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Loan Programs

Loan Categories

The major loan categories are conventional and government. Conventional loans can be further categorized into conforming and non-conforming. Government loans primarily refer to FHA and VA loans.

Conforming Loans
A conforming loan adheres to the guidelines established by Fannie Mae or Freddie Mac. These guidelines establish maximum loan amounts, down payment, credit and income requirements and acceptable property types. Lenders that make loans according to these guidelines may sell them to Fannie Mae or Freddie Mac. Conforming loans make up the majority of loans in the U.S.

Non-conforming Loans
Loans that do not conform to the guidelines established by Fannie Mae or Freddie Mac are called non-conforming loans. A loan that is larger than the conforming loan limit is called a Jumbo loan. Loans that do not meet the credit quality of conforming loans ('A' paper) are referred to ad A- through 'D' paper loans, or subprime loans.

Government Loans
FHA and VA loans are the two most popular types of Government loans. Government loans have different loan limits and qualifying criteria compared to conventional loans.

Portfolio Loans
Loans may be sold on the secondary market to Fannie Mae, Freddie Mac or a select number of conduits (e.g. GE Capital) or they may be kept in the bank's portfolio. Portfolio loans generally have more flexible qualifying criteria, while saleable loans must meet more strict criteria.

Commercial Loans
Loan programs discussed above apply to one- through four-family, residential properties. Loans on  residential properties containing five or more units, office buildings, warehouses and other commercial properties are considered commercial loans.

Fixed Rate Mortgages

Fixed-rate mortgages are very popular because the interest rate and monthly payments are constant. Fixed loans are generally amortized over ten, fifteen, twenty or thirty years.

A fixed-rate mortgage is generally preferred when the interest rate is relatively low and one intends to keep the property for more than five to seven years. When rates are relatively high, or if one intends to sell the property in fewer than five to seven years, adjustable loans are generally preferred.

The most common fixed rate mortgage is the thirty-year fixed. Borrowers who want to pay off their loan sooner may opt for a fifteen-year mortgage. If you are trying to decide between a thirty-year and a fifteen-year loan, consider the following:

  1. Paying your loan over fifteen years can save you thousands of dollars in interest. Paying less interest results in less of a tax deduction.  Determine in advance if a larger tax deduction (with a thirty-year loan) will offset the benefits derived from paying less interest (with a fifteen-year loan).
  2. The payment on a thirty-year loan can be substantially less than the payment on a fifteen-year loan of the same amount.  You could obtain a thirty-year loan and invest the difference in mutual funds, stocks, CDs, etc. If you could earn a higher, after-tax rate on your investment than the rate you pay on your mortgage, it may be advantageous to invest the difference.

The final decision you make will depend on your preferences. If your goal is to live debt free, then a fifteen year mortgage may be right for you. If you goal is to maximize your tax deductions, a thirty year loan may be best for you.

Balloon Mortgages

With a balloon loan, at some point you'll be forced to pay off the loan, refinance the loan, or exercise a conversion option to get a new loan on or before the balloon due date. Unlike standard fixed or adjustable loans, balloon loans are not amortized.  The entire loan balance is all due and payable in a relatively short time.

One of the most popular balloon programs is the 30/5, commonly referred to as a "thirty-year due in five." The interest rate is fixed and the monthly payment is sufficient to pay off the loan in thirty years, but the outstanding principal balance is due at the end of five years.  Some 30/5s have a conversion option which allows you to convert to a twenty-five year, fixed rate at the time the balloon becomes due. There may be a minimal processing fee (typically $250) to convert to the new loan. The conversion rate is normally the FNMA sixty-day rate plus .5 percent. The conversion option may also be conditioned upon:

  1. Satisfactory mortgage-payment history. If your payments were late, the conversion may be denied.
  2. If the loan was secured by an owner-occupied dwelling, the dwelling will still need to be owner-occupied. If the house is a rental at the time of loan-conversion, the conversion may be denied, or you might be charged a higher interest rate.
  3. Secondary financing may not be allowed. If you have a second mortgage, the conversion may be denied unless you pay off the second mortgage.

