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The Loan Officer’s Practical Guide to Residential Finance Copyright 2014 June 15, 2014 By Thomas A. Morgan


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

32nd Printing ISBN 0-9718205-0-3/ISBN 13 - 9780971820500 "The Loan Officer's Practical Guide to Residential Finance"


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Table of Contents Table of Contents ...................................................................................................................................... i Introduction .............................................................................................................................................. xi SAFE Act Curriculum Syllabus - Nationwide Licensing System............................................................. xiii Test Preparation ................................................................................................................................................ xiii National Test Preparation Source Reference ............................................................................................... xiii

Chapter 1 – Mortgage Math .......................................................................................... 1 Decimals and Fractions ........................................................................................................................................ 1 Understanding the Mortgage Business ................................................................................................................. 2 Types of Lenders/Primary Originators ............................................................................................................. 2 Retail Lending .................................................................................................................................................. 3 Reading the Rate Sheet ....................................................................................................................................... 3 Points ............................................................................................................................................................... 4 The "Purchase Price" Format .......................................................................................................................... 5 The Origination Fee/Discount Points ............................................................................................................... 5 The Mortgage Broker Business ............................................................................................................................ 6 Originator Compensation and its Impact on Pricing .............................................................................................. 7 What is a BP? .................................................................................................................................................. 7 Understanding Interest Rate Lock-in Terms .................................................................................................... 7 Reading the Pricing Sheet ............................................................................................................................... 8 Principal and Interest or Interest Only - Amortization ....................................................................................... 8 Solving for X - Mortgage Math and the Financial Calculator ................................................................................. 9 Choosing a Financial Calculator ......................................................................................................................... 11 “What is the Payment?” ................................................................................................................................. 12 What is the Balance over Time? .................................................................................................................... 12 What is the Maximum Loan Amount I Qualify For? ........................................................................................ 13 “I Know How Much I Need to Borrow. What is the Maximum Rate?” ............................................................. 13 How Much Income is Required for a Certain House? .................................................................................... 13 What is the Maximum Loan Term with a Specific Payment? ........................................................................ 14 Understanding Ratios – Loan to Value - LTV................................................................................................. 15 Understanding Ratios – Qualifying Ratios .......................................................................................................... 15 The Effect of Computer Automation on Qualifying Practices ......................................................................... 15 "Pre" and "Re" Qualifying - Doing the Math ........................................................................................................ 16 Using a Pre-Qualification Worksheet .................................................................................................................. 16 Qualifying and Pre-Qualification – Two Different Things................................................................................ 17 Advanced Concepts - The Concept of Leverage ................................................................................................ 18 Advanced Concepts - The Concept of Taxable Equivalency ......................................................................... 18 Tax Deduction – The Mortgage Payment and Rental Equivalent .................................................................. 19

Chapter 2 - Major Loan Types .................................................................................... 23 Choosing a Fixed Rate Mortgage ....................................................................................................................... 23 Interest-Only (Non-Traditional Loan Type)..................................................................................................... 24 Prepayment as an Interest Savings Tool ....................................................................................................... 24 Other Prepayment Strategies - The Bi-Weekly Mortgage .............................................................................. 25 Other "Fixed Rate" Mortgages ............................................................................................................................ 25 Balloon Mortgages ......................................................................................................................................... 25 The Two-Step ARM ....................................................................................................................................... 26 Buydowns - The Low Down on Interest Rate Reduction ................................................................................ 26 Primary Reason for Buydowns – Qualify for More ......................................................................................... 27 Using Discount Points to Create Beneficial Programs ........................................................................................ 28 ADJUSTABLE RATE MORTGAGES (Non-Traditional Loan Types) .................................................................. 29 ARM Components - The Basic Four .............................................................................................................. 30 The Role of the Index in the Interest Rate Change ........................................................................................ 31 The Margin – The Spread Over Market ......................................................................................................... 32 Interest Rate Caps & Payment Caps – Limiting the Change ......................................................................... 32 Initial Adjustment Cap .................................................................................................................................... 33 The “Option” ARM – The Ultimate Non-Traditional Loan .................................................................................... 34 Comparing ARMS .......................................................................................................................................... 37 Conversion Options ............................................................................................................................................ 38 Second Mortgages ......................................................................................................................................... 39

