Real Estate Financing
Most people finance real estate by borrowing money. Because real estate serves as secure collateral, real estate loans generally have the lowest interest rates. Real estate loans for properties consisting of 1 to 4 residential units are heavily regulated by law and by custom. The lender will 1st determine that the borrower can repay the loan, by looking at the borrower's income and creditworthiness. Additionally, the lender will require that the collateral be protected and that there are no superior liens on the property. Consequently, most loan repayments consists not only of principal and interest, but also monthly payments for real estate taxes and insurance to cover property damage or destruction, held in escrow so that the lender can be sure that taxes and insurance premiums are paid. The combined payments are frequently referred to as PITI (principal, interest, taxes, and insurance) payments.
Borrowers will generally seek preapproval for a loan so that they can know what they can afford while shopping around, but being preapproved for a loan is not the same as a loan commitment, which the lender will not make until the property is selected and appraised, to ensure that the value of the collateral is more than sufficient to cover the loan.
Financing and Payments
Besides the loan itself, lenders charge other fees, such as a loan origination fee, that is usually assessed as a percentage of the loan, referred to as points, where 1 point = 1% of the loan. An application fee (aka processing fee, underwriting fee) may also be charged that may include a prepayment for the appraisal for the lender. A preparation fee may also be charged for preparing the loan documents.
Prepaid interest is the interest charged on a loan when the closing date falls before the beginning of the month, covering the number of days in the partial month. Additionally, insurance and property taxes are also paid at closing.
Each loan payment will also include 1/12 of the annual amount for property taxes and insurance in addition to the monthly loan payment. The money for the real estate taxes and insurance is held in an escrow account, which is held in trust until used to pay taxes or insurance premiums. If taxes or insurance increase, then escrow payments will also increase to cover the additional costs.
When discount points are paid, the lender gives the borrower the loan amount minus the discount points, but the full loan amount must be repaid. Discount points are paid to the lender to lower the interest rate, where each discount point on a 30-year loan will typically lower the interest rate by 0.125%. However, it may not make sense to pay discount points for a loan of shorter duration or if the buyer intends to sell within a few years. Naturally, it would make sense to compare the cost of the discount points with a higher interest rate over the expected term of the loan. Sometimes, the seller will pay the points in exchange for a higher selling price.
For the lender, receiving a discount point is equal to raising the interest rate by 1/8%, so a lender must charge 8 points to raise the yield by 1%.
So if a lender needs to earn 7% of a loan offered at 6.5% then points would be calculated thus: 7.0% – 6.5% = .5%
.5% × 8 (points per 1%) = 4 points
So on a $100,000 loan, the lender would need to charge $4000 as points. Thus, the lender would lend $96,000, but the principal and interest would be based on $100,000.
Oftentimes, the borrower will pay the points in a separate check to the lender, so that the points can be deducted from taxable income in the year paid rather than ratably over the term of the loan.
A real estate loan is generally referred to as a mortgage, where the borrower receives the money from the lender in exchange for a promissory note, promising to repay the loan, while the lender places a lien on the property as collateral. Most lenders use the same mortgage application — the Uniform Residential Loan Application, or some version thereof — used by Fannie Mae or Freddie Mac.
The borrower is a maker or payer of the promissory note, while the lender is the payee. At a minimum, the note would specify:
- loan amount
- term of the loan
- method and timing of repayment
- the loan interest rate
- the borrower's promise to repay the loan
The loan agreement may also have the following provisions:
- the right to prepay the loan
- late payment charges
- conditions for default
- notifications and cures for default
- other charges associated with the loan
Many of the above items may also be in the mortgage or deed of trust. Because promissory notes are negotiable instruments, the payee can assign the note to a third party. The borrower would then send the payments to the assignee instead of the lender.
The parties to the loan agreement will have a slightly different legal relationship, depending on the type of contract. With a mortgage, the borrower is the mortgagor and the lender is the mortgagee. With a deed of trust, the borrower is the trustor, the lender is the beneficiary, and a trustee holds legal title to the property until the loan is repaid. The mortgage or trust document generally identifies the property being given as security, specifying both the mailing address and the legal description of the property, and some of the other items listed in the promissory note, including the date, amount, loan term, and method and timing of payments.
Payments of only principal and interest to the lender are called P&I payments (principal and interest). Payments that include escrow payments for taxes and hazard insurance are often referred to as PITI (principal, interest, taxes, insurance) payments. The Real Estate Settlement Procedures Act (RESPA) limits the amount that the lender can require for taxes and hazard insurance. Unless local law specifies otherwise, the application of the payments goes to prepayment charges, escrow, interest, principal, then late charges. The proceeds of hazard or property insurance are applied to restoring the property, if possible. If not, then the proceeds are used to reduce or pay the debt.