Terms vary by lender. More information can be found in the loan obligation (promissory note). This is a document the lender will require you to sign at the time of closing.

Another popular balloon loan program is the 30/7. This is similar to the 30/5 except that the balloon comes due at the end of the seventh year.

Adjustable Rate Mortgages

An ARM is a loan which allows for the adjustment of its interest rate according to the terms of the note and as market interest rates change. The ARM interest rate is based upon one of many indices which reflect market interest rates. The borrower assumes the risk that interest rates (and their monthly payment) will rise. By assuming this risk, lenders may charge a lower initial interest rate compared to fixed rate loans. The lower initial rate is the main reason borrowers choose ARM loans--it allows them to qualify for a larger loan and obtain a higher-priced home.

Borrowers considering an ARM should familiarize themselves with standard ARM features.  These features include:

  • Start rate (Teaser rate):  This temporary rate is the starting interest rate. It is often referred to as the teaser rate.  The start rate is lower than the fully-indexed rate (sum of the index plus the margin), and lower than the market rate on fixed loans.
  • Initial Adjustment Period:  The length of time the interest rate is fixed initially. For example, if the initial adjustment period were six months, the interest rate would remain fixed for the first six months.  Beginning in month seven, the loan would adjust at regular intervals.
  • Regular Adjustment Period:  The frequency at which the interest rate adjusts. If the regular adjustment period were six months, the interest rate would adjust every six months.
  • First Adjustment Cap:  The maximum amount the interest rate can increase when it adjusts for the first time. For example, if your teaser rate and first adjustment cap were 5 percent and 3 percent respectively, the maximum your rate could increase after the initial adjustment period would be 8 percent.
  • Regular Adjustment Cap:  The maximum the interest rate can adjust up or down each adjustment period.
  • Lifetime Cap:  The maximum interest rate allowed over the life of the loan.
  • Index:  The variable index referenced in your note. The margin is added to the index to set the ARM interest rate. The index can usually be found in business newspapers. More information about various indices is available below.
  • Margin:  A fixed number which is added to the index to arrive at the ARM rate.
  • Fully-indexed rate:  The fully-indexed rate is equal to the index plus the margin. Your loan always adjusts toward this rate.
  • Conversion Options:  Some ARMs have an option which allows the borrower to convert the ARM to a fixed-rate loan.  Exercising the option usually must occur within a predetermined time frame; the fixed rate is determined by a formula.  For example,  a one-year T-bill ARM may be converted to a fixed-rate loan during the first five years on the adjustment date. I.e., you could convert during the thirteenth, twenty-fifth, thirty-seventh, forty-ninth or sixty-first month. 

Computing the fully-indexed mortgage rate:

The formula to calculate the fully-indexed interest rate is:

fully-indexed rate = value of index + margin

Note:  The rate you pay after one or more adjustments may not be the fully-indexed rate.  This can ocurr when the interest rate adjustments are limited by a cap.

Examples:

  1. Not reaching the fully-indexed rate:  Your previous rate was 7 percent, your loan has a 1 percent adjustment cap, the index is 7 percent, your margin is 3 percent.  The fully-indexed rate is 10 percent.  Because of the limiting payment cap, your new interest rate is 8 percent.
  2. Reaching the fully-indexed rate:  Your previous rate was 7 percent, your loan has a 3 percent adjustment cap, the index is 7 percent, your margin is 3 percent.  After the adjustment, your interest rate reaches the fully-indexed rate of 10 percent.

