Financing Residential Real Estate
Lesson 10:
Conventional Financing
Introduction
In this lesson we will cover:
conforming and nonconforming loans,
characteristics of conventional loans,
qualifying standards for conventional loans, and
special programs and payment plans.
Introduction
Loans made by mortgage lenders can be divided
into two main categories:
 conventional loans
 government-sponsored loans
Introduction
Conventional loan
Any institutional loan that isn’t insured or
guaranteed by a government agency.
Conforming & Nonconforming Loans
Most conventional loans comply with underwriting
guidelines set by Fannie Mae and Freddie Mac.
Conforming loan: complies with those guidelines.
Nonconforming loan: doesn’t comply.
Conventional Loan Characteristics
Fannie Mae/Freddie Mac underwriting guidelines
are widely followed in the mortgage industry
because lenders want to be able to sell their loans
on secondary market.
Many of the rules covered here are based on
their guidelines.
Conventional Loan Characteristics
Topics:
 Property types and owner-occupancy
 Loan amounts
 Repayment periods
 Amortization
 Loan-to-value ratios
 Risk-based loan fees
 Private mortgage insurance
 Secondary financing
Conventional Loan Characteristics
Property types and owner-occupancy
Fannie Mae and Freddie Mac buy loans secured by
residential property:
 detached site-built houses
 townhouses
 condominium units
 cooperative units
 manufactured homes
Conventional Loan Characteristics
Property types and owner-occupancy
Fannie Mae and Freddie Mac don’t require owneroccupancy, but different (generally stricter)
underwriting rules apply to investor loans.
Investor loan: Borrower purchasing property
doesn’t intend to occupy it.
Conventional Loan Characteristics
Property types and owner-occupancy
Conventional loan may be secured by:
Principal residence
 Up to 4 dwelling units
Second home
 No more than 1 dwelling unit
Investment property
 Up to 4 dwelling units
Conventional Loan Characteristics
Loan amounts
Conforming loan limits are set annually by Federal
Housing Finance Agency, which oversees Fannie
Mae and Freddie Mac.
If loan amount exceeds applicable limit,
the agencies won’t purchase the loan.
Different loan limits for different areas,
based on area median home prices.
Different limits for one-, two-, three-, and
four-unit dwellings.
Conventional Loan Characteristics
Loan amounts
2009 conforming loan limits for one-unit dwellings
In most areas: $417,000
In high-cost areas: 125% of area median house
price, up to a maximum of $729,750.
Higher limits for Alaska, Hawaii, Guam, and
Virgin Islands.
Conventional Loan Characteristics
Loan amounts
Loan that exceeds conforming loan limit is called a
jumbo loan.
Typically, jumbo loans:
have higher interest rates and loan fees
than conforming loans, and
are underwritten using stricter standards.
For example, lower maximum LTV,
higher credit score requirements.
Conventional Loan Characteristics
Repayment periods
Repayment periods can range from 10 to 40 years.
 30-year loans are standard.
 15-year loans also popular.
Conventional Loan Characteristics
Amortization
Standard conventional loan is fully amortized.
Partially amortized and interest-only loans
also available.
Conventional Loan Characteristics
Loan-to-value ratios
Traditional standard conventional LTV: 80%
Loans with LTVs up to 95% also available.
During subprime boom, higher LTVs were
available: 97% or even 100%. Now
uncommon.
Also, loans with LTVs of 90% or 95% are
less easily obtained than they were a few
years ago.
Conventional Loan Characteristics
Loan-to-value ratios
Conventional loans may be categorized by LTV
ratio, with different underwriting rules applied to
each category.
Fannie Mae and Freddie Mac require any
conventional loan with LTV over 80% to have
private mortgage insurance.
Conventional Loan Characteristics
Loan-to-value ratios
High-LTV loans also usually have:
 higher interest rates and fees, and
 stricter underwriting rules.
Conventional Loan Characteristics
Combined loan-to-value ratios
If there are other mortgages against a property,
lender will be concerned with the combined
loan-to-value ratio (CLTV).
CLTV generally should not exceed usual LTV
limit, but in some cases a higher CLTV is
allowed.
Conventional Loan Characteristics
Risk-based loan fees
Fannie Mae and Freddie Mac require most
borrowers to pay risk-based loan fees called
loan-level price adjustments (LLPAs).
Conventional Loan Characteristics
Risk-based loan fees
Loan-level price adjustments shift some of the risk
(cost) of mortgage defaults onto borrowers.
Generally, the riskier the loan, the more the
borrower will have to pay in LLPAs.
Conventional Loan Characteristics
