by Attorney William Bronchick (legalwiz.com). 
For more information go to legalwiz.com .

Understanding Loan Terms

When considering an investment property loan from an institutional lender, you need to consider many of the variables involved in the loan terms being offered.

Interest Rate

The cost of borrowing money, i.e., the interest rate, is one of the most important factors. Interest rates affect monthly payments, which in turn affects how much you can afford to pay for a property. It may also affect cash flow, which affects your decision to hold or sell property.

Loan Amortization

There are many different ways a loan can be structured as far as Simple Interest and Amortized. A simple interest loan is calculated by multiplying the loan balance by the interest rate. So, for example, a $100,000 loan at 12% interest would be $1,000.00 per month. The payments here, of course, represent interest–only, so the principal amount of the loan does not change.

An amortized loan is slightly more involved. The actual mathematical formula is complex, so it requires a calculator. The amortization method breaks down payments over a number of years, with the payment remaining constant each month. However, the interest is calculated on the remaining balance, so the amount of each monthly payment that accounts for principal and interest changes. For the most part, the more payments you make, the more you decrease the amount of principal (the amount of the loan still left to pay) owed.

Balloon Mortgage

A balloon is a premature end to a loan’s life. For example, a loan could call for interest–only payments for three years, then be due in full at the end of three years. Or, a loan could be amortized over 30 years, with the principal balance remaining due in five years. When the loan balloon payment becomes due, the borrower must pay the full amount or face foreclosure.

Adjustable Rate Mortgages (ARM)

With interest rates uncertain in the future, many lenders are offering variable–rate financing. Known as an “ARM” loan (adjustable rate mortgage), there are dozens of variations to suit the lender’s profit motives and borrower’s needs. ARM loans have two limits (“caps”) on the rate increase. One cap regulates the limit on interest rate increases over the life of the loan; the other limits the amount the interest rate can be increased at a time. For example, if the initial rate is 6%, it may have a lifetime cap of 11% and a one–time cap of 2%. The adjustments are made monthly, every six months, once a year or every few years, depending upon the “index the ARM loan is based.” An index is an outside source that can be determined by formulas, such as:

“LIBOR” (London Interbank Offered Rate) – based on the interest rate at which international banks lend and borrow funds in the London Interbank market.

“COFI” (Cost of Funds Index) – based on the 11th District’s Federal Home Loan Bank of San Francisco. These loans often adjust on a monthly basis, which can make bookkeeping a real headache!

T–bills Index – this is based on average rates the Federal government pays on U.S. treasury bills. Also known as the Treasury Constant Maturity or “TCM,” these are the rates banks are paying on six month CDs.

The mortgage business is a complicated and ever-changing industry. It is important that you understand how the mortgage market works and how the lenders make their profit. In doing so, you will gain an appreciation of loan programs and why certain loans are offered by certain lenders.

Understanding the Mortgage Market

Institutional Lenders

The first broad category of distinction is institutional versus private. Institutional lenders include commercial banks, savings and loans, credit unions, mortgage banking companies, pension funds, and insurance companies. These lenders generally make loans based on the income and credit of the borrower, and they generally follow standard lending guidelines. Private lenders are individuals or small companies that do not have insured depositors and are generally not regulated by the federal government.

Primary Versus Secondary Market

First, these markets should not be confused with first and second mortgages. Primary mortgage lenders deal directly with the public. They “originate” loans, that is, they lend money directly to the borrower. Often referred to as the “retail” side of the business, lenders make a profit from loan processing fees, not the interest paid on the loan.

Primary mortgage lenders generally lend money to consumers, then sell the mortgage notes (in large packages, not one at a time) to investors on the secondary mortgage market to replenish their cash reserves.

The largest buyers on the secondary market are the Federal National Mortgage Association (FNMA or “Fannie Mae”), the Government National Mortgage Association (GNMA or “Ginnie Mae”) and the Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”). Private financial institutions such as banks, life insurance companies, private investors, and thrift associations also buy notes.

Mortgage Brokers Versus Mortgage Bankers

Many consumers assume that “mortgage companies” are banks that lend their own money. In fact, a company that you deal with may be either a mortgage banker or a mortgage broker.

A mortgage banker is a direct lender; it lends you its own money, although it often sells the loan to the secondary market. Mortgage bankers (also known as “direct lenders”) sometimes retain servicing rights as well.