The borrower must occupy the property for a specified minimum duration, and also must preserve, maintain, and protect the property so that the value of the lender's security interest is preserved. If the lender must take any actions to preserve the property, then those costs will be charged to the borrower. Additionally, with proper notice, the lender may inspect the property to ensure that the property is being preserved.
Additionally, the borrower must not incur any charges that would result in a lien on the property that would supersede the lender's lien, such as the nonpayment of taxes. If the property is condemned by an agency or government, then the lender will stake a claim on the proceeds.
Any forbearance by the lender in regards to the terms of the contract does not eliminate or alter the original liability of the borrower. If the lender does not take immediate action in regard to a default, it still has a right to do so in the future.
If the borrower transfers either the property or interest in the property without the lender's approval, then the lender can demand full repayment of the loan based on the alienation clause, due-on-sale clause, or what is sometimes known as a call clause, because the lender can call the loan in. Mortgage documents also have a redemption clause, stipulated by state law, that allows a borrower to redeem the property by paying past-due payments or other expenses that the lender incurred in protecting its rights.
After all necessary payments have been made, then the lender will execute a satisfaction of mortgage (aka release of mortgage, mortgage discharge) to the borrower. If the loan is based on a deed of trust, then the lender instructs the trustee to execute a release of deed or a deed of reconveyance to the trustor, who is the borrower. The release should be recorded in title records to indicate that the lender has no lien on the property.
Mortgage Loan Underwriting
Loan underwriting is the evaluation of the lender's risk for a given loan. Risk is evaluated by the following factors:
- the borrower's ability to repay the loan
- creditworthiness of the borrower
- determining whether the property value is sufficient to cover the loan
- the terms of the loan
The loan underwriter assesses both the borrower and the property. To determine if the borrower can repay the loan, the underwriter considers income, cash resources, net worth, creditworthiness, and employment stability.
The property value should exceed any potential losses, including costs of collection or foreclosure, so lenders will only loan a percentage of the property value, referred to as the loan-to-value ratio (LTV ratio). If the LTV ratio is high, then the lender may also require private mortgage insurance.
To assess the borrower, the lender considers income, debt, cash, and net worth, in addition to creditworthiness. The Equal Credit Opportunity Act (ECOA) requires lenders to evaluate the income and credit rating of the applicant only, unless the applicant wants to include the income of a spouse or some other person. There are additional requirements to prevent discrimination. The lender may not discount or disregard the income from part-time work, a spouse, child support, alimony, or separate maintenance payments, nor may the lender ask if the applicant's income is derived from any of these sources. Additionally, the lender may not assume that income will be reduced because of the possibility of pregnancy or raising a child nor can the lender ask about plans concerning childbearing and birth control. The lender cannot refuse a loan based solely on geographic location of the property nor may the lender ask about age, sex, religion, race, or national origin, except as required by law. There can be no condition requiring that a spouse cosign a loan unless the spouse's income is supposed to be included in the application or if the state requires a signature to deliver a clear title.
If the loan is denied or changes were made to the requested terms of the loan, then the lender must provide written notice to the applicant as to the reasons. Since January 2014, the Consumer Financial Protection Bureau has amended the ECOA for new mortgages. The law specifies that only 8 factors can be considered in qualifying a borrower's ability to repay:
- current income, or assets, not including the mortgaged property
- employment status
- credit history
- monthly mortgage payments
- monthly payments for other loans secured by the same property
- monthly payments for other mortgage related expenses, including insurance and real estate taxes
- other debts
- monthly debt payments to monthly pre-tax income, the debt-to-income ratio.
In qualifying an applicant, the lender may not use teaser rates. For adjustable rate mortgages, the highest rate that the borrower would have to pay must be used.
The rules are not as rigid if the loan applicant is seeking a less risky loan to replace a riskier loan, such as replacing an interest-only mortgage with a 30 year fixed term mortgage.
Fannie Mae Will Start to Use Trended Credit Data to Underwrite Consumers
Starting in mid-2016, Fannie Mae will start using trended credit data from all 3 credit reporting agencies — Equifax, Experian, and Trans Union — for all mortgage applications. The trended credit data focuses on credit data from the past 30 months, showing not only if payments were made on time, but whether the borrowers carried balances from month-to-month, paid off the balances in full, or at least paid more than the minimum. Studies by TransUnion have shown that consumers who carry balances or who only pay the minimum balance are a greater risk than those who pay in full. TransUnion estimates that trended credit data will put more consumers, from 12% to more than 21%, in the so-called Super Prime risk tier, who are offered the best credit terms.
