Residential Mortgages

RECENT NEWS
The Times of India  Jun 10  Comment 
This is the second time that SBI is revising rates in a month. In May, the bank reduced its interest rates by 25bps by shrinking the spread over its benchmark rates. In May, the bank reduced its interest rates by 25bps by shrinking the spread...
The Hindu Business Line  Jun 9  Comment 
State Bank of India has reduced interest rates on home loans above Rs 75 lakh by 10 basis points. The new rates will take effect on June 15, 2017. The revised interest rates will be 8.55 per cent a y...
The Economic Times  Jun 8  Comment 
Provisions for standard assets have been reduced by 15 basis points to 0.25% from 0.40%.
The Hindu Business Line  Jun 7  Comment 
Softening the risk weight on home loans will augur well for the growth of the real estate sector: Jaxay Shah, President, CREDAI
The Times of India  Jun 7  Comment 
The Reserve Bank on Wednesday said targeted interventions like reducing standard asset provisions for home loans which will make them cheaper, will help revive the sagging growth rather than rate cuts.
The Hindu Business Line  Jun 4  Comment 
With the lowering of rates, go for a cheaper loan or pre-pay an existing one
The Economic Times  Jun 2  Comment 
The private sector bank has a total of 769 branches across the country and 1,400 ATM locations besides 110 e- lobbies.
Forbes  May 31  Comment 
The 5 largest U.S. banks originated residential mortgages worth less than $111 billion in Q1 2017 – a figure which is considerably smaller than the $143 billion in first mortgages originated in the previous quarter.
The Times of India  May 26  Comment 
Following SBI, two leading private lenders ICICI Bank and HDFC Ltd today slashed interest rate by up to 0.3 per cent for loans of up to Rs 30 lakh to promote affordable housing. New home loans rates for up to 30 lakh for women will be 8.35 per...




 
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A mortgage loan is a loan that uses real estate as collateral. Banks and other lenders make these loans to individuals primarily for the purpose of purchasing property. It is important to note, however, that depending on the type of mortgage, the loan can be used for a number of activities ranging from renovation or refinancing, to buying a car. The main thing that most mortgages have in common, is that they use real estate as collateral. This means that if the borrower does not pay back the loan the bank has the right to foreclose on the property.

Mortgage Process

In the United States mortgage loans are issued by both banks and non-bank loan companies. These companies make money primarily by charging the consumer a rate of interest on the total outstanding amount of the loan. They also charge application fees that can range from a few hundred dollars to several thousand. Finally, a lender may require a borrower to pay points before issuing a mortgage. A point is equal to 1% of the total loan amount.

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Fico Score Ranges and Interest Rates as of 11/24/08 [1]

Mortgage loans are typically much larger than most other types of personal loans. As a result, the screening process to determine borrowers’ eligibility is more rigorous, at least in theory. Banks try to make loans, to borrowers who have high likelihood of paying back the loan, or at the very least try to price the loan at an APR that is high enough to account for any additional risk that they would be taking on by lending to unqualified buyers. Banks judge potential borrowers based on several criteria.

  • Credit Scores – The FICO score is a measure of a borrower's credit worthiness --the likelihood that he or she will pay back his or her loan. Consumers with higher FICO scores are considered to be less risky by lenders. The FICO score is derived from a formula that was created in the 1950s by Fair Isaac and Company as a way to help lenders to more accurately and more consistently measure the credit risk associated with borrowers. The formula takes into account factors like number and recency of late payments, total debt and length of credit history. This formula was then adopted by the three major credit bureaus- Equifax, Transunion and Experian - which collect information from thousands of lending institutions throughout the U.S. in order to calculate a comprehensive score for each borrower.
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Percentage of Income spent on housing for top 18 states [2]
  • Income – When considering borrowers for loans banks and other mortgage companies look at the borrowers income. The pay particularly close attention to the borrower's front end ratio - the amount of pre-tax income spent on housing expenses (includes mortgage or rent, property taxes, etc.) and the back end ratio, the amount of money spent all debt, including credit cards, loans, mortgages, etc. The front end ratio should be no more than 28% where as the back end ratio should not exceed 35%. [3] This of course is easier said then done. According to the last U.S. Census more than half of Americans live in states where the average amount of gross income spent on housing exceeds this 35% threshold. [4] [5]

Size of down payment and loan to value (LTV) As part of the loan process the borrower has to get an appraisal on the house or condo that he or she wishes to buy. Based on a serious of inputs – sales values for comparable properties in the same neighborhood and condition of the property) the appraiser comes up with an approximate value for the property. Most banks will not lend a borrower more than the appraised value of the property. In fact most banks prefer to lend significantly less. The size of the loan relative to the value of the property is known as the loan to value. For instance an 80,000 mortgage on a 100,000 property represents an LTV of 80%.

The ability of a borrower to get a loan from a bank and the interest rate he or she pays for that loan depend partly on the size of his or her down payment. A higher down payments means a lower loan to value. The more money the borrower puts down, the more likely he is to be approved and the more likely he is to get a lower interest rate. A minimum down payment of 20% is standard, although in recent years (2000-2008) loans with no money down have been made available to borrowers.


