Articles about Mortgages

In order to have continuity in the mortgage process and to protect the rights of borrowers, The Department of Housing and Urban Development (HUD) has developed regulations called RESPA (the Real Estate Settlement Procedures Act) and TIL (the Truth in Lending Act.)

These acts were designed to provide borrowers who are shopping for mortgages with certain information, in a standardized format, so that costs and other information can be compared from lender to lender.

A few of the documents that must be provided to the borrower, either within three days of application or at closing, are listed below:

Good Faith Estimate (GFE)

Regulations require that this document be given to the borrower within three days of application.  It discloses rates and fees, including escrow deposits the lender expects to charge and/or collect from the borrower.

Truth in Lending Disclosure (TIL)

This document shows the APR (Annual Percentage Rate).  APR is, in effect, the total cost of the loan, expressed as a rate, with the costs of the loan factored in.  This is useful for borrowers to understand because lenders who charge the same rate but with different fees will have different APRs. The lower the APR, the lower the total cost.

Escrow Account Disclosure

If the lender is requiring the borrower to have an escrow account from which taxes and/or insurance will be paid the lender is required to notify the borrower within three days of application.

HUD

Also known as a Settlement Statement, this HUD paper breaks down for the borrower, at closing, the fees that are being charged in the transaction, as well as payoffs, escrows, etc.  The figures here should closely match, and can be compared to, the Good Faith Estimate.

With so many choices available today for consumers who want to obtain home financing, it may be helpful to compare and contrast mortgage brokers and banks from a mortgage perspective.

There are three main differences:

1) How many lenders each works with
2) How the loans are funded
3) How each are compensated

Mortgage brokers connect lenders and borrowers. They can and usually do work with many lenders. This gives borrowers a range of choices because brokers can select the best product and terms for their clients.

Another difference is how the loan is funded, or how the money gets to the borrower. At closing, a broker will request funds from the lender, who will send them electronically, but the broker never holds the funds. A bank will deliver the loan directly out of its own funds, from what is called a warehouse line.

The broker gets paid by the lender in the form of what is called a Yield Spread Premium (YSP), or fee for finding and processing the borrower. Brokers by law must disclose the YSP to the borrower; banks, if they charge one, are exempt from having to disclose the YSP.

The higher the interest rate, the higher the Yield Spread paid to the broker. Brokers stay competitive by keeping the YSP and the rate low.

Brokers, if needed, are able to charge a slightly higher rate and then refund a portion of the YSP back to borrowers in the form of a broker credit toward closing costs. This assists borrowers who would otherwise be lacking in the funds to pay closing costs.

If there has been a good time to buy an investment property in the last 10 or so years, it is probably now. There are many properties that would be suitable as investments, as a result of foreclosures and declining market values in general.

There are, however, things to know about in the current market that may have been less of a factor, even several years ago.

Financing

Getting financing is probably one of the most significant factors. Interest rates over time generally have been slightly higher for an investment property than for a house that the borrower had planned to live in.  In light of the current credit crisis though, both Fannie Mae and Freddie Mac (FHA generally stays away from investment properties) have added premiums to their loans, which for the borrower are reflected in the rate.

These premiums are largely based on the amount that the borrower has as a down payment on the property.  A borrower putting down 25% will pay a slightly lower rate than someone putting down 20%.

Lenders, knowing that renters, as anyone, can be unpredictable in their income stream, reward borrowers that have more of a vested interest in a property.  First-time investors will generally need to put more down, as property management experience is a factor in determining the overall risk of borrowers.

Long-Term Investment

Even with the challenges of financing it, owning an investment property and thinking of it as a long-term investment might make sense.  The right property at the right price can generate a positive monthly income stream and appreciate over time, making it a great vehicle for retirement.

Keep in mind also that many expenses related to an investment property are tax deductible, affording investors benefits in that area.

With all the talk these days in the world of mortgages about Fannie Mae and Freddie Mac, it is worth considering who they actually are and what do the do?

Fannie Mae is the Federal National Mortgage Association, and Freddie Mac is the Federal Home Loan Mortgage Corporation. They are what’s called government-sponsored entities, GSEs.  Although they have recently been taken over by the federal government, they are still publicly traded companies (both are listed on the NYSE).  What GSEs do is provide mortgage lenders with funds.  The lenders in turn lend the funds to end consumers.