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Piggybacks or Blends (Non-Traditional Loan Type) ....................................................................................... 39 Computing the Blended Rate ......................................................................................................................... 40 Bridge Loans and Reverse Bridge Loans - 2 Strategies ................................................................................ 40 Seller held Mortgages, Assumptions and Wraps ........................................................................................... 41 Reverse Mortgages for Seniors .......................................................................................................................... 41

Chapter 3 - Loan Plan Specifications ........................................................................ 43 Program Specifications - Understanding Guidelines .......................................................................................... 43 Conventional Loans - What is Conforming? ....................................................................................................... 45 “Generic Jumbo” Non-Conforming ................................................................................................................. 49 Automated Underwriting – Electronic Decision Engines ..................................................................................... 49 Simple Troubleshooting Strategies ................................................................................................................ 49 Variance Tolerance ........................................................................................................................................ 50 Common Problems with AU (Automated Underwriting) ................................................................................. 50 DU or LP? ...................................................................................................................................................... 50 First Time Homebuyer Programs ........................................................................................................................ 52 Private Mortgage Insurance (PMI) ...................................................................................................................... 52 Mortgage Insurance Coverage Requirements ............................................................................................... 53 Mortgage Insurance Premium Plans .............................................................................................................. 53 Choosing the Right Plan - Premium Plan Options ......................................................................................... 54 PMI Underwriting Guidelines ......................................................................................................................... 55 HOPA and PMI Cancellation.......................................................................................................................... 55 The Federal Housing Administration (FHA) ........................................................................................................ 56 The Direct Endorsement Program (DE) ......................................................................................................... 58 2007 – 2010 Transitional Issues with FHA..................................................................................................... 59 Risk-Based Insurance Premiums – No Longer in Effect ................................................................................ 59 Financing Mortgage Insurance ...................................................................................................................... 59 The Refinance Conundrum ............................................................................................................................ 60 FHA Secure Refinance Program – Cancelled 12/31/08 ................................................................................. 60 Documented Underwriting “Compensating Factors” ...................................................................................... 60 The Department of Veteran's Affairs (VA) .......................................................................................................... 61 Loan Level Price Adjustments – You May See Them or Not ......................................................................... 64

Chapter 4 - QUALIFYING -Ratios and Credit History ............................................... 67 Understanding Guidelines ...................................................................................................................... 67 Owner Occupancy and Qualifying ................................................................................................................. 68

The Mathematics of Qualifying Ratios .................................................................................................... 69 The Housing Expense Ratio .......................................................................................................................... 70 The Total Debt Ratio ...................................................................................................................................... 72 Regular Business Expenses/Self Employed Borrowers ................................................................................. 76

Credit History .......................................................................................................................................... 77 Credit Bureaus vs. Credit Repositories .......................................................................................................... 77 Obtaining a Credit Report .............................................................................................................................. 80 Understanding the Ratings - What is "Bad" ................................................................................................... 80

Sub-Prime Lending ................................................................................................................................. 83 High-Rate, High-Fee Loans (HOEPA/Section 32 Mortgages)........................................................................ 84 Credit Counselors/Agencies .......................................................................................................................... 85

Understanding Credit Scoring................................................................................................................. 85 Risk Grading ....................................................................................................................................................... 87

Consider the Impact ................................................................................................................................ 89 Income Fraud Alerts/Red Flags ..................................................................................................................... 89 Understanding Income ................................................................................................................................... 91

Chapter 5 – QUALIFYING: Income & Other Restrictions ......................................... 91 "Stable" Income ............................................................................................................................................. 91 Base Income with Enhancements .................................................................................................................. 92