A qualified mortgage adheres to certain rules, allowing certain government agencies, such as Fannie Mae and Freddie Mac, to buy the loan from a lender and gives the lender some protection if the borrower fails to repay the loan. A qualified mortgage has the following provisions:
- no interest-only period
- no negative amortization, when the principal increases over succeeding payment periods
- no balloon payments, where the last payment is much larger than the previous payments
- the loan term cannot exceed 30 years
- no excessive upfront fees and points
- the monthly debt to monthly pretax income ratio cannot exceed 43%.
Qualified mortgages can be bought by Fannie Mae or Freddie Mac or by certain other government agencies. Loans insured by the Department of Housing and Urban Development, including the Federal Housing Administration, are qualified mortgages.
A qualified mortgage also requires the lender to notify the borrower of any property appraisals or valuations. The borrower must be notified within 3 days of the loan application that any copies of the real estate appraisal will be provided. Additionally, on the earlier of when valuation reports are completed or by 3 days before closing, the lender must provide the borrower with a free copy of appraisal reports, automated valuation model reports, or broker's price opinions that were used in determining the property value. This information must be provided even if the loan does not close. However, the lender may charge a reasonable fee for the evaluation and may ask for an extension to the deadline in delivering the documents before closing. Borrowers can waive their right to receive appraisal copies by the 3rd day before closing, but probably shouldn't because it will take time to examine the report for possible mistakes. If borrowers waive their right, then lenders may give them a copy of any reports on the day of closing.
To reduce credit risk, lenders qualify borrowers to ensure that they can repay the loan. Lenders 1st screen applicants by using several income and debt ratios, some of which are required by the secondary mortgage market, to assess the creditworthiness of borrowers. Lenders depending on government guarantees may also be required to use other ratios.
One required ratio is the income ratio (aka housing ratio):
Income Ratio = Monthly Housing Expense ÷ Monthly Gross Income
Housing costs include principal, interest, taxes, homeowners insurance, and may include mortgage insurance, utilities, and monthly assessments. The maximum income ratio generally ranges from 25 to 28%. The maximum FHA based loan ratio is 29%, while VA guaranteed loans do not use the income ratio. The maximum income ratio determines the maximum monthly housing expense for a given income:
Monthly Housing Expense = Monthly Gross Income × Income Ratio
Example: if your income is $4000 per month and the maximum income ratio is 28%, then the maximum housing expense is calculated thus: $4000 × 28% = $1120
Another ratio used to determine the ability to repay the loan is the debt ratio (aka housing plus debt ratio). The debt ratio includes expenses accounted for in the income ratio plus additional monthly payments on other debt, especially credit card debt and other consumer loans.
Debt Ratio = (Monthly Housing Expense + Monthly Debt Obligations) ÷ Monthly Gross Income
The maximum debt ratio for most lenders is 36%; for FHA and VA loans, 41%. FHA and VA loans include any expense greater than $100 per month and any debt with a remaining term exceeding 6 months.
VA guaranteed loans require that borrowers have a minimum net income after paying federal, state, and unemployment taxes, and housing maintenance and utility expenses. These income requirements will depend on family size, loan amount, and geographic region.
Income stability is also important and is measured by:
- length of time in present job
- frequency of job changes
- likelihood that secondary income, such as bonuses and overtime, will continue regularly
- the probability of current income continuing in the future, assessed by educational level, age, training and skills, and occupation.
If the borrower borrows money from friends, relatives, or other sources for the down payment, then that debt will be considered in calculating the ratios. If part or all the down payment is a gift, then the lender may require a gift letter stating that it is a true gift that does not have to be repaid.
A higher net worth also reduces credit risk. Lenders want to see a higher net worth, consisting of liquid assets, including cash reserves.
Net Worth = Assets – Liabilities
Credit is generally evaluated by obtaining a credit report and credit score on the borrower. The credit report lists all outstanding debts, timeliness of debt payments, and any legal public records, such as bankruptcies, foreclosures, garnishments, repossessions, defaults, divorces, lawsuits, and judgments. Lenders will generally deny a loan to a borrower with serious credit problems unless the borrower can provide a reasonable explanation for the adverse marks on the report and that those reasons will not affect future obligations. If a lender denies an applicant a loan because of credit problems, then the applicant is entitled to the reason for the denial and the reasons for the negative marks from the creditors responsible for the negative marks.
If the borrower qualifies for the underwriting guidelines and the lender decides to make a loan, then the lender will provide a written notice of agreement to lend under specific terms. The terms of this loan commitment can take various forms: firm commitment, a lock-in commitment, a conditional commitment, and a takeout commitment.
- The most common type of the loan commitment is the firm commitment that specifies a specific loan amount, interest rate, and term for the loan.
