Partnership Lending | Mortgage Wizard

Mortgage Wizard

Understanding Mortgages and the Loan Process

1. What you should know about property values.
2. What other costs will you encounter before closing?
3. What information do you need to provide to complete a loan application?
4. How does your loan get "Approved"?
5. How does the lender determine how much you can borrow?
6. What is owner's equity?
7. What is the Loan-to-Value?
8. How is your credit evaluated?
9. How is your ability to repay evaluated?
10. How much will your house payment be?

1. What you should know about property values.

Maybe you've never considered a home as anything more than a place to live, but when you own a house and the land it sits on, that property is considered an asset. Thinking of a home in these terms will help you better understand many of the concepts involved in mortgages and property lending.

Measuring Value
Assets are simply things that have value or worth. We gauge their value in a couple of different ways. One is personal, which we measure in terms of appreciation and satisfaction. That's not something you can easily hold a yardstick up to measure-think of sentimental value, for instance. But another side of value is very measurable in monetary terms. The monetary value of a home is usually the market value-what someone would pay to buy the home if it were for sale.

Determining A Home's Value
One way to determine the market value of a house is for a sales transaction to occur. A seller agrees to sells the property to a buyer who agrees to buy it at a mutually agreeable price. That mutually agreeable price becomes the present market value of the house.

Another common way to determine market value is to hire an appraiser. This is a professional whose business it is to evaluate and judge a property's value. The appraiser compares the property to similar properties that have recently sold in same neighborhood-noting the similarities and differences between the properties (such as whether one house has a swimming pool and the other does not). Appraisers always support their conclusions with physical descriptions and photos of the compared properties and a complete explanation of how they determined the value.

Many loan programs specify a list of approved appraisers who are qualified to determine property value, so your lender will handle the appraisal arrangements. Appraisals typically cost between $400 and $500.

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2. What other costs will you encounter before closing?

Throughout the loan process you'll be required to pay certain fees before the actual closing of your loan. We've created a list of standard cash requirements so you can know what to expect before your loan is funded. We call these "cash requirements" instead of expenses, because some costs are considered investments. Take for example, the down payment you make on a house. It's actually an investment in your new property, because it reduces the total amount you need to borrow!

Cash requirements include:

Your down payment. A down payment is a percentage of the sales price-it can be 3%, 5%, 10%, 20%, or more, depending on the loan program and the amount you have available to invest. Most loan programs don't require more than 20% down, and some loans even allow for 0% down payment. Making a down payment larger than 20% is entirely up to you, but the more you put down, the less you have to borrow.
Closing costs. These are the combined costs of the appraisal (typically between $400 and $500), title insurance, credit report, etc.
Pre-paid items. These are recurring costs that cannot be financed such as real estate taxes, home owner's insurance premium, interest adjustment (depending on day of the month your loan closes), and Home Owner Association Dues.
Cash Reserves. Some loans require one to two months of house payment reserves.
Lender costs. These include loan origination fee and administrative fees.

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3. What do you need to provide to complete a loan application?

Your lending representative will complete a review of credit, which requires several pieces of information from you:

Two year's most recent W-2s
30 day's most recent pay stubs
Two month's most recent bank, investment and retirement statements
A voided check or credit card information to allow the lender to order your credit report
Your Insurance agent's information (name, address, phone number)
If your mortgage is for a home purchase (instead of refinance):
- The source and amount available for your down payment
- A copy of the Purchase and Sale Agreement involving the property
If applicable:
- If you are self-employed or receive commissions, your most recent tax returns
- If you are self-employed, your year-to-date Profit and Loss Statement and Balance Sheet
- If you are currently a renter, your landlord information (name, address, phone number, and rental dates) for the last 2 years
- A Recorded Property Settlement from Divorce, where the divorce was settled within the last 7 years
- Information regarding any problems in your credit history

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4. How does your loan get "Approved"?

Approval of your loan is all in the hands of the underwriter. The underwriter is an employee of the lender whose job it is to determine whether your application can be approved. The underwriter analyzes your loan package based on the loan program guidelines, and your ability and willingness as the borrower to repay the loan.

Whether or not your loan will be approved boils down to the review of your credit history and the value of the property. The credit history review will include confirmation of your present employment and current income.