Getting the most of Overtime, Bonus, & Commissions .......................................................................... 92 Bonus, Tips and Commission ........................................................................................................................ 93 Future Raises ................................................................................................................................................ 94 Dividends & Interest ....................................................................................................................................... 95

Self-Employment .................................................................................................................................... 95 Who is Self-Employed?.................................................................................................................................. 96 Analyzing Self-Employment Income and Required Documentation .................................................................... 97

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Income Analysis - Start With the Personal Returns ....................................................................................... 98 Income Sources & "Add-backs" .................................................................................................................... 99 Partnership and S Corporation Tax Returns and Income Analysis ................................................................99 Analyzing the US Corporation Income Tax Return ...................................................................................... 100 The Profit and Loss Statement .................................................................................................................... 101 No Income Verification Loans ...................................................................................................................... 102 Documentation Types and Their Meanings ...................................................................................................... 102

What is a Compensating Factor? ......................................................................................................... 103 Co-borrowers ............................................................................................................................................... 103 Income “Red Flags” .......................................................................................................................................... 104

Eligible Borrowers ................................................................................................................................. 105 Resident Aliens ............................................................................................................................................ 106 Non-Immigrant Visas ................................................................................................................................... 106

Chapter 6 – QUALIFYING: Assets, Down-Payment and Closing Costs ................ 109 Understanding Asset Qualifying ................................................................................................................... 109

Understanding Closing Costs ............................................................................................................... 109 The Components of a Buyer's Closing Costs ................................................................................................... 109 1.) Loan Fees and “Points” .......................................................................................................................... 110 2.) "Hard" Closing Costs .............................................................................................................................. 110 Title Insurance ............................................................................................................................................. 111 3.) Government/Municipal Title Related Charges ....................................................................................... 111 4.) Prepaid Items ......................................................................................................................................... 112 Interim Interest ............................................................................................................................................. 112 Insurance Escrow ........................................................................................................................................ 113 Real Estate Tax Escrows ............................................................................................................................. 114

Estimating Closing Costs – Qualifying for Cash ................................................................................... 115 Seller Contributions .............................................................................................................................. 119 Avoiding Problems with Seller Contributions ............................................................................................... 119 Structuring Seller Paid Closing Costs .......................................................................................................... 120

Sources of Assets for Down Payment, Closing Costs and Reserves .................................................. 120 Borrower’s Own Funds ................................................................................................................................ 121 Reserves...................................................................................................................................................... 122 Lender Credits for "Above Par" Pricing Towards Closing Costs .................................................................. 122 Tips for Using Gifts ...................................................................................................................................... 122 Shared Equity .............................................................................................................................................. 123 “Red Flags” for Assets and Deposits ................................................................................................................ 123

Chapter 7 - The Home Financing Process .............................................................. 125 Understanding the Home Buying Process ............................................................................................ 125 The Loan Application Process .......................................................................................................................... 126 Why You Should Use a Pre-Application Kit ................................................................................................. 126

The Application Interview- Completing the Application Form ............................................................... 127 Loan File Set Up ................................................................................................................................... 132 Red Flags in the Application Process .......................................................................................................... 133

Understanding Truth-in-Lending ........................................................................................................... 134 The APR Formula ........................................................................................................................................ 135 Determining the Amount Financed - What are Finance Charges? ............................................................... 135

How to Process a Loan......................................................................................................................... 137 The Approval Process - Who is the Underwriter? ............................................................................................. 138

Desktop Underwriter and Loan Prospector .......................................................................................... 140 Conducting Weekly Status Reviews ..................................................................................................... 141 The Closing and Requirements ............................................................................................................ 142 Settlement Agent ......................................................................................................................................... 142 Lender Sends Loan Instructions to Settlement Agent .................................................................................. 145 Closing “Red Flags” ..................................................................................................................................... 145 The HUD-1 – Settlement Statement ................................................................................................................. 146

