. They do not fluctuate, even if rates go down. In order to take advantage of lower rates a borrower would need to refinance. In a typical market fixed rates are higher than ARM’s. However this market is not typical. Most ARM’s are now the same or higher than fixed rates.

Hybrid mortgages combine the features of both ARMs and Fixed Rate mortgages. They offer a fixed rate for a certain period of time. That could be anywhere from two to ten years. After the Fixed portion of the loan ends the loan becomes a standard Adjustable Rate mortgage. Most ARMs that are originated today are indeed Hybrid mortgages. These loans might make sense for someone who only expects to own a house for a few years and is able to save money by taking a Hybrid ARM.

Most mortgage programs (conventional, government, etc) offer ARM’s, Hybrid’s, and Fixed Rates.

FHA and VA

FHA and VA mortgages are secured by government agencies. HUD secures FHA mortgages, while the Department of Veteran Affairs secures VA mortgages. These agencies also prescribe the underwriting guidelines for these mortgages. FHA and VA mortgages offer competitive rates and typically are not driven by credit scores. This doesn’t mean that you can be negligent with your bills and still qualify for an FHA loan.

FHA loans are meant to provide financing for low to moderate income families. They require mortgage insurance in the form on an upfront fee, which is usually financed into the loan, as well as an additional monthly payment for a number of months. In exchange for the mortgage insurance, FHA borrowers get very competitive rates for which they might not otherwise qualify. FHA loans allow borrowers to borrow up to 97.75 of a home’s value. FHA imposes loan limits that limit the amount of money a person can borrow. In Baltimore County the limit is $362,790 for a single family home. In most counties the limits are substantially lower.

VA mortgages are intended to get eligible veterans into homes with no money down. They do require a funding fee that is financed into the loan. This funding fee varies depending upon the veteran’s status, and can even be waived for disabled veterans. Veterans can also finance certain home improvements into the purchase of a home or refinance. Rates are competitive. The maximum loan amount for a single family home is $417,000.

Conforming Mortgages

Conforming loans are prime loans for low risk borrowers that are secured by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are Government Sponsored Enterprises that purchase low risk loans as well as setting the lending guidelines for such mortgages. They are called conforming loans because they must “conform” to the standards set forth by Fannie and Freddie. Conforming mortgages are often called “prime” or “A-paper” loans. They offer the most competitive rates, and have a greater variety of terms than FHA and VA loans. Conforming loan programs include Fixed Rates, ARM’s, as well as Interest Only loans.

Conforming loans typically allow a buyer to finance up to 95% of the homes value, but some programs allow up to 100% financing. Financing values that exceed 80% of the homes value require private mortgage insurance. At certain times the mortgage insurance can be financed into the loan. This typically results in a higher interest rate, but a lower overall payment. The maximum loan amount for a single family home is $417,000.

Non-Conforming Mortgages

Non-conforming mortgages encompass all residential financing programs that are not Government or Conforming mortgages. In 2005, this meant the word “non-conforming” could represent a dizzying array of loans. The recent credit crunch of the last year has reduced the number of non-conforming programs. We will discuss a few of the non-conforming programs that are the most common.

Jumbo

Jumbo mortgages are those that exceed the $417,000 limit for conforming loans. These loans could be for people with great credit or less than perfect credit. Jumbo loans represent more risk for the lender, hence they are offered at higher rates. For very high value homes (sometimes called Super-Jumbo) the credit and down payment requirements are significantly higher.

Alt-A

Alt-A mortgages are for those borrowers who represent low risks, but don’t fit within conforming guidelines. This could mean borrowers that have great credit but are unable to prove their income, or other such difficulties that stop them from obtaining more traditional financing. This catch all phrase has different definitions depending on the lender, but represents some sort of alternative to traditional programs. This is where you are most likely to find Stated Income or No Doc. loans.

Interest Only Loans

Interest Only loans offer lower payments by offering borrowers a payment that pays the interest that accrues on their mortgage, but not the principal. Borrowers can always make payments on the principal, but are only obligated to pay the interest as it accrues. Lowering the payment obligation makes it easier for borrowers to qualify for loans, or to purchase a larger home than they might otherwise be able to afford.