Details about the various indices:

  1. Prime rate:  The interest rate banks charge their best (prime) customers.
  2. Treasury bill rate:  Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.
  3. Libor:  London Interbank Offered Rate. The interest rate international banks in London charge when lending to each other. Indices are quoted for maturities of one, three, six and twelve months. The most common Libor rate referred to in ARMs is the six-month Libor rate.
  4. 6 month CD rate:  The average rate that banks pay on a six-month Certificate of Deposit.
  5. 11th District Cost of Funds Index (COFI):  The index is the average monthly cost of the interest expenses incurred by members of the 11th District of the Federal Home Loan Bank System. Deposits in checking and savings accounts, certificates of deposit, transaction accounts, and passbook accounts are the primary source of funds for these savings institutions. The COFI moves slowly and lags behind the market. For COFI ARM borrowers, this is an advantage when interest rates are rising, but a disadvantage when rates are falling. When rates are rising, the COFI rate, and consequently the ARM rate, will rise slowly. Conversely, when rates are falling, the COFI rate and ARM rate will decrease slowly.

Popular ARM programs. Some of the more popular ARM programs include:

  • One-Year Treasury Bill ARM
    Adjusts annually with a two percent annual cap.
  • Six-Month Certificate of Deposit (CD) ARM
    Adjusts every six months with with an adjustment cap of 1 percent. The CD rate is very volatile and changes quickly with the market.
  • Six-Month Treasury Average ARM
    This index is relatively stable because it averages the treasury rate over the previous six months. This loan has a maximum interest rate adjustment of 1 percent every six months.
  • Twelve-Month Treasury Average ARM
    This index is relatively stable because it averages the treasury rate over the previous twelve months. This loan has a maximum interest rate adjustment of 2 percent every twelve months.
  • Three-month COFI ARM
    The COFI is one of the most stable indices and adjusts very slowly. The three-month COFI ARM typically has a very low start-rate for the first three months, after which time the interest is fully indexed and adjusts monthly.

Intermediate ARMs

The most popular intermediate ARM loans are the 3/1, 5/1, 7/1 and 10/1. These loans are normally amortized over thirty years with the interest rate initially fixed for three, five, seven and ten years respectively. After the initial fixed period, these loans typically adjust annually.

Intermediate ARMs are very popular with borrowers who want the stability of a fixed rate and the benefit of a lower introductory rate. If you plan to sell or refinance your home in three to ten years, you may want to consider an intermediate ARM loan rather than a fixed-rate mortgage. You can save money with the lower introductory rate, but you risk having a higher rate if you are still in your home when the introductory rate period expires and the rate starts adjusting toward market levels.

Graduated Payment Method

In general, GPMs were created to facilitate early home ownership for borrowers who expect their incomes to increase. GPM programs allow homeowners to make smaller monthly payments initially and to increase their size gradually over time. GPMs may also be beneficial for homeowners who plan to move or refinance relatively quickly.

A GPM allows a borrower to qualify at a payment lower than a comparable fixed-rate loan. By qualifying at a relatively lower payment, one can obtain a larger loan and potentially purchase a higher-priced home.

A GPM’s initial payments are lower than the minimum required to amortize the loan. Over a predetermined period of two to seven years, the payments increase by approximately 7.5 to 12.5 percent per year. Since the initial monthly payments are insufficient to amortize the loan, these loans feature negative amortization--the loan balance increases in the early years. A borrower has the option, however, to pay the fully amortized payment and avoid negative amortization.

There is a premium for receiving the benefits of a lower initial monthly payment--the interest rate is approximately .5 to .75 percent higher than a comparable fixed-rate mortgage. GPMs are available for Conforming and Jumbo loans.

FHA Loans

An FHA loan is a mortgage loan insured by the Federal Housing Administration. FHA is part of the U.S. Department of Housing and Urban Development (HUD). FHA insures loans made by banks, savings and loans, mortgage companies, credit unions and other approved institutions. FHA does not originate loans. Since 1934, FHA has offered mortgage insurance programs which help people purchase homes with a modest down payment. Title II, Section 203(b) is the most often used single family program. Under this program a borrower may obtain a ten, fifteen, twenty, twenty-five or thirty year loan to purchase an existing one- to four-family home in a rural or urban area.

In recent years, Fannie Mae and Freddie Mac have introduced low down-payment programs also--the Community Home Buyer program for example. Consequently, FHA loans are less popular than they once were. The loan limits for FHA loans vary geographically.