Closing Documents ............................................................................................................................... 146 Promissory Note .......................................................................................................................................... 146 The Mortgage or Deed of Trust .................................................................................................................... 146 The Right of Rescission - Refinances .......................................................................................................... 147 Other Disclosures ........................................................................................................................................ 147

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Loan Officer and Processor Time Management Techniques ............................................................... 148 System 1 - The Complete Application System for Loan Officers ...................................................................... 148 Pipeline Review ................................................................................................................................................ 149

Chapter 8 – Property Types ...................................................................................... 151 Understanding Property Types ............................................................................................................. 151 Why Condos are Hard to Finance ................................................................................................................ 152 Conforming Guidelines ................................................................................................................................ 152 Private Mortgage Insurance and Projects .................................................................................................... 154 Documentation Required for Project Approval.................................................................................................. 155 PUD/Classifications & Requirements ............................................................................................................... 156

New Construction Projects - Construction Permanent Financing ........................................................ 157 Financing Investment Property ............................................................................................................. 158 Cash Flow .................................................................................................................................................... 159 What Must the Rent Be? .............................................................................................................................. 159 Investment Property ..................................................................................................................................... 160 Pre-Qualification .......................................................................................................................................... 160 Property Documentation Requirements for Investment Property Financing ................................................ 161

2 to 4 Unit Properties ............................................................................................................................ 161 Cooperatives ......................................................................................................................................... 162 Manufactured /Mobile, Modular and “Kit” Homes ................................................................................. 162 Commercial Loan Guidelines............................................................................................................................ 163 Commercial Property Types and Basic Guidelines ...................................................................................... 163

Appraisals ............................................................................................................................................. 164 Appraisal Basics .......................................................................................................................................... 164 Simple Approaches to Resolving Valuation Problems ................................................................................. 164 Fraud Alert ................................................................................................................................................... 165

Chapter 9 - REFINANCING ........................................................................................ 167 Where to Start - Determining “Value” ................................................................................................... 167 “Seasoning” ................................................................................................................................................. 167 Rate Reduction ................................................................................................................................................. 168 Term Reduction Refinances ............................................................................................................................. 169 Refinancing to “Cash Out” - Recapture Equity in Your Property ....................................................................... 170 Reasons to Take "Cash Out" ............................................................................................................................ 171 Low Cost of Cash ........................................................................................................................................ 171 Cash Out for Debt Consolidation ................................................................................................................. 171 Cash out for Investment ............................................................................................................................... 173 Cash Out to Purchase Investment Property................................................................................................. 173 Cash Out for Retirement .............................................................................................................................. 174 Refinance to eliminate Private Mortgage Insurance ......................................................................................... 175 Using a 1st and 2nd Mortgage to Solve Equity Problems ................................................................................. 176 Refinancing a 1st and 2nd Mortgage ........................................................................................................... 177 Refinancing an FHA Loan ............................................................................................................................ 177 Refinancing a VA Loan ................................................................................................................................ 178 Important Facts With Regard to Refinancing ............................................................................................... 179 Escrow Accounts and Prepaid - Understanding Costs of Refinancing ............................................................179 Problems with Existing Financing ................................................................................................................ 180

Chapter 10 – The Secondary Market........................................................................ 181 Selling Loans – The Basis of our Industry.................................................................................................... 181

Lock or Float ......................................................................................................................................... 181 Seasonality Patterns .................................................................................................................................... 182 Immediate Delivery ...................................................................................................................................... 182

The Secondary Market ......................................................................................................................... 182 Who’s Who in the Secondary Market ........................................................................................................... 183 Par is not a Golf Score ................................................................................................................................. 184 How Lenders Make Money .......................................................................................................................... 185 Interest Rate Drivers ......................................................................................................................................... 187 Playing the Market ....................................................................................................................................... 188