Risk-based loan fees
Nearly all loans sold to Fannie Mae and Freddie
Mac are subject to an LLPA that varies based on
borrower’s credit score and loan-to-value ratio.
Example:
Borrower with 650 credit score and 80% LTV
might be charged LLPA of 2.75% of loan
amount.
But borrower with 710 credit score
and 90% LTV might be charged
only 0.5%.
Conventional Loan Characteristics
Risk-based loan fees
One or more additional LLPAs may be charged
because loan is ARM, investor loan, interest-only
loan, or some other relatively risky type of loan.
Fannie Mae and Freddie Mac also levy a flat fee
called an adverse market delivery charge on every
borrower to help agencies recover losses caused
by poor market conditions.
Conventional Loan Characteristics
Private mortgage insurance
Private mortgage insurance (PMI) helps protect
lenders from risk of high-LTV loans.
Required for convention loans if LTV over 80%.
Makes up for reduced borrower equity.
Private Mortgage Insurance
How PMI works
Private mortgage insurance company assumes only
a portion of risk of default and foreclosure loss.
 PMI covers upper portion of loan.
 Typically 25% to 30% of loan amount.
Private Mortgage Insurance
How PMI works
Upon default and foreclosure, lender makes claim
for reimbursement of actual losses.
 Or may relinquish property to insurer.
Private Mortgage Insurance
How PMI works
Insurers have own underwriting standards, which
have been influential in mortgage industry.
Private Mortgage Insurance
PMI premiums
Mortgage insurance company charges risk-based
premiums for coverage.
Variety of payment plans, including:
 flat monthly premium;
 initial premium at closing, plus renewal
premiums; or
 financed one-time premium.
Private Mortgage Insurance
PMI premiums
With some plans, borrower who pays off loan early
is entitled to partial refund of initial premium or
financed one-time premium.
But plans that don’t provide for refunds are
less expensive.
Private Mortgage Insurance
Deductibility of PMI premiums
PMI premiums are currently tax-deductible.
No deduction if family income is over
$109,000.
Deductibility set to expire in 2010.
Private Mortgage Insurance
Cancellation of PMI
Under federal Homeowners Protection Act,
lenders must cancel loan’s PMI under certain
conditions:
1. once loan has been paid down to 80% of
property’s original value (upon borrower
request); or
2. once loan reaches 78% of property’s original
value (automatic cancellation).
Private Mortgage Insurance
Cancellation of PMI
Homeowners Protection Act applies only to loans
on single-family dwellings occupied as borrower’s
primary residence.
Depending on payment plan, cancellation of PMI
may reduce monthly mortgage payment.
Secondary Financing
Lenders generally allow secondary financing in
conjunction with a conventional loan.
Most impose some restrictions to minimize
increased risk that borrower will default on
primary loan.
Secondary Financing
Restrictions
Examples of restrictions lenders may impose:
1. Borrower must qualify for payments on both
first and second mortgages.
Secondary Financing
Restrictions
Examples of restrictions lenders may impose:
1. Borrower must qualify for payments on both
first and second mortgages.
2. Borrower must make 5% downpayment.
Secondary Financing
Restrictions
Examples of restrictions lenders may impose:
1. Borrower must qualify for payments on both
first and second mortgages.
2. Borrower must make 5% downpayment.
3. Scheduled payments must be due on regular
basis.
Secondary Financing
Restrictions
4. Second mortgage can’t require balloon
payment less than 5 years after closing.
Secondary Financing
Restrictions
4. Second mortgage can’t require balloon
payment less than 5 years after closing.
5. If first mortgage has variable payments,
second mortgage must have fixed payments.
Secondary Financing
Restrictions
4. Second mortgage can’t require balloon
payment less than 5 years after closing.
5. If first mortgage has variable payments,
second mortgage must have fixed payments.
6. No negative amortization.
Secondary Financing
Restrictions
4. Second mortgage can’t require balloon
payment less than 5 years after closing.
5. If first mortgage has variable payments,
second mortgage must have fixed payments.
6. No negative amortization.
7. No prepayment penalty.
Secondary Financing
Piggyback loans
Secondary financing is sometimes referred to as a
piggyback loan, especially when it is used to either:
avoid paying private mortgage insurance, or
avoid jumbo loan treatment.
Secondary Financing
Piggyback loans
With piggyback loan, LTV of primary loan isn’t
over 80%.
So PMI requirement doesn’t apply.
With piggyback loan, loan amount for primary loan
doesn’t exceed conforming loan limit.