FHA requires a mortgage insurance premium (MIP) when insuring a loan. Currently, the up-front MIP is 2.25 percent of the base loan amount, or 1.75 percent for a qualified first-time homebuyer. The up-front MIP may be financed. In addition, there is a monthly MIP payment which is calculated by multiplying the loan amount by .5 percent and dividing by twelve. Condominiums do not require up-front MIP--only monthly MIP.

Down Payment Gifts:  One of the key benefits of an FHA program is that you do not have to use your own funds for the down payment. Under certain conditions, gifts are allowed if the donor is a relative, a close friend, an employer, or a humanitarian, welfare, or charitable organization. A gift letter, signed by the donor, is required stating the amount given and specifying that no repayment is expected, (See HUD Handbook 4000.2 REV-2)

Bridal Registry:  The Bridal Registry Account allows couples who are getting married to open a bridal registry savings account with a participating Federal Housing Administration approved bank. Family and friends may deposit cash wedding gifts directly into the interest-bearing account.

FHA Streamline Refinance:  FHA has made it very easy for borrowers to refinance their existing FHA loans. If your mortgage is currently FHA insured, your payments have not been late, you are not taking cash out, and you are reducing your payment--you may qualify for the FHA Streamline Refinance Program. An FHA Streamline Refinance typically does not require an appraisal

203(k) loan:  FHA insures rehabilitation loans for owner-occupants, municipalities and non-profit housing providers to finance 1) rehabilitation of an existing property, 2) rehabilitation and refinancing of a property, and 3) the purchase and rehabilitation of a property.

Investors must have a 15 percent down payment and can purchase (or refinance) and rehabilitate properties for rental purposes or sell the property (and get their profit using the Escrow Commitment Procedure) to a qualified Homebuyer (who assumes the loan).

203(k) can be used with one- to four-family dwellings, condominiums and HUD homes that require a minimum of $5,000 in repairs. CO-OPS ARE NOT ELIGIBLE. Garden apartment style row housing can be converted with 203(k) to fee simple or condominium with the addition of firewalls every four units. 203(k) loans can be used to bring illegal dwellings into code compliance.

Mixed use residential property is acceptable provided the property has no greater than 25 percent for a one story building; 33 percent for a three story building; and 49 percent for a two story building of its floor area used for commercial (storefront) purposes. The rehabilitation funds can only be used for the residential functions of the dwelling and areas used to access the residential part of the property.

Reverse mortgages for seniors:  Homeowners sixty-two and older who have paid off their mortgages or have only small mortgage balances remaining are eligible to participate in HUD's reverse mortgage program. The program allows homeowners to borrow against the equity in their homes.

Homeowners can receive payments in a lump sum, on a monthly basis, or on an occasional basis similar to a line of credit. Under certain circumstances, homeowners may restructure their payment options.

Unlike ordinary home equity loans, a HUD reverse mortgage does not require repayment as long as the borrower lives in the home. The reverse mortgage is repaid in one payment, after the death of the borrower, or when the borrower no longer occupies the property as a principal residence. Upon sale of the home, any remaining equity goes to the homeowner or to his or her survivors. If the sales proceeds are insufficient to pay the amount owed, HUD will pay the lending institution the amount of the shortfall.

The maximum amount of the reverse mortgage is determined by multiplying the maximum claim amount by the factor corresponding to the age of the youngest borrower and the expected rate. It is beyond the scope of this document to present the factorial tables required to calculate your particular maximum loan amount.

Home Improvement FHA Title 1 loans:  Under Title I, FHA insures loans obtained for repairs, alterations, and improvements to existing structures, and for the building of small new structures for nonresidential use. The property can be non-residential, multi-family, or single-family. Interest rates on these loans are set by HUD-approved lenders.

For answers to your FHA questions, call 1-800-CALLFHA.

Less Than Perfect Credit

Are there loan programs available for borrowers with less than perfect to extremely poor credit?  Absolutely.  Fundamentally, all the lender wants to be assured of is that 1) one has the ability, and 2) the desire to repay the debt.  The worse one's credit, the more evidence of one and two one will need to muster.