Chapter 11 – Practical Compliance - Understanding Federal Laws...................... 189 Test Preparation .......................................................................................................................................... 189

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Regulators – The Consumer Financial Protection Bureau ................................................................... 190 The Rules.............................................................................................................................................. 190 The Housing and Economic Recovery Act of 2008 (HERA) ............................................................................. 191 Regulator – Federal Housing Finance Agency ................................................................................................. 191 Secure and Fair Enforcement for Mortgage Licensing (SAFE Act)................................................................... 192 The Dodd/Frank Act – Originator Compensation (Anti-Steering) ...................................................................... 193 Process ........................................................................................................................................................ 193 The Qualified Mortgage Rule (QM) and Steering ......................................................................................... 193 RESPA – The Real Estate Settlement Procedures Act .................................................................................... 195 Purpose of the Law ...................................................................................................................................... 195 Exempt Transactions ................................................................................................................................... 195

The Anti-Kickback Rule - Payment or Receipt of Non-Approved Fees ................................................ 196 Prohibited - Kickbacks and Referral Fees......................................................................................................... 196 Prohibited Payment – “Anything of Value” ................................................................................................... 196 Prohibited - Fee Splitting..............................................................................................................................196 Permitted – Approved Affiliated and Controlled Business Arrangements .................................................... 196 Approval Required - Desk Rental Arrangements ......................................................................................... 197 Approval Required – Joint Marketing Arrangements ................................................................................... 197 Required Disclosures ................................................................................................................................... 197 Operating Areas Affected............................................................................................................................. 197 Penalties for Non-Compliance ..................................................................................................................... 197 Application Disclosures - The Closing Cost Worksheet ............................................................................... 198 The Good Faith Estimate Form ........................................................................................................................ 198 Application Disclosures - The Special Information Booklet .......................................................................... 200 Application Disclosures - Notice of Transfer of Servicing............................................................................. 200 Disclosures - at Closing - HUD-1 Settlement Statement .............................................................................. 200 Disclosures – at Closing – Aggregate Escrow Disclosure............................................................................ 201

The Truth-in-Lending Act (TILA) - Regulation Z ................................................................................... 201 Purposes of Truth-in-Lending Act ................................................................................................................ 201 Mortgage Disclosure Improvement Act of 2009 (MDIA) ................................................................................... 201 Corrective Truth-in-Lending Disclosures ...................................................................................................... 202 At Application - The “Early Disclosure” ........................................................................................................ 202 APR Tolerance ............................................................................................................................................ 202 Determining the Amount Financed - What are Prepaid Finance Charges? ................................................. 203 Disclosures at Application – ARM Disclosure .............................................................................................. 203 Home Equity Lines and Open-Ended Credit ................................................................................................ 203 Notice of Right to Cancel (Right to Rescind)................................................................................................ 204 Waiver of Right to Rescind .......................................................................................................................... 204 Right to Rescind in Open-end Transactions ................................................................................................ 204 Three Day Right to Cancel........................................................................................................................... 205 Regulations - Advertising ............................................................................................................................. 205 Section 32 of Truth-in-Lending Act ................................................................................................................... 205 Loans Subject to Section 32 ........................................................................................................................ 205 Points and Fees Trigger...............................................................................................................................205 Section 32 Disclosures ................................................................................................................................ 205 Section 32 Prohibitions ................................................................................................................................ 206 Penalties for HOEPA Violations ................................................................................................................... 206 “Higher Priced Mortgage Loans” - Section 35 .............................................................................................. 206

The Equal Credit Opportunity Act (“ECOA” or “Fair Lending” .............................................................. 207 Unlawful Inquiries ........................................................................................................................................ 207 Prohibitions .................................................................................................................................................. 207 Notification Requirements ............................................................................................................................ 208 Penalties ...................................................................................................................................................... 208

