Real Estate Loan Types
There are several types of loans and methods to finance the purchase of residential properties:
- conventional loans
- loans insured by the government
- seller financing
- special-purpose loans
Because there is some uncertainty in pricing real estate, all loans secured by the real estate are limited to a maximum percentage of the appraised value of the collateral, called the loan-to-value ratio (LTV ratio), minus the amount of any remaining senior loans secured by the real estate.
Loan to Value Ratio = Mortgage Amount / Appraised Value of Real Estate
- Appraisal: $100,000
- Maximum LTV: 80%
- Appraisal × Maximum LTV = $80,000
- Mortgage balance: $65,000
- Maximum loan secured by the real estate: $80,000 – $65,000 = $15,000
Many residential mortgages are guaranteed by the federal government and many lenders sell those mortgages to Fannie Mae (aka Federal National Mortgage Association, FNMA) and Freddie Mac (aka Federal Home Loan Mortgage Corporation, FHLMC), who, then, create mortgage-backed securities that are sold to investors. Once public corporations, both Fannie Mae and Freddie Mac are controlled by the Federal Housing Finance Authority (FHFA), a federal conservator, who assumed operation of Fannie Mae and Freddie Mac in September 2008 as a result of the Great Recession. Hence, both institutions are owned mostly by the U.S. Treasury.
A conventional loan is the most common type of mortgage that provides adequate security to the lender without government guarantees. The borrower must pay at least 20% of the appraised value of the property, so that the loan-to-value (LTV) ratio does not exceed 80%. In case of default, the lender can repossess the property and can usually sell it for a price high enough to pay off the loan. The lender protects itself by ensuring that the borrower is able to repay the loan, as determined through the borrower's income, employment history, high income-to-housing-expense ratios, high income-to-debt ratios, and by the borrower's credit score. Additionally, the lender obtains a real estate appraisal to ensure that the property is worth at least 125% of the loan amount, equal to the minimum LTV ratio of 80%.
The Federal Housing Administration (FHA), an agency of the Department of Housing and Urban Development (HUD), insures long-term loans by lenders. Its primary purpose is to administer loan guarantees and loan insurance for residential mortgages to make owning a home more affordable for low-income Americans. Lenders must be approved by the FHA and borrowers must meet minimum FHA qualifications. Moreover, the property securing the loan must also meet FHA standards for quality of construction, neighborhood quality, and other factors. Additionally, the appraiser for the property must be approved by the FHA.
The FHA insures against borrower default, but the borrower must pay for this protection by paying a mortgage insurance premium. As a consequence of the insurance, borrowers can make smaller downpayments, currently at 3.5%, which is considerably lower than the 20% required for conventional loans. When the borrower defaults, the FHA reimburses the lender for losses, including foreclosure costs.
FHA insured loans can be used to buy residential properties with 1 to 4 units. The FHA frequently changes mortgage premium charges, but currently, for terms not exceeding 15 years, and a loan-to-value ratio not exceeding 90%, the FHA charges an upfront premium of 1.75% of the loan amount and an annual premium of 35 basis points, or 60 basis points if the LTV exceeds 90%. For loan terms exceeding 15 years and with the LTV not exceeding 95%, the upfront premium is 1.575% and an annual premium of 120 basis points, or 1.2%; if the LTV exceeds 95%, then the annual premium is 1.25%. For loans exceeding $625,000, the FHA adds 25 basis points to the premium. If the seller pays the greater of 3% or $6000 of the buyer's closing costs, then these payments will be treated as sales concessions, which will lower the sales price on which the loan insurance premium will be calculated.
For any given region, the FHA sets a maximum loan amount, so all loans are restricted to the lesser of the maximum amount or the LTV ratio. The maximum LTV of 96.5% is based on the lesser of the sale price or the appraised value; 30 years is the maximum loan term and 3.5% is currently the minimum down payment required for a single-family residence.
The borrower can prepay without penalty if at least a 30-day notice is given to the lender of the prepayment; if less than 30 days, then the lender may charge up to 30 days interest.
Loans originated after December 15, 1989 are not assumable for investment properties nor for borrowers unless they fully qualify for the FHA loan. Loans originated before December 1, 1986 can be assumed, but loans after that require a creditworthy buyer.
The FHA also insures other types of loans, such as:
- subsidized loans for low- and middle-income families
- graduated payment loans
- adjustable-rate loans
- loans for home improvement, condominiums, and multifamily projects
The Veterans Administration (VA) also guarantees loans to qualified veterans, and, like FHA loans, qualifications for VA insured loans requires minimum standards of the lenders, borrowers, and the property. VA loans have several distinct advantages over other loan types: up to $417,000 can be borrowed with no down payment, if the property will be the borrower's principal residence. Additionally, VA loans impose no maximum debt ratio and no minimum credit score. However, since the VA uses its own appraisers, the real estate closing can take several weeks longer than average. Because of the additional red tape with VA loans, lenders try to steer veterans away from VA loans, even though a VA loan would probably be better for the borrower. There is no prepayment penalty and VA loans can be assumed if the buyer agrees to an assumption agreement. However, the original borrower remains liable for the debt unless a release is granted by the VA.