So higher costs and stricter rules for
jumbo loans don’t apply.
Secondary Financing
Piggyback loans
Piggybacking was popular during subprime boom,
but is no longer widely used.
Advantages of piggybacking reduced by:
 tax deductibility of PMI premiums
 loan-level price adjustments imposed
on secondary financing
Summary
Conventional Loan Characteristics
Conventional loan
Conforming loan
Nonconforming loan
Conforming loan limits
Jumbo loan
Loan-level price adjustment (LLPA)
Adverse market delivery charge
PMI
Piggyback loan
Conventional Qualifying Standards
Evaluating risk factors
Fannie Mae and Freddie Mac have changed how
they evaluate creditworthiness of applicants.
Newer methods influenced by automated
underwriting systems and computer analysis.
Conventional Qualifying Standards
Evaluating risk factors
Fannie Mae uses “comprehensive risk assessment”
to evaluate risk factors.
Two primary risk factors:
 applicant’s credit reputation, and
 the loan-to-value ratio.
Conventional Qualifying Standards
Evaluating risk factors
Fannie Mae uses “comprehensive risk assessment”
to evaluate risk factors.
Two primary risk factors:
 applicant’s credit reputation, and
 the loan-to-value ratio.
Loans ranked as low, moderate, or high
primary risk.
Conventional Qualifying Standards
Evaluating risk factors
Fannie Mae treats other aspects of application,
such as debt to income ratio and cash reserves, as
contributory risk factors.
Each factor assigned value depending on
whether it:
 satisfies basic risk tolerances,
 increases risk, or
 decreases risk.
Conventional Qualifying Standards
Evaluating risk factors
Freddie Mac’s underwriting guidelines call for
separate evaluation of each component of
creditworthiness: credit reputation, income, net
worth.
Underwriter then considers overall layering of risk.
Weakness in one component can be
outweighed by strength in another.
Conventional Qualifying Standards
Evaluating risk factors
Difference between Fannie Mae’s approach and
Freddie Mac’s approach is mainly a difference in
terminology.
Both agencies consider the borrower’s overall
financial picture, with positive factors offsetting
negative ones and vice versa.
Conventional Qualifying Standards
Credit reputation
Credit scores have become a central factor in
conventional underwriting.
Excellent score can offset weaknesses in other
aspects of application.
Poor score may doom application.
For instance, Fannie Mae won’t buy a loan
if borrower’s score is under 580.
Conventional Qualifying Standards
Credit reputation
Credit scores from the three main credit bureaus
usually vary somewhat for a given borrower.
Under Fannie Mae and Freddie Mac rules, credit
score used for underwriting (representative credit
score) is:
 lower of two scores, or
 middle of three scores.
Conventional Qualifying Standards
Credit reputation
When two people apply for a loan together, lowest
representative credit score (not an average) is used
for underwriting.
Conventional Qualifying Standards
Income analysis
Fannie Mae and Freddie Mac consider income
durable if it is expected to continue for at least 3
years after loan is made.
Income Analysis
Income ratios
For a conventional loan, applicant’s stable monthly
income is generally considered adequate if they
don’t exceed these benchmarks:
Total debt to income ratio: 36%
Housing expense to income ratio: 28%
Income Analysis
Income ratios
Housing expense ratio is less important than total
debt to income ratio.
Fannie Mae no longer applies a housing
expense to income ratio.
Income Analysis
Compensating factors
Fannie Mae and Freddie Mac allow income ratios to
exceed benchmarks if there are compensating
factors.
Income Analysis
Compensating factors
Possible compensating factors include:
 large downpayment
 substantial net worth
 demonstrated ability to incur few debts
and accumulate savings
 education, job training, or employment
history indicating potential for increased
earnings
Income Analysis
Compensating factors
(Possible compensating factors, cont.)
 short-term income that doesn’t count as
stable monthly income
 demonstrated ability to devote large
portion of income to basic needs, such as
housing expense
 significant energy-efficient features in
home being purchased
Income Analysis
Compensating factors
Even if there are compensating factors, income
ratios shouldn’t exceed benchmarks by too much.
For manually underwritten loan, Fannie Mae
and Freddie Mac won’t accept total debt to
income ratio over 45%.
No set maximum for loan evaluated by
automated underwriting system.
Income Analysis
Factors that increase risk
Some applications have factors that pose increased
risk to lender.
If so, higher-than-benchmark income ratios usually