ECOA Related Consumer Protection Laws .......................................................................................... 208 Fair Housing Act ............................................................................................................................................... 208 Fair Credit Reporting Act (“FCRA”) ............................................................................................................. 209 The Fair and Accurate Credit Transactions Act (FACTA) ............................................................................ 209

Home Mortgage Disclosure Act (“HMDA”) ........................................................................................... 209 Depository Institutions Subject to the Act..................................................................................................... 209 Community Reinvestment Act (CRA) ............................................................................................................... 210

Common Consumer Protection Laws Relating to Mortgages .............................................................. 210

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Home Owner’s Protection Act ...................................................................................................................... 211 PMI Cancellation .......................................................................................................................................... 211 Gramm-Leach-Bliley Act .............................................................................................................................. 211 Flood Disaster Protection Act (FDPA).......................................................................................................... 211 USA Patriot Act ............................................................................................................................................ 212

Appraiser Independence Rules (Formerly HVCC) ............................................................................... 213 History of the Appraiser Independence Rule ............................................................................................... 213

Chapter 12 – The Real Estate Settlement Procedures Act (RESPA) ..................... 215 Key Concepts .............................................................................................................................................. 215

Introduction to RESPA .......................................................................................................................... 215 Transactions Subject to the Law .................................................................................................................. 216

Issues Relating to Business Practices – Kickbacks ............................................................................. 216 Prohibition on Kickbacks, Fee-Splitting and Unearned Fees ....................................................................... 217 Compensable Settlement Services – What the Borrower can Pay For ........................................................ 217 Controlled and Affiliated Business Arrangements (ABA) .................................................................................. 218 Why an ABA is not a RESPA Violation ........................................................................................................ 218 Mortgage Brokers are Controlled Business Arrangements .......................................................................... 219 Other Controlled Business Arrangements.................................................................................................... 219 Sample Cases – Is it a Controlled Business Arrangement?......................................................................... 222 Enforcement of Section 8............................................................................................................................. 225

Application Disclosure – Good Faith Estimate of Closing Costs .......................................................... 225 Timing and Delivery of the GFE ................................................................................................................... 226 RESPA Reform and the Good Faith Estimate ............................................................................................. 226 Preparing the Good Faith Estimate .............................................................................................................. 227 Preparing the 2010 GFE .............................................................................................................................. 228

Calculating the Components of a Buyer's Closing Costs ..................................................................... 228 Loan Fees .................................................................................................................................................... 228 Interim Interest ............................................................................................................................................. 230 The Special Information Booklet – HUD Guide to Settlement Costs ............................................................ 232 What These Costs Represent ...................................................................................................................... 232

The Disclosure of Yield Spread Premiums (YSP) ................................................................................ 234 The Debate over Interest Rate Premiums.................................................................................................... 235 Preparing the “Adjusted Origination Charge” Section of the 2010 GFE ............................................................ 235

RESPA Reform and the Impact on Originator Compensation.............................................................. 237 The Good Faith Estimate (GFE) and Settlement StatementHUD-1/HUD-1A.................................................... 237 The Good Faith Estimate, Itemization, and Broker Compensation .............................................................. 238 Limits on changes –The Issue of Tolerance ................................................................................................ 239 Tolerance for Variances ............................................................................................................................... 239 Circumstances in Which the GFE Can Be Revised ..................................................................................... 240 Single Application Process – Timing and Requirements for Delivery of GFE ................................................... 240 “No Cost Loans” ........................................................................................................................................... 242 Lender v. Broker Fees ................................................................................................................................. 243

HUD – 1 Revision - Comparability ........................................................................................................ 244 Average Cost Pricing and Negotiated Discounts – Kickback Violations....................................................... 245 Methodology for Average Cost Pricing......................................................................................................... 245

Transfer of Servicing and Servicing Practices Act................................................................................ 245 Transfer of Servicing .................................................................................................................................... 246 Aggregate Escrow Accounting ..................................................................................................................... 248 Prohibition against Excessive Escrow ......................................................................................................... 248 Aggregate Escrow Accounting Disclosure ................................................................................................... 249

