4.1 Mortgage financing and loan types

Mortgage financing is a crucial aspect of real estate transactions. This section covers various loan types, from fixed-rate to government-backed options, and explains how interest rates affect affordability and borrower qualifications.

Understanding mortgage payments and underwriting processes is key for potential homebuyers. We'll explore payment calculations, the impact of interest rates on purchasing power, and the essential metrics lenders use to evaluate loan applications.

Mortgage Loan Types and Characteristics

Fixed and Adjustable Rate Mortgages

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• Fixed-rate mortgages (FRMs) maintain a constant interest rate throughout the loan term providing stability in monthly payments
• Adjustable-rate mortgages (ARMs) have fluctuating interest rates based on market conditions often starting with lower initial rates (5/1 ARM, 7/1 ARM)
• FRMs offer predictable budgeting while ARMs may provide initial savings but carry risk of future payment increases
• Hybrid ARMs combine fixed and adjustable periods (3/1 ARM has 3-year fixed rate followed by annual adjustments)

Government-Backed and Conventional Loans

• Government-backed loans (FHA, VA, USDA) offer more lenient qualification requirements and lower down payments for eligible borrowers
  • FHA loans allow down payments as low as 3.5% and credit scores as low as 580
  • VA loans offer 0% down payment options for eligible veterans and service members
  • USDA loans provide 100% financing for rural home purchases
• Conventional loans lack government insurance and typically require higher credit scores (620+) and down payments (3-20%)
• Conventional loans offer more flexibility in terms and property types (primary residences, second homes, investment properties)

Specialized Mortgage Products

• Jumbo loans exceed conforming loan limits set by Fannie Mae and Freddie Mac designed for high-value properties ($548,250 in most areas for 2021)
  • Stricter qualification criteria including higher credit scores (700+) and larger down payments (10-20%)
• Interest-only mortgages allow borrowers to pay only interest for a set period resulting in lower initial payments
  • After interest-only period, payments increase to cover principal and interest
• Balloon mortgages feature lower monthly payments for a set term followed by a large lump sum payment
  • Typically used for short-term financing or by borrowers expecting a future windfall

Mortgage Payment Calculation

Basic Payment Formula and Components

• Principal and interest payment for fixed-rate mortgages calculated using formula: $P = L[c(1 + c)^n]/[(1 + c)^n - 1]$
  • P represents payment, L loan amount, c periodic interest rate, n total number of payments
• Total monthly mortgage payment (PITI) includes principal, interest, property taxes, and insurance
  • Often expressed as percentage of borrower's income for qualification purposes (28-36% front-end ratio)
• Amortization schedules detail allocation between principal and interest over loan life
  • Interest comprises larger portion of early payments gradually shifting to more principal

Advanced Calculation Considerations

• Adjustable-rate mortgage payments account for potential interest rate changes at predetermined intervals
  • Initial fixed period followed by adjustment caps (2/2/5 cap structure)
• Extra principal payments reduce total interest paid and shorten loan term
  • $100 extra monthly on$200,000 30-year loan at 4% saves $30,000 in interest and 4 years off term
• Negative amortization occurs when payments are less than accrued interest increasing loan balance
  • Some ARMs allow for payment options that may result in negative amortization

Calculation Tools and Methods

• Mortgage calculators and spreadsheet functions generate amortization schedules and payment information
  • Excel PMT function calculates monthly payment:

    =PMT(rate/12, term*12, loan_amount)

• Online amortization tools allow for comparison of different loan scenarios and extra payment analysis
• APR (Annual Percentage Rate) calculations include fees and closing costs for more accurate cost comparison

Interest Rate Impact on Affordability

Monthly Payment and Total Cost Effects

• Lower interest rates increase affordability by reducing monthly payments and total interest paid
  • 1% rate reduction on $200,000 30-year loan saves ~$120/month and $43,000 over loan term
• Longer loan terms (30-year vs. 15-year) result in lower monthly payments but higher total interest costs
  • $200,000 loan at 4$955/month, 15-year = $1,479/month, but saves$82,000 in interest

Borrower Qualification and Purchasing Power

• Debt-to-income (DTI) ratio capped at 43% for qualified mortgages assesses borrower's payment ability
  • $5,000 monthly income with$1,500 existing debt allows $650 maximum mortgage payment (36% DTI)
• Changes in interest rates affect borrowers' purchasing power
  • 1% rate increase reduces maximum loan amount by ~10% for same monthly payment
• Points and origination fees paid upfront can lower interest rate but increase initial costs
  • 1 point (1% of loan amount) may reduce rate by 0.25%, requiring break-even analysis

Market-Wide Affordability Factors

• Inverse relationship between interest rates and home prices impacts overall market affordability
  • Lower rates may lead to increased demand and higher prices, potentially offsetting payment savings
• Adjustable-rate mortgages offer initial affordability but carry risk of payment shock
  • 5/1 ARM may start 1% lower than 30-year fixed but could adjust up to 5% higher after fixed period
• Federal Reserve monetary policy influences mortgage rates through federal funds rate adjustments

Mortgage Underwriting and Approval

Underwriting Fundamentals and Processes

• Mortgage underwriting evaluates borrower's creditworthiness, income stability, assets, and property value
• "Three C's" of underwriting form foundation of loan approval process
  • Capacity (ability to repay), Credit (willingness to repay), Collateral (property value and condition)
• Automated underwriting systems (Fannie Mae's Desktop Underwriter, Freddie Mac's Loan Prospector) streamline initial evaluations
  • Provide rapid pre-approval decisions based on inputted borrower and property data
• Manual underwriting required for complex cases or when automated systems cannot make definitive recommendation
  • Self-employed borrowers, unusual income sources, or credit history exceptions

Key Metrics and Documentation

• Debt-to-income (DTI) and loan-to-value (LTV) ratios are crucial metrics in underwriting risk assessment
  • Maximum DTI typically 43-50%, maximum LTV varies by loan type (80-97%)
• Documentation for underwriting includes pay stubs, tax returns, bank statements, and asset verification
  • Typically 2 years of employment history and income documentation required
• Appraisal process ensures property value supports loan amount and meets lender requirements
  • Comparative market analysis, property condition assessment, and valuation determination

Approval Process and Conditions

• Conditional approval issued pending additional documentation or clarification
  • May require explanation of credit inquiries, source of down payment funds, or employment verification
• Final approval contingent on satisfying all underwriting conditions
  • Clear to close issued once all conditions are met and final loan terms are set
• Underwriting exceptions possible for compensating factors
  • High credit score may offset higher DTI, substantial assets may compensate for irregular income