Definitions of the Various Loan Programs

We going to start with the general types of underwriting guidelines and then we’ll move into a brief description of the more common mortgage programs.

In general the more documentation that is required on a program, the better the pricing is. So we are going to start with the lowest priced program and move up to the most expensive.

General Categories of Programs:

FNMA Conforming - This is a program that conforms to the FNMA underwriting guidelines. The loan amount is within the conforming limit, credit is good to excellent, income and assets are verified.

Jumbo Loans - These mortgages are underwritten to FNMA standards except that the amount of the mortgage exceeds FNMA guidelines. Jumbo mortgages typically are 0.25% to 0.375% higher in rate than conforming mortgages. The pricing difference between conforming and jumbo will come into play with the rest of the types we are going to discuss.

Stated Income – Here we are not going to document the income flow of the applicant but we will be providing documentation supporting his assets. Why would an applicant be willing to pay a higher rate for the luxury of not supplying documentation supporting his income? There are several circumstances when this approach is used. The applicant may have a complicated income flow. Self-employed with several different corporate entities to deal with or tax returns haven’t been finalized yet are just 2 possibilities. Maybe the applicant is in an all cash business or his income isn’t consistent year to year. These are all reasons to use this program.

Stated Income & Stated Asset – Here we don’t supply income documentation or proof of assets.

No Ratio Loan – Here we are listing the source of income but not the amount. In a stated income program the income stated must be reasonable to the job that the applicant has. For instance it’s not likely that a maid is earning $100,000 a year but a doctor can easily make that salary. Under a No Ratio program we just list the job without any income figures. This program can also be offered in conjunction with no asset verification.

4506 – The IRS form 4506 (8821 for corporations) is a form that grants the lender permission to request summary data from the IRS so they can verify that the income shown on the application matches the income that was claimed on the 1040. This form is typically part of the application package when originating a full income/full asset verified mortgage. Especially when the applicant is self-employed and therefore there is no third party verification of income. Typically, it is also signed as part of the closing package even with stated income programs. There are 2 reasons for this. The first is that in the event the mortgage goes into default, the mortgagee can check to see if insufficient income was a contributing factor. The second reason is that a percentage of closed mortgages are reviewed for quality control. If an applicant is applying for a stated income product he needs to be made aware of the fact that this form may appear at closing. If he is not comfortable signing it he will need to stay in a no ratio program, and pay the higher rate. It is the originator’s job to make the applicant aware of the details and then allow the applicant to choose what path he wants to take.

Specific Program types:

Fixed Rate Mortgage – The simplest and oldest mortgage type. The mortgage rate is fixed for the term of the mortgage and as a result the mortgage payment remains constant.

Adjustable Rate Mortgage – Typically identified as an ARM. Here the risk of a changing interest rate environment is transferred from the lender to the borrower. The lender has a guaranteed profit between their costs of funds and the interest collected on the mortgage. The borrower gains the benefit of a lower interest rate than a prevailing fixed. ARMs will vary as to the frequency of the adjustment period. It can adjust daily (as is typical in Home Equity Mortgages), monthly, 6 months, 1 year, 3 year or 5 years. The interest rate is determined by an index value that the lender has no control over, plus a margin. The most common index values are Prime Rate, 1-year Treasury or LIBOR (London Inter-Bank Offered Rate). The margin is a constant that when added to the index rate gives the actual rate charged on the mortgage for the upcoming period.

Hybrid ARM – These mortgages have become popular over the last several years. As the name implies, the idea is to create a mortgage that has the security of a fixed rate and the lower interest rate of an ARM. Typical Hybrid ARMS would be 3/1, 5/1, 7/1 or 10/1. A 3/1 would have a predetermined fixed rate for 3 years then become a 1-year ARM, a 5/1 would be fixed for 5 years before becoming a 1-year ARM, etc. The longer the fixed rate term is, the closer the rate gets to a fixed rate. The theory here is that the average life of a mortgage is historically 5 to 7 years, so why not design a mortgage product that gives the security of a fixed rate only for the time needed and not the life of the mortgage.

Home Equity Line of Credit (HELOC) – This is special type of mortgage. It can be used in a first or second position. Here the mortgage balance can increase or decrease at the borrower’s choice. The minimum payment is interest only and the amount of principal pay down is entirely up to the borrower. This type of mortgage comes with check writing privileges. It permits the borrower to increase the outstanding balance on the line (up to the credit limit) simply by writing a check. The following month’s payment will be based on a higher principal balance to reflect the draw.

Interest Only Mortgage (I/O) – A typical mortgage payment includes a portion of the payment that is applied to reduction of principal. If the mortgage is written as an interest only mortgage then the payment is reduced to the interest component only with no principal pay down. Principal is paid either as a balloon (payment of the entire principal balance) after a predetermined time period or the mortgage begins to amortize (monthly principal pay down as in a standard mortgage) at a certain point. The majorities of I/O mortgages written today are designed to be I/O for 10 years and then amortizes at the same interest rate for the remaining term. If it was originated as a 30-year mortgage you would have a 10-year I/O period followed by a fully amortized mortgage for the remaining 20 years. In order to minimize the payment shock at the 10-year point lenders have begun to offer 40-year mortgages. Some are even beginning to offer 50-year mortgages.