Closing Costs and the HUD-1 Settlement Statement ........................................................................... 251

Chapter 13 - Truth-In-Lending Act – “Regulation Z” .............................................. 253 Introduction .................................................................................................................................................. 253 Purposes of Truth-in-Lending Act ..................................................................................................................... 253 The Federal Reserve ................................................................................................................................... 254 Disclosures - At Application - The APR (Annual Percentage Rate) Disclosure ................................................ 255 Calculating the APR Formula ........................................................................................................................... 257 Third Party Fees “Generally” Included in the Finance Charge ..................................................................... 258 APR Tolerance ................................................................................................................................................. 261 Errors in Calculating the APR ...................................................................................................................... 261

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Using APR to Compare Loan Fee Options .................................................................................................. 261 Disclosures at Application – Adjustable Rate Mortgage Terms ........................................................................ 262 The Consumer Handbook on Adjustable Rate Mortgages ...........................................................................264 Home Equity Lines and Open-Ended Credit ..................................................................................................... 264 Specific Disclosures for Home Equity Lines of Credit .................................................................................. 264 When Your Home is on the Line .................................................................................................................. 265 Notice of Right to Cancel (Right to Rescind) .................................................................................................... 265 Effects of Rescission ........................................................................................................................................ 267

Advertising and Truth-in-Lending.......................................................................................................... 269 Trigger Terms ................................................................................................................................................... 270 Rules of Advertising for Open-End Credit and Closed-End Credit ...............................................................270 Rules of Advertising for Home Equity Loans................................................................................................ 271 The Challenge of Compliance ...................................................................................................................... 271 FTC Actions for Advertising Violations ......................................................................................................... 271 Penalties ...................................................................................................................................................... 272

Section 32 of the Truth-in-Lending Act ................................................................................................. 273 Loans Subject to Section 32 ............................................................................................................................. 273 Section 32 Disclosures ................................................................................................................................ 273 Section 32 Prohibitions – “Flipping” ............................................................................................................. 274 Section 32 Prohibitions - Lending Without Regard to Repayment Abili ....................................................... 274 Section 32 Prohibitions - Direct Payments to Contractors ........................................................................... 274 Section 32 Prohibitions - Documenting Closed-end Loans as Open-End Credit ......................................... 274 Other Section 32 Prohibitions ...................................................................................................................... 275 Penalties for HOEPA Violations ................................................................................................................... 275 “Higher Cost” Loans- Section 35 .................................................................................................................. 275 Advertising Practices ................................................................................................................................... 276

Chapter 14 - Understanding Federal Credit-Granting Related Laws .................... 277 The CFPB and Secondary Regulators ......................................................................................................... 278 Equal Credit Opportunity Act – Federal Reserve Regulation B - 12 CFR Part 202 .......................................... 279 General Rules for Compliance §202.4 ......................................................................................................... 279 Definitions - §202.2 ...................................................................................................................................... 279 What information can be Requested – Section 202.5 .................................................................................. 280 How Applications are Evaluated – Section 202.6/202.7 .............................................................................. 281 What is a “Statistically Sound Credit Scoring System?” ............................................................................... 282 Adverse Action ............................................................................................................................................. 282 Other General Requirements ....................................................................................................................... 284 Right to Receive a Copy of the Appraisal .................................................................................................... 284 Lenders May Not Discourage the Filing of an Application............................................................................ 285 The ECOA Code – Who Is Responsible For the Account? ..........................................................................285 Lender Do’s and Don’ts ............................................................................................................................... 286 Borrower’s Recourse for Inaccurate Credit Information ............................................................................... 286 If the Loan is “Counter-Offered” ................................................................................................................... 287 What Recourse Does the Borrower Have .................................................................................................... 288