How quickly your loan can be approved depends on the type of loan selected. If you've selected a loan program that is considered "conforming"-meaning it falls within the Freddie Mac or Fannie Mae guidelines-the underwriter can use an automated approval system and give you a very quick response. Other applications may take longer for approval if they don't necessarily fit those guidelines-for instance, if the applicant is self employed, or the loan program is a Jumbo, non-conforming program-requiring the underwriter to approve them individually. Even the most difficult loans can be underwritten within 48 hours.

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5. How does the lender determine how much you can borrow?

Every loan program has its own set of guidelines. To participate in a loan program, the amount you request to borrow must fit within the program's guidelines, including the loan limits.

A loan program sets maximum limits of how much the lender can lend. For instance, Jumbo Loan Programs have a maximum loan size of as much as $2,000,000. For the federal-regulated Freddie Mac and the Fannie Mae loan programs, the maximum loan size for a single-family home is currently $333,700. (Freddie Mac and Fannie Mae loan program restrictions are referred to as Conforming loan guidelines.)

Maximum loan sizes are also specified by property type. So for Conforming loans, the 2004 loan size limits are:

$333,700 for a single-family home
$427,150 for a 2-family property
$516,300 for a 3-family property
$641,650 for a 4-family property

The Conforming loan limits in Alaska and Hawaii are 50% higher.

Although a loan program has a set maximum size, it doesn't automatically mean that you will be eligible to borrow the full amount of your purchase price, or that you will be able to refinance the full property value of your home. The value of the property being mortgaged is an important factor in determining how much you can borrow. Sections 6 and 7 will explain how property value and down payment or owners equity work together to create your loan amount.

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6. What is owner's equity?

Your owner's equity is the amount that you have financially invested in the property, plus any appreciation (or less any decline) in value since acquiring the property.

Owner's equity translates into less risk for the lender. What that means exactly is the more you are financially invested in your property-whether your loan was a mortgage, home equity loan, or an equity line of credit-the more the lender will perceive you as dedicated to maintaining your property to maximize your investment.

Owner's equity in a home purchase
In the case of a home purchase, your owner's equity begins when you make the down payment. Your down payment when combined with the mortgage loan amount equals the total sales price. After the home is purchased, the owner's equity begins to grow in two ways: First, as the value of the home naturally rises over time, and second as you make your monthly payments on the unpaid principal balance, which decrease the outstanding mortgage.

Owner's equity in a refinance
In the case of a refinance loan, your owner's equity is the appraised value minus any mortgages using the property as collateral. In other words, it is the proceeds you would end up with after you sold your home, paying off the existing mortgages in the process.

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7. What is the Loan-to-Value?

When you reach the application stage of securing your loan, the term loan-to-value is something you will hear frequently. The loan-to-value is simply a ratio-the percentage that you get when you divide the mortgage amount by the value of the property.

When it comes to determining property value, there are some differences between a purchase and a refinance loan:

Purchase loan value When purchasing a home, there are two values we look at. The first is the sales price, which is the amount agreed upon in the sales contract. The second is the appraised value, which is determined by a professional appraiser.

Perhaps you're wondering why there are two values? Shouldn't the two values be the same? Very often they are the same. However, they might differ if, as the buyer, you are lucky enough to negotiate a lower sales price from the seller! On the other hand, you might want a property so much that you are willing to pay more than the asking price, outbidding all other potential buyers to guarantee that you get the house. Lenders use the two values-sales price and appraised value-to support each other, giving a better sense of the property's value.

Refinance loan value
When refinancing an existing loan, there is no sales contract, so the appraisal is the only way to determine the property value. Sometimes for very large mortgages, a second appraisal or a supporting "review" appraisal is required for the lender to feel confident in the property's value.

Calculating loan-to-value
Because there is no sales price to work with on a refinance mortgage, we calculate the loan-to-value using a different formula than we would for a purchase mortgage. Here's the difference:

For a purchase mortgage, divide the mortgage amount by the lower of the sales price or the appraised value. You use the lower figure of the two because it is a more conservative valuation of the property. Generally, these two figures will be very close to each other, and very often they are the same!
For a refinance mortgage, divide the mortgage amount by the appraised value.

Let's try an example:

Say the purchase price of your new home is $100,000 and the appraised value is $102,000. And let's say you are making a down payment of $15,000. That means you will need an $85,000 mortgage to make the purchase.

To calculate the loan-to-value, you would divide $85,000 by $100,000 (the lower of the sale price and the appraised value). In this example, the loan-to-value is 85%.