The process, from beginning to end, goes basically as follows:  Fannie and Freddie, through the use of investors raise money to provide to lenders, who in turn lend that same money to people who are either purchasing, or refinancing a home.  Lenders find borrowers whose income, assets, and credit fall within a previously determined set of guidelines.

Once the loan transactions are completed by the lenders, the GSEs buy back, then package the loans into what are called mortgage-backed securities.  The mortgages are packaged together based on the type of loan (30-year fixed, 5/1 ARM, etc.) and on the profile of the borrower.

There could be hundreds or thousands of loans in each security.  These securities are then sold, to investors, who trade them as they would other types of securities, in markets around the globe. Most of the mortgages in this country are obtained within the guidelines of Fannie and Freddie.

Here are some terms commonly used in the mortgage industry.

ARM, or Adjustable Rate Mortgage: This is a mortgage loan that has a fixed rate for a specific period of time, say 1, 3, or 5 years, after which the rate becomes dependent on some index, such as a treasury bill rate.

Buy Down: A fee given to a lender which will either temporarily or permanently lower the interest rate on a mortgage.  On purchase transactions, by downs may be offered by sellers or builders as an incentive to potential buyers, making their payments more affordable.

FICO Score: A credit score for borrowers, demonstrating their ability to obtain and manage credit over time.  Lenders typically pull scores from three bureaus, Experian, Equifax, and Trans Union, and use the middle score of the three in making a lending decision.

Interest Only Mortgage: A mortgage loan where only interest is paid for a specified period of time in the first part of the loan, typically 10 years.  The entire principal would then be paid over the remainder of the term of the loan.

Mortgage Broker: An entity through which mortgage lenders work to lend money to borrowers, versus a bank, which lends directly to borrowers.  Brokers are able to present products from multiple lenders to borrowers.

Mortgage Insurance: When lenders lend more than 80% of the value of a property, they require mortgage insurance.  This is where a third party insurer, for a premium, paid by the borrower, assumes the risk of the loan, in case of default.  FHA loans incorporate mortgage insurance directly into the loan.

Prepayment Penalty: A penalty charged by a lender for early repayment of a loan, usually within the first few years.  Lenders often offer lower rates to borrowers who accept these terms.

With all of the changes in the mortgage industry these days, it is more important than ever to understand how a credit score works - and how to keep your credit score as high, and the mortgage rate you get, as low as possible.

Many conventional lenders, those which use Fannie Mae guidelines, are now charging a premium for credit scores that are between 620 (the minimum they will lend on) and 720, part of which is passed on by Fannie Mae itself.

The lower the score, the higher the premium and the rate, with borrowers in the 720+ range getting the best rates.

FHA is also an option, and has premium for credit scores in that 620-720 range, but their upfront premium for all borrowers is 1.5% of the loan amount plus a monthly mortgage insurance premium, so this can be a pricey option as well.  And they do have sub-620 score premiums.

Your credit score consists of several components, each which contributes to your score.

Credit is pulled from the three main credit bureaus (Trans Union, Experian, and Equifax) and lenders use the middle of the three scores.

The major factors are:

1) Payment history, which is about 35% of the total score.

This indicates how well a borrower is able to pay on time. Recent late payments of any kind, including utility bills, and mortgage late payments weigh the most heavily.

2) Level of indebtedness.

This is the balance of a credit line versus the total limit, and is about 10% of the score.  Ideally the balance will be under 40% of the limit.

3) Length of credit history.

Demonstration of being able to manage credit long-term. This makes up about 10% of a credit score.

While the list of options seems to be shrinking for mortgage customers, understanding the differences between two of the major programs, Conventional and FHA, and when you might want to use each, should help to make you a more informed consumer.  Each has its benefits and drawbacks.

Borrowers that have good credit, some money in the bank, and some equity in their homes, are most likely suited to having a Conventional loan, meaning a loan that falls into either Fannie Mae of Freddie Mac guidelines.

Benefits to Conventional Loans

One benefit to having a Conventional loan is that there is neither an upfront mortgage insurance premium that FHA charges, which is typically 1.5% of the loan amount, nor the monthly mortgage insurance premium.

The total debt to income ratio for Conventional loans is near 65%, depending on other factors per Fannie Mae and Freddie Mac guidelines, versus around 43% for FHA.