Conforming vs. Non-conforming Mortgages

In the United States Fannie Mae and Freddie Mac, both of which are government sponsored entities, purchase home loans from banks and other mortgage lenders. This is a critical to the health of the financial markets, because it means that mortgage lenders do not need to wait 15-30 years to receive full payment for their loans. Instead they sell to Fannie and Freddie and then are free to use the proceeds of the sell to make new loans. This also reduces the risk to the bank of loan defaults, because the bank doesn’t have to hold the loans for long. If a loan issued meets the criteria that Fannie and Freddie set, then it is classified as conforming. Otherwise it is non-conforming. There are several reasons that loan might fail to conform:

  • Loan size- Jumbo loans or loans that exceed the caps established by Fannie and Freddie are not eligible for purchase. In 2008, these limits were 417,000 for a single family house and 533,000 for a two family house [6] Certain areas, such as some counties in California, are considered high income and have higher caps.
  • Size of downpayment- Fannie and Freddie typically require that the LTV not exceed 80% of the appraised value. In cases where LTV exceeds 80%, the borrower must purchase private mortgage insurance. Borrowers can get around this requirement, by taking out a second mortgage for up to 15% of value of the property.
  • Credit Scores - If the borrower has a credit score below a certain range, his mortgage may also be classified as non-conforming. In this case, the loan may also be classified as subprime.

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Types of Mortgages

Fixed Rate Mortgages: This is the most common type of mortgage. Nearly 70% of mortgages originated in the United States fall into this category. [7] These mortgages are the least risky, because their rates and thus the borrower's payments are fixed for the life of the loan. Fixed rate mortgages are typically made for a period of 30 years or 15 years, although in recent years, banks have begun offering 40 year mortgages as well.

Interest Only Mortgages – As the name suggests, borrowers with interest only mortgages do not have to pay any principal, but instead pay only the monthly interest on their loans. These loans are typically incorporated as part of another type of loan. For instance, a 30 yr fixed may be interest only for the first 10 years. Over the last 20 years of the loan the borrower pays both principal and interest until the loan is paid off. The avantage of these loans is that the initial monthly payments are lower than the payments would be on a similar fixed rate loan. The disadvantage is that once the interest only period has expired, the borrower has to pay higher payments over the remainder of the loan, to make up for the interest only period.

  • Adjustable Rate Arms - These loans, which have become notorious in recent years are available in 1, 3, 5, 7 and 10 year terms. These mortgages have a fixed rate of interest for during their initial period, after which the rate adjusts based on whatever index the loan is tied to. During the initial period, the borrower pays a lower rate of interest. For instance, the 5yr ARM may have an interest rate of 5% vs. 5.5% for a 30yr fixed mortgage. At the end of the 5 years however, the interest rate is no longer fixed and is reset. If libor is 7%, then the borrower pays 7%. These mortgages can be cheaper than 30yr fixed mortgages, especially in the beginning, but are also riskier.
  • Negative amortization

This loan product functions in the opposite manner of most other types of loans. The payments are set at a level where they do not full cover the interest on the loan. Overtime, the amount that the borrower owes the lender increases as the unpaid interest is added to the initial debt. This loan can sometimes be beneficial to the elderly who need additional cash in their last years. They can borrow against the equity in their house, under the condition that the loan will be repaid by selling the house upon their death.

Federally Insured Loans

  • FHA Loans – FHA loans are insured by the Federal Housing Administration. These loans are especially meant for first time home buyers. Typically the criteria for qualifying for these loans is less stringent then other types of loans. Moreover, borrowers can qualify for FHA loans with down payments as low as 3% [8]
  • VA Loans - VA loans are available to veterans. These loans require little to no down payment, as long as the applicant can demonstrate the capacity to pay back the loan.
  • Rural Loans - Section 502 loans are available to low income individuals who want to purchase properties in rural areas.

Home Equity and Refinancing

  • Cash out refinancing – Need to renovate your house? Need a new car? Cash out refinancing allows borrowers to take out loans against their home equity. Home equity is the difference between the market value of a borrower’s home, and the amount of his or her mortgage. For instance, if a person borrows 400,000 to buy a 500,000 home, then he or she has equity of 100,000. If the home appreciates an additional 100,000 over the next 5 years, then his or her equity will have increased to 200,000. He or she can than go to a bank and take out a loan for 600,000. 400,000 of this must go to pay back the original lender. The other 200,000, however, can go directly to the borrower in the form of a check. This, of course, wipes out his or her equity.

2nd Mortgages

If an individual needs additional cash he or she can take out another mortgage on their home before paying off the first. There are several scenarios under which this is done.

  • Renovation: If the borrower has equity the property but doesn’t want to refinance his or her entire loan he or she can get a second mortgage up to and sometimes over the amount of the equity in the home. The home equity line of credit (HELOC) and the home equity loan are two types of common loans. As the name suggests, the HELOC is a line of credit. The borrower can use as little or as much of it as he wants. Generally the borrower will have up to 10 years to draw on the HELOC and an additional 10-20 years to pay off any amount borrowed. [9] The home equity loan, takes the form of a lump sum that the bank loans to the individual. The interest rates for both loans are based on prime interest rates. The prime interest rate is the Federal Funds rate + 3%. To come up with the rate for the HELOC or home equity loan the lender will an additional percentage on to this number.
  • Initial purchase: Under this scenario, the person buying the house may not have the 20% down payment needed to qualify for a conforming loan and may be unwilling to pay private mortgage insurance. His or her other option is to get a second mortgage. Using this approach, the first mortgage will still only be 80% of LTV and thus qualify for repurchase for Fannie Mae. The other 10-15% of the LTV typically is priced at Libor + and additional percentage. For instance, if Joe wants to buy a house for 500,000, but he only has a 50,000 downpayment, he can take out two loans. The first loan is for 80% or 400,000 of the purchase price. Second loan is for 50,000 of the purchase price. The first loan is conforming is and has an interest rate of 5.5%. Interest rate for the second loan is based on libor + 2%. If libor is 6% , then the interest rate for the second loan is 8%. Although this seems much more expensive, it be significantly cheaper than paying private mortgage insurance on the entire amount of the loans.
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