A mortgage broker is a middleman; he does the loan shopping and analysis for the borrower and puts the lender and borrower together. Many of the lenders through which the broker finds loans do not deal directly with the public (hence the expression, “wholesale lender”).

Conventional Vs. Non-Conventional

“Conventional” financing, by definition, is not insured or guaranteed by the federal government. Conventional loans are generally broken into two categories: “conforming” and “non-conforming.” A conforming loan is one that conforms or adheres to strict Fannie Mae/Freddie Mac loan underwriting guidelines.

Conforming loans are a low risk to the lender, so they offer the lowest interest rates. Conforming loans also have the strictest underwriting guidelines.

Conforming loans have three basic requirements:

• Borrower Must Have a Minimum of Debt: Lenders look at the ratio of your monthly debt to income. Your regular monthly expenses (including mortgage payments, property taxes, insurance) should total no more than 25 to 28% of gross monthly income (called “front end ratio”). Furthermore, your monthly expenses, plus other long-term debt payments (e.g., student loan, automobile, alimony, child support) should total no more than 36% of your gross monthly income (called “back end ratio”). These ratios can sometimes be increased if the borrower has excellent credit or puts more money down.
   
• Good Credit Rating: You must be current on payments. Lenders will also require a certain minimum credit score called a “FICO” ( http://www.myfico.com ).
   
• Funds to Close: You must have the requisite down payment (generally 20% of the purchase price, although lenders often bend this rule), proof of where it came from, and a few months of cash reserves in the bank.

Non-Conforming Loans

Non-conforming loans have no set guidelines and vary widely from lender to lender. In fact, lenders often change their own non-conforming guidelines from month to month.

Non-conforming loans are also known as “sub-prime” loans, because the target customer (borrower) has credit and/or income verification that is less-than-perfect. The sub-prime loans are often rated according to the creditworthiness of the borrower – “A,” “B”, “C” and “D.”

The sub-prime loan business has grown enormously over the past ten years, particularly in the refinance business and with investor loans. Every lender has its own criteria for sub-prime loans, so it is impossible to list every loan program available on the market. Suffice it to say, the guidelines for sub-prime loans are much more lax than they are for conforming loans.

Non Income Verification Loans

The best interest rates are generally for conforming loans. A conforming loan is one that adheres to FNMA's strict lending guidelines. Conforming loans generally require strict proof of income, assets and other debts. If, for example, you cannot prove income to a lender, whether it be you are self-employed for a short time or can't otherwise prove income, there are non-income verification (NIV) loans.

NIV loans are not just for people that are self-employed. In fact, I often use NIV programs because the loan process is faster. Because I have many rental properties, documentation for the loan process becomes more and more cumbersome each time I apply. The NIV loan makes the process smoother and easier.

NIV loans (also known as "stated income") require less documentation than traditional conforming loans. Lenders often advertise these programs as "no doc" loans, meaning the borrower does not have to come up with any documentation other than a credit report and a loan application.

Some loans are called "no ratio" loans, in that you don't have to justify your total debt (mortgages plus other continuing obligations, such as car loans and student loans) compared to your income.

Few, if any loans are true "no documentation" loans. Most of these offered programs are either "bait and switch" tactics; the lender says they don't need documentation, but when the loan is being processed, the lender will ask for more and more documentation. Often times the lender will see some red flags that trigger the additional inquiry.

The best defense to these tactics is a good offense; speak to your lender or mortgage broker up front. Identify documentation issues up front, educate the lender about your finances and be truthful. The more a lender suspects you are hiding something, the more documentation the lender will ask for.

SIDE NOTE: Watch What You Say on NIV Loans. Just because you don’t have to provide documentation of your income to the lender, it doesn’t mean you have a license to lie. Most lenders will make you sign an authorization to release federal income tax returns. They may not check now, but if your loan goes into default, they may obtain copies of your tax returns. If the income you report on your loan application is way out of sync with your tax returns, you may be answering to loan fraud charges.

Of course, there is a price to pay for doing an NIV loan; the interest rate is generally higher for NIV loans than for full documentation loans. The reason for the higher rate is obvious – the less documentation you provide, the more risky you are as a borrower. However, the more aggressive portfolio lenders, such as Countrywide and Washington Mutual, are now offering more competitive rates on NIV loans to borrowers with high credit FICO scores.

by Attorney William Bronchick (legalwiz.com). 
For more information go to legalwiz.com .

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