- The lock-in commitment is the same as the firm commitment but the interest rate expires after a specified duration, such as 30 or 60 days. The interest rate guarantee for the period specified may cost points.
- A conditional commitment is most often made for construction loans, where funding depends on the amount of completion
- A takeout commitment is for a loan that will take out another lender's loan by paying it off and replacing it. Most often used to pay off the construction loan, the lender issues a long-term loan to replace the short-term construction loan.
Proscribed Lending Practices
In the aftermath of the 2007 to 2009 credit crisis, new laws were enacted to protect borrowers against unscrupulous lending practices. During the credit crisis, many of the borrowers used mortgage brokers to find a loan. However, many lenders offered financial incentives to mortgage brokers to offer borrowers loans with higher interest rates or other undesirable features. Consequently, loan originators can no longer tie payments to mortgage brokers based on the interest rate of the loan nor can mortgage brokers receive financial incentives for using a particular service, such as a particular title company. If the borrower is paying for the mortgage broker, then the broker cannot also receive payment from lender.
Loan originators must be licensed or registered under any applicable state or federal laws. However, employees of some banks and nonprofits do not require a state license, but do have to pass background and reference checks by their employer.
Mandatory arbitration clauses are prohibited in contracts for both mortgages and home equity lines of credit, since arbitration often limited the rights of borrowers and often favored the plaintiffs, since lenders often had better information about the arbitrators, obtained as participants in numerous arbitration cases. However, the borrower can agree to arbitration after a dispute has arisen, if both parties agree to it.
Lenders cannot add the cost of credit insurance to the loan amounts. Credit insurance pays some or all the balance of a loan if the borrower becomes disabled or dies or because of some other specified condition, such as losing a job. Borrowers can still buy credit insurance, but only as an upfront payment or as monthly premium payments that are separate from the loan payments, which is advantageous to the borrower because interest does not accrue on any loan amounts for the credit insurance. Special additional rules apply to credit unemployment insurance.
At closing, the mortgage loan is placed with the escrow agent with instructions on how the funds are to be disbursed. The title to the mortgaged property is transferred and recorded as required by law. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank act), the Consumer Financial Protection Bureau implements most of the laws for federal consumer financial protection, including enforcement of RESPA, ECOA, and Truth in Lending.
Regulation Z requires that lenders who provide credit for at least 5 residential properties per year disclose all finance charges as an APR before closing. However, other closing costs, such as for the credit report, appraisal, title, survey, or any legal expenses is not required to be disclosed by Regulation Z.
HUD requires lenders to provide a good faith estimate of settlement costs within 3 days of receiving the loan application. Furthermore, the buyer has the right to see the Uniform Settlement Statement at least 1 day before closing. Lenders must also give buyers a copy of the Settlement Costs Booklet, published by HUD.
The settlement statement, which can be modified according to local practices, must specify:
- title charges
- recording and transfer fees
- tax and insurance escrow deposits and any other settlement charges
If the property is in a federally designated flood area, then any borrowers obtaining funds guaranteed by the federal government must get flood insurance.
To free up money for other loans, lenders generally sell their mortgages in the secondary mortgage market. The primary mortgage market is formed by lenders who originate mortgage loans directly to consumers, including:
- savings and loans
- commercial banks
- mutual savings banks
- credit unions
- mortgage bankers
- life insurance companies
Mortgage brokers are also considered part of the primary mortgage market, even though they do not lend to consumers, but rather serve as intermediaries between lenders and consumers.
The secondary mortgage market consists of lenders, investors, and government agencies who buy loans originated by other lenders to sell as securities to investors. Secondary mortgage market participants include:
- Fannie Mae, Freddie Mac, Ginnie Mae
- investment firms
- life insurance companies
- pension funds
- primary market institutions
Primary lenders sell their loans so that they can make more loans. The primary lenders profit from the sale of the loans to the secondary market as compensation for underwriting, originating, and servicing the loans.
Secondary mortgage market participants securitize the purchased loans, then sell the securities to investors, usually as mortgage-backed securities. Only loans that meet minimum requirements of quality of collateral, borrower, and documentation can be sold in the secondary market. Hence, primary lenders who want to sell their loans in the secondary mortgage market will have to use the same guidelines when underwriting loan applicants. However, the secondary mortgage market participants generally hire mortgage servicing companies or primary lenders to service the loans.
Because the secondary mortgage market requires certain loan provisions, some lenders choose not to resell their loans so that they can provide loans that other primary lenders do not offer. These portfolio lenders do not resell their loans to the secondary market. Instead, their portfolio loans are held by the lender. Portfolio lenders are not subject to the restrictions imposed by the secondary mortgage market, thus allowing lenders to relax the underwriting criteria for downpayments and the quality of the collateral.