Although the VA will generally only insure loans, in rural areas, where mortgages may not be readily available, the VA may actually lend the money. Although the borrower does not pay for the loan guarantee, a VA funding fee is charged at closing. If the borrower defaults, then the VA will pay for the amount between the guaranteed amount and the proceeds of any foreclosure.
The appraiser must be approved by the VA, and based on the appraisal, the VA will issue a Certificate of Reasonable Value, which will be the maximum value guaranteed by the VA.
The VA has no requirements for downpayments, but the lender probably will. Although there is no maximum loan amount, the VA will only guarantee 25% of the amount, up to a maximum that depends on the medium home values, as estimated by the FHA, for the county in which the property is located. The maximum loan amount can be obtained from the VA by applying for a Certificate of Eligibility. For 1 to 4 family residences, the maximum loan term is 30 years; for farms, 40 years.
As with FHA loans, the interest rate is negotiable, and the lender may charge discount points, origination fees, and any other reasonable costs. Some of these costs may be paid by the seller, but they cannot be financed. The VA funding fee, which can be financed, is a percentage of the loan amount, where the percentage depends on the loan type, military category, whether there is a down payment, and if it is the 1st VA insured loan for the borrower.
A property seller may provide several types of financing. With a purchase-money mortgage (PMM), the borrower gives a mortgage and note to the seller and the seller conveys title to the buyer.
A wraparound loan is often used when a seller is not permitted to prepay an existing mortgage on the property without penalty or when the buyer wants to minimize or eliminate a down payment on the purchase. The buyer gives a junior mortgage to the seller, then the seller uses the payments from the wraparound loan to make payments on the original 1st mortgage. Wraparound loans allow the buyer to purchase property with a minimum cash investment, while a seller can profit from a possible lower interest rate on the senior loan and a higher rate on the wraparound loan.
A buyer should ensure that there are provisions in the wraparound mortgage that would allow the buyer to pay the original lender if the seller should default on the original mortgage. Also, wraparound loans will not work if the original mortgage has acceleration or alienation clauses, where the balance of the original mortgage would be due when the title is transferred to the buyer.
In a contract for deed sale, the seller retains title, but the buyer receives equitable title, thus allowing possession, while making payments to the seller under the terms the contract. The seller conveys legal title when the purchase price has been paid. A contract for deed sale is used by sellers whose existing mortgage has a due-on-sale clause, where the outstanding loan balance would be due when the legal title is transferred to the buyer.
Home Equity Loans
A home equity loan is usually a junior mortgage secured by the homeowner's equity and almost always has a variable interest rate. Home equity loans are generally used to consolidate debt or to finance other large purchases. The interest charged on home equity loans is generally tax-deductible as an itemized deduction. Home equity loans can be structured either as a home equity line of credit or HELOC, where the homeowner can draw on the credit line as needed, or as a lump sum that is received when the financing is completed. The maximum loan amount is the difference between the property's appraised value and the maximum loan-to-value ratio allowed by the lender, taking into consideration all existing mortgage loans on the property. The amount of deductible interest is limited:
Deductible Home Equity Interest = Lesser of $100,000 or (Fair Market Value of Home – Acquisition Debt)
How much the lender is willing to lend will depend on the value of home, the borrower's credit score, and how much is owned on the 1st mortgage. The LTV ratio usually ranges from 60% to 80% of home's appraised value. Home equity loans are often advertised as loans with no closing costs and low teaser rates, but usually include hidden fees, such as an appraisal fee and an annual fee. Borrowers should also consider whether interest rates will rise in the future, since interest rates are variable, and will rise along with general interest rates, making loan repayments more expensive.
HELOCs may also have additional loan provisions: the borrower may have the option to pay only interest for up to 10 years, called the draw period; afterwards, both interest and principal must be paid back. Additionally, some HELOCs may require an immediate draw.
Special-purpose loans are different, either in their purpose or in their provisions, from the more common home acquisition mortgages or loans secured by home equity. These are the most common types of special-purpose loans.
A straight loan (aka term loan) is a type of loan where only the interest is paid during the term of the loan and the principal is paid at the end of the term. Straight loans were the 1st type of loans available for financing real estate. So if the interest rate is 5% and the loan amount is $100,000, then the total amount that must be repaid annually would equal $100,000 × 5% = $5000. If the loan term is 10 years, then the borrower must pay $5000 annually and at the end of the 10th year, the borrower must also repay the $100,000 principal, for a total last year payment of $105,000.