This means that you could make less money and get the same loan amount with a Conventional loan than you would with FHA.

While there are still some no-income-verified Conventional programs available, FHA is always full documentation.

Benefits to FHA Loans

Looking at the credit side of this comparison, Conventional borrowers will need a credit score of at least 620 to qualify, and will be charged a premium, based on how close their score is to 620.  FHA borrowers can in many cases be lower than 620, but another benefit to having FHA versus Conventional is the amount of vested interest a borrower has in a property.

FHA lenders will allow borrowers to make as little as a 3% contribution to the transaction; and this contribution can go toward expenses such as closing costs.  Conventional lenders usually want borrowers a bit more vested.

To try to help sort out how the mortgage crisis came to be where it is today, it may help to look back at where the industry has been.  Since the earliest days of mortgages, well over 100 years ago, borrowers wanting to purchase a home put down a sizeable down payment, usually 20%, or more, and proved their credit, income and assets to qualify.  The lender, usually a bank, after providing the loan, held it in-house in what is called a portfolio, bearing all the risk of repayment by the borrower.

Along these lines, one factor contributing to the crisis is the emergence of the Mortgage Backed Security (MBS), in the 1980s.  An MBS is a security that is made up of mortgages that have been bundled together.  These securities, like others, are traded by investors.  This is an important point, in that the traditional lender/borrower relationship had now changed, with the investor influencing the lending decision.

As time passed, and these securities were used more by investors, they, the investors - looking to increase their rates of return - began relaxing their acceptable criteria. They directed lenders, from whom they would buy the loans, to lend money to borrowers that were either putting down less than 20%, or less creditworthy than in prior years, or both. Many of these mortgages were what was called sub-prime.

Moving forward to the current market, as these sub-prime borrowers are turning out to have high default rates, investors, who are watching their mortgage portfolios implode, are returning to the purchase of more traditional mortgages.  This will in turn limit options of borrowers today, holding them to more strict standards, as they were a generation ago.

There are three stages in the life of a mortgage: origination, funding and servicing. The origination phase is where the borrower and loan professional sit down and determine the best course of action for the borrower.

Once this process is complete, and the borrower goes to the closing, the money is given to the borrower and/or seller, in what is called loan funding.  Once the loan is funded, it needs to be serviced.  This means collection of payments, escrows, and the disbursement of those escrows to the tax collector, insurance company, etc.  This servicing can be done by either the lender itself, or contracted out to what it called a servicing company.

Regardless of who services the loan, the loan itself is either kept by the original lender, in what is called a portfolio, or sold to investors.  Borrowers give lenders this right to sell their loans, through a loan servicing agreement.  The original lender agrees that the terms of the loan will remain the same, regardless of who owns it, and loans may be sold multiple times.

When they are sold, mortgages of similar types and borrower grade, based on creditworthiness, are bundled together into what are called Mortgage Backed Securities, or MBSs.  These securities are bought by and sold to investors around the world, similarly to other types of securities.

As with any other type of security, and as you might expect, they also carry risks to the investors that own them.  Riskier and less creditworthy borrowers, many of whom are starting to default on loans that have been bundled, with like loans into these securities, are causing the securities themselves to lose value.

Before looking at properties, determine first what the current market rents are for the property type you have in mind in your area.

An experienced real estate agent or property appraiser should be able to tell you this.

You can then determine what your net income on the property would be each month (also remember the tax benefits, if any) after factoring in regular and unforeseen maintenance expenses.

Determine also your long-term strategy for owning the property.

Will you be willing or able to break even, or potentially take a loss on the property each month, anticipating a high sales price in the future?  Will you be able to hold the property during times of declining property values, as we are experiencing now?

Getting a Mortgage

Mortgage lenders will typically charge a higher interest rate (one or more percent) on an investment property than they would on a property that a borrower will live in.

This is partly due to the fact that both renters and the rental market itself can be unpredictable.

In calculating their risk, things that lenders look at when considering to lend on a rental property are:

• How much money will the borrower be putting down?  Typically lenders want between 10% and 25% (for first time investors) to show the borrower has a vested interest in the property and wants to make it work.
• Landlord experience: How long has the borrower been managing rental properties, if at all?
• Income and assets: Will the borrower have enough money in the bank to cover the mortgage, taxes, and other expenses if the property is vacant for an extended period?  Typically lenders want six months in reserves.