Chapter 10 NOTES 2021

Class 3.
Residential Mortgage Types & Borrower Decisions

(Chapter 10)
2 Markets for Home Mortgage Loans:
1. Primary Mortgage Market is the loan origination market

where borrowers & lenders (banks & credit unions) come
together.
2. Mortgage originators can either hold those loans in their

portfolio or sell them in the Secondary Mortgage Market to
Government Sponsored Enterprises (GSE) like Fannie Mae &
Freddie Mac
- This secondary market makes the primary market more

efficient by allowing originators to sell their mortgage
investments quickly to obtain funds to originate more
mortgages in the primary market.
1
5 Types of Home Mortgages
1. Conventional – any standard home loan not insured by a US
agency (90% of home loans)
- Excludes FHA & VA loans
- Prime Conventional Mortgages – fixed rate “level payment

mortgage” (LPM) typically 30 years, and 80-90% loan-to-
value (LTV)
- - “Conforming” Conventional Loan – meets the standards
required for purchase by Fannie or Freddie
- - Must use standard GSE documentation (mortgage
application, promissory note and appraisal form)
- - Loan can’t exceed certain amount ($822,375 in SD
County, $548,250 most places), or % of property value or
borrower’s (B’s) income. [Minimum FHA loan anywhere is
$356,362]
- - Easier to sell on secondary market and therefore lower
interest rate and lower monthly payment (more efficient)
- - “Nonconforming” Conventional Loan – fails 1 or more of
these requirements
- - “Jumbo” Loans – meet conforming criteria but exceed the
max amount (e.g., $850,000 loan)
2. Adjustable Rate Mortgages (ARM)

- Fixed for 3, 5, 7 & 10 yr, and then adjusts with margin
[approx. 250 basis points (bps)] over an index like the LIBOR
(London Inter-Bank Offer Rate)
2
- Cap on annual adjustments (e.g., 2%) and lifetime adjustments
(5-6%)
- Characterized by lower teaser rates for fixed periods, and
lender hedge against rising interest rates. [Note: lenders have
higher interest rates on loans fixed for longer periods, to hedge
risks.]
3. Government Sponsored Loans (private lenders insured by

government; no loans are actually made by the government)
- FHA Loans – US govt agency insures loans that meet Federal

Housing Administration (FHA) property & credit-risk
standards. Borrower pays insurance premium to protect lender
from 100% of default losses. [Premium = 1.75% of loan
upfront plus @.45%-.85% of loan balance annually] More
expensive because more risk. The upfront premium can be
financed with the loan.
- If default on loan, the property is foreclosed upon by

lender and then goes to Federal Department of Housing &
Urban Development (HUD) for public auction.
- FHA targets weaker buyers for help (first-time buyers

with only 3.5% down payment vs 10%+ down payment for
prime conventional loan borrowers)
3
- Limitations: higher insurance premiums and lower max
loan ($822,375 in SD in 2021); premium = 80-100 bps (i.e.,
1%) of loan until loan reaches a 78% LTV
- VA Loans- help Vets readjust to civilian life, VA guarantees

loan ($0 down payment $0 PMI, but still pay closing costs)
- - 25% of loan amount typically guaranteed
- - www.VA.gov/housing apply for Certificate of Eligibility
4. Home Equity Loan & HELOC -- advantages: lower interest

rate than credit card, longer term, tax deductible (Careful!!!)
5. Reverse Mortgage – house poor elderly can liquify some

equity without having to sell their home
- Every month they are borrowing equity with interest

- Government insures lender against risk of exceeding all equity
Miscellaneous:
Private Mortgage Insurance (“PMI”) protects lender against top
20% of losses on default (Example: See Slide 10-7)
- Required when LTV is over 80%
- Makes LPMs more viable by reducing the risk to lender
- Premium paid by Borrower over time (@0.5% of loan
annually) Example: $480k loan x .005= $2400/12months =
$200/month
4
- Borrower may cancel PMI after LTV reaches 80% or less (by
appreciation and/or principal reduction)
- How else can we avoid PMI if don’t have 20%?
- - Piggy-Back Mortgage (2nd Trust Deed) or seller-carry
back
- - Example: 80% 1st Loan and 10% 2nd Loan = No PMI
- Any mortgage obtained to purchase property is a “Purchase
Money Mortgage” – the lender cannot get a deficiency
judgment for a Purchase Money Mortgage in CA [i.e., it’s
non-recourse]
5
Subprime & Alt-A Loans – ARM teaser rate, negative
amortization, required refinancing because of high interest rates
- Example: only 2% interest payment but 8% interest accruing
- Since LTV was high with negative amortization – Borrowers
gambled on appreciation to refinance in the future.
- Alt-A loans: just relax some LTV or credit score requirements.
Qualified Mortgages (QMs) – created by Dodd Frank Act

imposed an “ability to repay” standard that provided lenders with a
safe harbor shield against Borrower on default.
- Borrower’s Debt-to-Income Ratio cannot exceed 43%, and
loan must fully amortize (no balloon payment)
- Example: B monthly debt is $4,000 & income is $10,000 =
40%
- QMs include conforming conventional, FHA and VA.
6
Borrower Decisions & Considerations
1. Compare mortgage costs – upfront fees and ongoing costs
- The Annual Percentage Rate (“APR”) allows this by showing
the true cost of borrowing, compared to the stated interest rate.
- - but loans don’t always go to maturity, and earlier
repayment of the loan means higher costs.
- NOTE: Home loan interest rates were around 15% in late 70s
and early 80s which greatly impacts home affordability. Today
@ 3%, but what happens when they go back up to 5% or
7%???
2. Loan Size (consider leverage, PMI, monthly payment, interest

rate, etc.)
3. Refinancing: When does it make sense?

Net benefit = loan payment reductions minus cost of
refinancing
- Example: Refi costs $3,000 in lender fees and charges, and
reduces monthly payment by $300 = 10 months until
profitable
- Cash-out refinance = tax-free $ (Careful how you spend it!!!)
4. Tax deductions for mortgage interest can reduce the interest

cost
7
- Example: 25% tax rate and deduct $12,000/yr in mortgage
interest = $3,000 tax savings (25% of $12,000)
- 6% interest rate on mtg = 4.5% interest after tax savings (25%
lower)

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Chapter 10 NOTES 2021

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Class 3.

Residential Mortgage Types & Borrower Decisions

2 Markets for Home Mortgage Loans:

1. Primary Mortgage Market is the loan origination market

2. Mortgage originators can either hold those loans in their

- This secondary market makes the primary market more

- Prime Conventional Mortgages – fixed rate “level payment

2. Adjustable Rate Mortgages (ARM)

3. Government Sponsored Loans (private lenders insured by

- FHA Loans – US govt agency insures loans that meet Federal

- If default on loan, the property is foreclosed upon by

- FHA targets weaker buyers for help (first-time buyers

- VA Loans- help Vets readjust to civilian life, VA guarantees

4. Home Equity Loan & HELOC -- advantages: lower interest

5. Reverse Mortgage – house poor elderly can liquify some

- Every month they are borrowing equity with interest

Qualified Mortgages (QMs) – created by Dodd Frank Act

2. Loan Size (consider leverage, PMI, monthly payment, interest

3. Refinancing: When does it make sense?

4. Tax deductions for mortgage interest can reduce the interest

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