When an I/O feature is added onto a mortgage program the interest rate will be increased. As an example we will take a 30-year fixed rate mortgage at a rate of 6.25% and compare it to its I/O version with a 0.25% increase and a 0.375% increase. Doing this will allow you to compare the payment saving each month to the actual cost of using this feature.

After the first year there was a saving of $7,553.16 ($62,803.20 - $55,250.04) in monthly payments compared to the 6.5% I/O payment. The trade off is that the total interest paid for the money increased by $2,407.15 ($55,250.04 - $52,842.89) and the outstanding balance on the mortgage is still $850,000 instead of dropping by $9,960.11 ($850,000.00 - $840,039.69). If you compare it to the 6.625% I/O payment you'll see that the total interest increase by $3,469.63 ($56,312.52 - $52,842.89). Let's look at what happens at year 2 and 3.

After year 3 there was a savings of $22,659.34 ($188,409.46 - $165,750.12) in monthly payments compare to the 6.5% I/O payment. Now the total interest paid for the money increased by $9,184.66 ($165,750.12 - $156,565.46) and the principal balance of the mortgage didn't drop by $31,844.14 ($850,000 - $818,155.86).

Fixed Payment Mortgages - These are the most complicated mortgages that have ever been designed by the industry. You'll see them identified as COFI, COSI, Pay Option ARM, Pick-a-Payment or other variations. COFI is the index value for the mortgage; it's short for the 11th District Cost of Funds Index. The 11th district represents the West Coast and the region where this mortgage type began. COSI is an index that reflexes the yield on saving accounts. Pay Option ARM or Pick-a-Payment focuses on the ability of borrower to choose what payment is going to be made (the minimum, interest only, 30 year amortization or 15 year amortization payment). This mortgage was designed to meet the needs of two classes of borrowers. They are the high net worth individuals that find the flexibility of this product very appealing or the second group, made up of those who need lower monthly payments in the short term, at any cost.

This type of mortgage creates a new term in mortgages, that is payment rate. The payment rate is the rate that is used to determine the payment for the first year.

Let’s start by walking through the reasoning that is responsible for the creation of this product. Problem: How to reduce the monthly payment on a mortgage? If you start with the traditional fixed rate you can reduce the payment by making it interest only. You can reduce the interest rate by making the mortgage an adjustable rate. Now you have an adjustable I/O mortgage but you still want to deliver a lower monthly payment, what do you do? The lender needs to get a certain yield on the mortgage, or it doesn’t make economical sense to be in the mortgage business, so lowering the rate isn’t an option. The only option available is to design a negative-amortization mortgage. If an amortizing mortgage means that a portion of the principal balance is paid down on each payment then a loan with negative amortization means that the principal balance increases on every payment. The lender effectively lends the borrower additional capital each month. Seems dangerous and it is. This is a product that an originator needs to spend a lot of time explaining to a client.

The best way to explain how this product works is with an example. We start with a $100,000 mortgage. The interest rate (that is index rate plus margin) on the Note will be 7.0%. This is a monthly adjustable. The payment rate shall be 2.0%. The loan will have a 7.5% annual payment cap, a 10% maximum negative amortization cap and a lifetime interest rate cap of 12%. Let’s begin with looking at what all this means. This is a monthly ARM so the interest rate will change each month. As I noted in the ARM section, adding the index value to a margin makes up the interest rate on an ARM. The payment rate is used to determine the original mortgage payment and nothing else. If there were never any increase in the monthly payment the principal would just continue to go up every month. This can’t happen for obvious reasons so the mortgage payment is designed to increase by a predetermined amount each year. In this case that’s a 7.5% increase. If the index rate climbs dramatically the amount on negative amortization could get out of hand. To prevent this there is a 10% cap on the amount the mortgage can increase over the life of the mortgage. What this means is that if the principal balance increases to $110,000 in our example, the monthly payment would immediately have to increase enough to meet the interest accrued for that month. The interest rate on this mortgage can never exceed 12%, no mater how high the index value should go.

Now we can look at the numbers. $100,000 @ 2.0% for 30 years gives us a payment of $369.62. This payment will remain the same for 12 months, then it will increase to $397.34, at the 24th month the payment will increase to $427.14, and so on. The actual mortgage rate is 7.0% (for this example we will assume the index rate isn’t changing) so the interest that is due on month 1 is $583.33. Only $369.62 was paid resulting with the balance of the mortgage increasing to $100,213.71. Month 2 carries an interest payment of $584.58 due to the higher principal balance.

Remember this is based on no changes to the index value. In reality there will be changes. The majority of consumers that get involved in this type of mortgage don’t realize all its features. They are focused on the initial monthly payment and nothing else. This is why the mortgage professional is obligated to invest the time needed to give a complete explanation.

Reverse Mortgage – This is a unique type of mortgage available only to senior citizens. Depending on the age of the applicant and the equity in the home, a senior citizen can receive money without any other investigation or any requirement to make monthly payments. This mortgage is designed to allow a senior citizen to stay in his/her home while living off of the home’s equity. The mortgage is required to be paid off when the senior no longer uses the property as his or her primary residence. When the property is sold by either the senior or his or her estate the mortgage is satisfied with the proceeds of sale. All funds in excess of the payoff goes to the senior or the heirs. In the event the property is sold for less than the outstanding mortgage balance, the lender has no recourse. The lender is required to absorb any shortfall and cannot go after the senior or the heirs for the payoff shortfall.