At some point the principal on the loan will need to be repaid. Thus an interest only loan only represents a temporary reprieve from the full payment of the loan. Most interest only loans offer an Interest Only period from anywhere from five to fifteen years. After the Interest Only period ends the payment on the loan will rise substantially, as the balance of the loan will now be amortized over the now shorter life of the loan.

Below is a typical Interest Only scenario:

Typical Mortgage: Interest Only:
$200,000 $200,000
6.5% Interest Rate 7% Interest Rate
30 year Payment 10 years Interest Only 20 years Amortizing
$1264.14 per Month $1166.67 per Month $1550.60
Savings $97.47 Loss $286.46

An Interest Only loan makes sense for a borrower who expects to their income to increase over the next several years. This might work for someone who is a recent college graduate entering a professional field. These loans are not meant for someone to buy more home than they can actually afford. They aren’t usually good choices for people who live on a fixed budget with little potential to increase their income in the future.

Graduated Payment Mortgage

You may run across a Graduated Payment Mortgage, also called a temporary buydown. In this scenario your interest rate is temporarily lower than the market average. Therefore your payments are lower as well. But the interest rate will rise over the first few years. For instance one example is called a 2-1 Buydown. In this instance your interest rate for the first year will be two percent below the “real” interest rate. At the end of the first year the rate will go up by one percent, but will still be one percent lower than the “real” interest rate. At the end of the second year the rate will finally be at the “real” rate. This can represent a substantial savings at the beginning of the loan. However the savings are due to a buydown subsidy that is a part of the closing costs of the loan. Every dollar that your save in payments is paid at the front of the loan! Therefore these loans aren’t often utilized unless a person has a substantial amount of equity, gift funds, etc. to pay for the buydown subsidy.

Typical Temporary Buy Down scenario:

Typical Mortgage: 2-1 Buydown: 1st year 2nd year
$200,000 over 30 years
6.5% Interest Rate 4.5% Interest Rate 5.5%
$1264.14 per Month $1013.37 $1135.58
Savings $250.77 Savings $128.56

Savings over the first two years = $4551.96
Buydown Subsidy paid in upfront fees = $4551.96

Again, this is a great program when someone else is paying the buydown subsidy. It’s also a great way for buyers to recoup the money that they have put into the transaction in the form of closing costs, down payments, etc.

Negative Amortization and Deferred Interest Programs

A negative amortization loan is one in which the balance of the loan can actually increase. These loans offer an artificially low payment that does not actually cover the interest that accrues. Thus whatever interest is not paid is added back onto the loan balance. These loans are typically based on ARMs though a few fixed rate and hybrid products do exist. These are the scenarios that you see offering below market value interest rates and payments. It’s not uncommon to see a rate as low as 1% offered, or payments that are thousands of dollars less than they would be with a typical loan. This is best illustrated by using examples.

Typical Neg-Am Scenario: $200,000 Mortgage at 7% with a 1% Payment Option

30 Year Payment Interest Payment Minimum Payment
$1330.60 $1166.67 $643.28
Balance decreases by $163.93 Balance Stays Fixed Balance increases by $523.39

These types of loans typically allow customers to make a variety of different payments in a given month depending upon their cash flow. They may have the option of paying a 15 or 30 year amortizing payment, the interest only payment or the minimum payment. Thus you will often hear them called Pay Option Arms. As time goes on the amount of the minimum payment will slowly rise. This lessens the amount of negative amortization.

As I stated earlier there are fixed rate and hybrid Neg-Am loans. These loans give a borrower the flexibility of a low payment without the fear of an Adjustable Rate. The fixed rate and hybrid Neg-Am loans usually have a higher minimum payment than those for ARMs.

These loans are meant for borrowers who have a good ability to manage their cash flow. Investors and people with variable income (commissions, bonuses, business owners, etc) make good candidates for these loans. They are not intended for those who only have the ability to make the minimum payments.

Closing

I hope this presentation has equipped you with enough knowledge to make an educated decision about the type of mortgage terms that are most appropriate for your situation. When you go onto the internet and see a banner ad that claims that you can get a $500,000 mortgage for $2,100 per month you will know that this isn’t a simple fixed rate loan, but instead an advertiser displaying a minimum payment on a Neg-Am loan.

It is important to note that all mortgage programs are tools that have their appropriate uses. But they may also have the potential for misuse. Please be careful when reviewing you loan documentation to insure that you understand the terms of your loan.