If you think you may be "credit challenged", one of the first things you'll want to know is, just how "less than perfect" is your credit?  Fortunately, many bright people have dedicated their professional lives to creating methods for answering such questions.  Statistical models which balance numerous credit factors provide methods for determining credit ratings.  The models generate a single number—a credit, or FICO score—which provides lenders with a starting point for making decisions about lending money.

How do you get your credit score?  Currently there is no law requiring that consumers be given their credit scores.  Lenders aren't required to give you your credit score—but some will if you ask them. The lender should, however, tell you what factors contributed to your credit score if your score was a factor in delaying or denying your loan application. Credit bureaus don't include credit scores on consumer credit reports.

Assuming you know your credit score—what does it mean?  Credit scores fall between approximately 375 to 900.  Anything over 670 is considered good credit.  Borrowers with good credit are able to get the best financing rates and terms available to the general public.

Lenders classify borrowers into the following credit categories based upon their credit scores. These categories can vary slightly among lenders. For example, a credit score of 620 could be a "B" with one lender, but a "C" with a different lender. The lower your score, the more expensive and restrictive your potential financing choices.

Credit
Rating
Credit
Score
A+670
A-660
B620
C580
D550
E520

It would be confusing at best to present general underwriting guidelines in an attempt to interpret credit ratings and scores as they relate to individual borrowers. In A- through E credit scenarios, dozens of factors are considered in the decision-making process. Your best assurance of getting the best possible loan is to shop among several lenders.

Bi-Weekly Programs

Making bi-weekly (ocurring once every two weeks) payments can shorten the life of your mortgage and reduce your interest expense over the life of the loan. Instead of making a full payment every month, you make a half payment every two weeks. Since there are fifty-two weeks in a year, you make twenty-six half payments, or thirteen full payments. As a result, you are making one extra mortgage payment per year. Making bi-weekly payments can reduce the term on a thirty-year, fixed loan to approximately twenty-two years.

There are several ways to implement a biweekly program:

  1. Contact your lender. See if they offer a bi-weekly program.
  2. Locate a company that helps borrowers make bi-weekly payments. The company will deduct payments from your bank account every two weeks, but will only pay your lender once per month. The disadvantage is that you loose interest on your money that you otherwise would have made. The advantage is that it is convenient and automatic. Be sure to fully investigate the company's credentials. There have been scams reported in the industry.
  3. Do it yourself. Open a bank account and make bi-weekly deposits. Each month, pay your lender from that account. You will earn interest on the money in your account.
  4. Make monthly pre-payments. Increase the amount you pay each month by one-twelfth (8.33%).  By increasing your mortgage payment by just over 8 percent, you shorten the life of your loan and save money effectively the same as you would with a bi-weekly loan.

Ask yourself some questions before committing in writing to a bi-weekly program.  Remember, any loan is potentially a bi-weekly loan.  If you have the discipline to make the extra payment per month or per year, why enter into a written agreement or pay someone to help you?  If you use a third party to help you, ask what their set-up and monthly servicing fees are, then determine what you're really saving.

Interest Rate Buydowns

Interest rate buydowns are used to help you qualify for a larger loan and obtain a higher priced home. Buydowns allow you to pay extra points up-front in return for a lower interest rate for the first few years. Since the additional points you pay are tax deductible, there is some tax benefit. People relocating due to employment often obtain buydowns. Employers sometimes pay the extra points as part of a relocation package.

The most common buydown program is the 2-1 buydown. With this program the interest rate is reduced 2 percent during the first year and 1 percent the second year. For example, if you obtain a 2-1 buydown on a 30-year, fixed, 8 percent mortgage, the rate is 6 percent the first year, 7 percent the second year and 8 percent thereafter.

Some companies offer a 3-2-1 buydown. This reduces your rate 3 percent the first year, 2 percent the second year and 1 percent the third year.

There are many variations of buydown programs. Some buydown programs result in interest rates changing every six months as opposed to every year.