An open-end loan is much like a home equity loan, but allows the borrower to increase the debt on an existing mortgage secured by the property, up to a certain amount. A note is executed by the borrower to the lender that specifies the maximum amount of the mortgage, which may be the original amount borrowed, and the terms and conditions for opening additional loans and for their repayment. Interest rates on open-end loans are usually based on market rates when the loan is opened.
A buydown mortgage is a mortgage where a large payment is made on the mortgage when it is originated, paid by someone other than the borrower, to lower the interest rate for the 1st few years of the loan. These types of loans are often used by homebuilders to stimulate sales of their new homes. A permanent buydown is a larger upfront payment that reduces the interest rate over the life of the loan, so it has a similar effect to paying discount points, but the funds are not paid by the borrower and the payment is held in an escrow account that is used to lower the effective interest rate of the loan.
However, most buydowns are temporary buydowns, based on buydown agreements between the borrower and the provider of the buydown funds, where the upfront payment is held in an escrow account. All mortgage instruments must reflect the permanent payment terms, without regard to the buydown. The lender withdraws an amount from the escrow account so that the mortgage payment by the buyer plus the withdrawn funds from the escrow account equals the regular payment that the lender would ordinarily receive at the interest rate stipulated in the mortgage. Because most lenders sell their mortgages to Freddie Mac and Fannie Mae, buydown agreements must conform to their requirements: the reduced interest rate period cannot exceed 3 years and the interest rate cannot increase by more than 1% per year. So a 3-2-1 buydown agreement would lower the borrower's interest rate by 3% in the 1st year, 2% in the 2nd year, and 1% in the 3rd year; thereafter, the interest rate would be the interest rate stipulated in the mortgage. Buydown funds are only refundable, either to the borrower or to the lender, depending on the agreement, if the mortgage is paid off within the initial 3-year period, such as would occur in a sale. If the mortgage is foreclosed, then the buydown funds will be applied to the debt on the property. If a buyer assumes a mortgage, then the new buyer may continue to use the funds under the terms of the original buydown agreement. Buydown funds cannot be used to pay past due amounts nor can they reduce mortgage amount for determining the LTV ratio. Additionally, buydowns can only be used for fixed rate mortgages or for certain adjustable-rate mortgages on primary or secondary residences, but they cannot be used for investment properties or cash-out refinance transactions.
Adjustable-rate mortgages (ARM) are mortgages where the interest rate can be adjusted periodically over the term of the loan. The interest rate is usually pegged to some specified market interest rate.
Graduated payment mortgages (GPM) require lower payments in the 1st few years for buyers who expect their income to increase in later years. Generally, GPM payments start out low in the 1st year than, then increase by a certain percentage for a certain number of years, then level off at a payment amount sufficient to amortize the loan.
On a balloon mortgage, interest and payments may be based on a longer-term than the actual term of the balloon loan. For instance, principal and interest payments may be based on a 30-year loan with a 5-year call for a balloon loan of 5 years. The last payment, which is by far the largest payment, is the balloon payment that pays off the loan. Most often, balloon mortgages are used by buyers who plan on living in the new home for only a few years.
Package loans finance the purchase of real estate and personal property, such as a furnished apartment or condominium.
Construction loans are high-risk loans used to finance home construction or improvements. However, construction loans are not usually given as a lump sum; instead, the lender pays installments, known as draws, as the construction progresses. The lender inspects the property before paying each draw. Additionally, the general contractor must provide a waiver to the lender that releases the rights of subcontractors to record a mechanics lien on the property. The borrower pays the accrued interest periodically, based on the amount dispersed. The borrower is expected to find permanent financing when construction is complete.
Construction loans usually have higher interest rates because the lender must periodically inspect the property to ensure that the work is progressing smoothly, because construction may be delayed, because the general contractor or subcontractors may go out of business, or because the release from possible mechanic's liens may be legally impaired.
Bridge loans are used to cover the period between the short-term construction loan and the long-term permanent loan, when the lender has difficulty finding a long-term lender with agreeable terms. Permanent loans (aka take-out loans) are used to pay off the balance of construction loans after completion. Terms are usually more favorable since construction is already completed, so the risk is reduced. Often, the original lender will offer a construction-to-permanent loan that becomes a permanent loan when construction is completed.
Participation loans allow the lender to participate in the income or equity of the property in exchange for more favorable loan terms. Participation loans are most often used for commercial realty, where the lender may receive a percentage of the rents.
A blanket mortgage is secured by more than 1 property, generally used to finance multiple parcels of land being developed by a contractor. A release provision allows the developer to sell individual lots without retiring the blanket mortgage.
Many commercial properties use a sale-and-leaseback loan to free up money for business. The business sells the property to an investor, who, in turn, leases the property back to the business.