won’t be accepted.
Income Analysis
Factors that increase risk
For example, some lenders apply stricter standards
to high-LTV loans.
Many lenders won’t accept a high total debt to
income ratio if LTV exceeds 90%.
Income Analysis
ARMs
ARMs should be underwritten carefully to make
sure that borrower will be able to handle rate and
payment increases.
ARM borrower should have:
strong potential for increased earnings,
significant liquid assets, or
demonstrated ability to manage finances.
Conventional Qualifying Standards
Available funds – reserves
As a general rule, conventional borrower should
have at least 2 months of mortgage payments in
reserve after closing.
Not an absolute requirement, but having a
smaller amount in reserve will weaken loan
application.
Available Funds
Gift funds
Both Fannie Mae and Freddie Mac set limits on use
of gift funds. Donor must be:
 borrower’s relative, fiancé, or domestic
partner;
 borrower’s employer;
 municipality; or
 nonprofit religious or community
organization.
Available Funds
Gift funds
Borrower required to make downpayment of at least
5% of sales price out of her own resources.
Rule doesn’t apply if LTV is 80% or less.
Summary
Conventional Qualifying Standards
Comprehensive risk assessment
Primary risk factors
Contributory risk factors
Overall layering of risk
Representative credit score
Total debt to income ratio
Housing expense to income ratio
Compensating factors
Reserves
Gift funds
Loans with Lower Initial Payments
Balloon/reset mortgages
Characteristics of balloon/reset mortgages:
Two types: 5/25 and 7/23.
Payment amounts based on 30-year
amortization schedule.
But loan is partially amortized, with balloon
payment of entire balance due at end of
initial 5- or 7-year period.
At end of initial period, borrower may be
allowed to reset loan.
Loans with Lower Initial Payments
Balloon/reset mortgages
Under reset option:
Reset loan remains in place.
Interest rate is set at current market rate
(again, interest rate cap may apply).
Rate and payment amount are level for
remaining 25 or 23 years.
Borrower avoids refinancing charges.
Loans with Lower Initial Payments
Balloon/reset mortgages
Borrower not allowed to reset if:
payments aren’t current, or
other liens have attached to property.
In that case, borrower will have to refinance or sell
property to make balloon payment on balloon/reset
mortgage.
Loans with Lower Initial Payments
Interest-only mortgages
Characteristics of typical interest-only mortgage:
30-year loan term.
Interest-only payments during specified period
at beginning of loan term.
At end of interest-only period, payments fully
amortized over remainder of loan term.
Risk of payment shock: monthly
payment likely to rise sharply.
Loans with Lower Initial Payments
Interest-only mortgages
Fannie Mae and Freddie Mac:
will buy loans with interest-only periods
ranging from under 3 years to over 15 years;
won’t buy interest-only ARMs unless initial
fixed-rate period is three years or more;
won’t buy interest-only balloon/reset loans.
Summary
Buydowns & Low Initial Payment Loans
Permanent buydown
Temporary buydown
Level payments
Graduated payments
Qualifying rate
Contribution limits
Two-step mortgages
Balloon/reset mortgages
Interest-only mortgages
Making Loans More Affordable
Low-downpayment programs
Secondary market agencies have developed lowdownpayment programs for first-time buyers and
others who tend not to have much money saved.
Low-Downpayment Programs
LTVs and downpayment rules
Examples of low-downpayment programs:
Loan with 95% LTV and:
3% of downpayment from borrower’s funds
2% of downpayment from alternative sources
Loan with 97% LTV and:
3% downpayment from borrower’s funds
3% contribution to closing costs from
alternative sources
Low-Downpayment Programs
Alternative sources of funds
Allowable alternative sources of funds may include
gifts, grants, or unsecured loans.
Funds may come from:

relative,

employer,

public agency,

nonprofit organization, or

private foundation.
Low-Downpayment Programs
Affordable housing programs
Many low-downpayment programs are targeted at
low- and moderate-income buyers.
Buyers qualify if stable monthly income
doesn’t exceed median income of area.
Debt to income ratio rules are relaxed.
Income limit may be waived for buyers
purchasing homes in low-income or
rundown neighborhoods.
Low-Downpayment Programs
Affordable housing programs
Other low-downpayment programs are offered to
specific groups such as:

teachers,

police officers, and

firefighters.
Summary
Low Downpayment & Accelerated Plans
Low-downpayment programs
Affordable housing programs
Alternative sources of funds
Accelerated payment plans
Bi-weekly mortgages
Growing equity mortgages