Why loan-to-value is important
Why do lenders talk so much about loan-to-value? Because a loan-to-value ratio is an easily calculable percentage that appears in all loan program guidelines. It's a thumbnail approach to assessing the risk involved when using the property as collateral. The rule of thumb is: the higher the loan-to-value, the greater the risk; and the lower the loan-to-value, the lower the risk.

You can clearly see that an 50% loan-to-value is less risky for the lender than an 80% loan-to-value. On a $100,000 purchase, the difference between these two loan-to-values is the difference between a borrower who has invested $50,000 to purchase the property, and a borrower who has invested $20,000 to purchase the property. Because the first borrower in this example has taken a greater financial risk by personally investing $50,000, the lender's risk as far as the collateral is concerned is less.

The advantage of low loan-to-values
There is an advantage to making your loan-to-value ratio at 80% or less-either by making a large enough down payment during the purchase or by not borrowing on your home equity beyond 80% loan-to-value. As an industry practice, lenders require borrowers to help reduce the risk on loan-to-values loans above 80%. Lenders do this by requiring buyers to purchase mortgage insurance on the portion of the mortgage above the 80% mark. GE, GMAC, PMI, and many other national mortgage insurance firms will accept that risk in return for payment of a mortgage insurance premium.

The mortgage insurance requirement for above-80% loan-to-value loans is a part of the loan program guidelines. If you require a greater-than-80% loan-to-value mortgage, some loan programs will allow the mortgage insurance premium to be waived if you agree to pay a slightly higher interest rate on the loan. Remember, if your loan-to-value is 80% or below, there is no mortgage insurance required!

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8. How is your credit evaluated?

When you apply for a loan, most lenders require a Tri-merge credit report. This credit report provides reports from the three main credit reporting agencies: Experian, Equifax and Trans Union. Besides listing each of your existing mortgages and credit accounts, the reports also list any late payments (30 days or more), liens, defaulted loans, judgments, delinquent child support, bankruptcies, etc., that you may have had. If any errors exist in the report, you have the chance to contest them.

Each of the credit report agencies will provide a FICO score with their report. FICO stands for Fair, Isaac & Company. The FICO credit score attempts to compress a borrower's credit history into a single number, which lenders then use to determine the likelihood that a credit user will pay their bills. Fair, Isaac & Company, and the credit bureaus will not reveal how the score is computed, but FICO scores have become widely accepted by lenders as a reliable means for determining credit worthiness. The U.S. Federal Trade Commission has deemed FICO scoring to be an acceptable approach to reaching decisions on applications for loans.

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9. How is your ability to repay evaluated?

Your lender will next calculate two ratios to determine your ability to repay your mortgage. Using your income and your credit obligations, they calculate a Front-End ratio and a Back-End ratio. All loan program guidelines state the upper limits that the ratios can reach and still be acceptable for approval. These ratios are based on your verified income.

The Front-End ratio is calculated by dividing your total proposed house payment (using your new mortgage) by your monthly income.

The Back End ratio is calculated by dividing your proposed house payment for the mortgage plus any revolving or installment debt divided by your monthly income.

If you want to do some analysis on your own, a good quality Front End ratio is 28% and a good Back End ratio is 33%. Some programs stretch those ratios to as high as 36% and 40%. Each loan program has its own guidelines, and compensating factors may allow ratios to go even higher.

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10. How much will your house payment be?

our total monthly mortgage payment will be a combination of some or all of the following items.

Principal. This is part of your payment that is applied to reducing the unpaid principal balance. Reducing the principal by making payments increases your owner's equity.
Interest. This is the part of your payment that the lender keeps as their earnings for lending you the mortgage money.
Taxes. 1/12 of your annual property tax payment goes into your reserve account so the lender can make the tax payments for you when they are due.
Insurance. 1/12 of your annual property insurance premium goes into your reserve account so that the lender can make the insurance payment for you when it comes due.
Mortgage Insurance. Mortgage insurance is required if your loan-to-value is higher than 80% and it is included in your payment.
Home Owner Association Dues. If the property is a condo or townhouse, the project's Home Owners Association requires that dues be collected to cover common area maintenance, hazard insurance, etc.

Principal and interest are paid on all mortgages except for Interest-Only mortgages. For Interest-Only mortgages, no principal repayment is required either until after the period specified by the loan, or until the loan has reached full term (the end of payment period).

Taxes, Insurance, Mortgage Insurance and Home Owners Association Dues are added to your mortgage payment if your loan-to-value is above 80%, or if you requested a reserve account be set up by the lender to handle the collection and payment of these regular bills.