The Fair Credit Reporting Act ............................................................................................................... 288 FCRA Features ............................................................................................................................................ 288 Penalties ...................................................................................................................................................... 289 Procedure for Correcting Errors ................................................................................................................... 289 Borrowers Copy of Report ........................................................................................................................... 289 "Imposter" Free Credit Report Sites ............................................................................................................. 290 Seven-Year Reporting Period ...................................................................................................................... 290 Permissible Purpose for Ordering a Credit Report ....................................................................................... 291 Lender’s Reporting Duties (Section 623) ..................................................................................................... 291

Fair and Accurate Credit Transactions Act (FACTA)............................................................................ 292 Disposing of Consumer Report Information ................................................................................................. 292 Identity Theft “Red Flag” Programs .............................................................................................................. 292 FACTA and Identity Theft ................................................................................................................................. 293 FACTA and the Credit Score Disclosure .......................................................................................................... 293 FACTA and the Risk Based Pricing Notice .................................................................................................. 294

The Gramm-Leach Bliley Act ................................................................................................................ 294 Defining the Customer ................................................................................................................................. 295 The Privacy Notice ....................................................................................................................................... 295

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Opting Out ................................................................................................................................................... 296 The Safeguards Rule ................................................................................................................................... 296 Receiving Nonpublic Personal Information .................................................................................................. 297

Fair Credit Billing Act (FCBA) ............................................................................................................... 297 While the Bill is in Dispute............................................................................................................................ 298

Fair Debt Collection Practices Act ........................................................................................................ 298 Rules Regarding Contact with Borrowers .................................................................................................... 299

Electronic Funds Transfer Act (EFTA) .................................................................................................. 300 Credit Repair Organizations Act (90-321, 82 Stat. 164) ....................................................................... 301 The Fair Housing Act ............................................................................................................................ 302 Covered Transactions .................................................................................................................................. 302 Unlawful Lending Practices.......................................................................................................................... 302 Violations and Enforcement ......................................................................................................................... 304 Advertising ................................................................................................................................................... 304 Limitations Extended to 3rd Parties ..............................................................................................................305 Allegations of Discrimination ........................................................................................................................ 305 Filing Complaints ......................................................................................................................................... 305 The Credit Report ............................................................................................................................................. 305

The Home Mortgage Disclosure Act (HMDA) – Regulation C.............................................................. 306 The Loan Application Register (LAR)........................................................................................................... 307 Interest Rate Data ........................................................................................................................................ 307

COMMUNITY REINVESTMENT ACT (CRA) ....................................................................................... 308 Evaluation of CRA Performance .................................................................................................................. 308 Home Owners Protection Act (HOPA) .............................................................................................................. 308 FTC's Telemarketing Sales Rule (TSR) – DO NOT CALL ................................................................................ 309 Rules for Telemarketers...............................................................................................................................309

The USA PATRIOT ACT ...................................................................................................................... 310 Bankruptcy Abuse Prevention and Consumer Protection Act ........................................................................... 311

Chapter 15 – Fraud .................................................................................................... 313 Types of Fraud ...................................................................................................................................... 314 Fraud for Housing ........................................................................................................................................ 314 Exigent Fraud .............................................................................................................................................. 314 Perpetrators ...................................................................................................................................................... 314 Real Estate Brokers ..................................................................................................................................... 314 Real Estate Attorney .................................................................................................................................... 315 Appraisers.................................................................................................................................................... 315 Borrowers .................................................................................................................................................... 315 Loan Officer ................................................................................................................................................. 315

Fraud Schemes..................................................................................................................................... 315 New Schemes – Short Sale Fraud ................................................................................................................... 316 New Schemes – Foreclosure “Rescue” ....................................................................................................... 316 Appraisal Fraud ................................................................................................................................................ 316 Appraisal Review .............................................................................................................................................. 318 Builder Bailout Scheme .................................................................................................................................... 319 Occupancy Fraud ........................................................................................................................................ 319 Flips ............................................................................................................................................................. 320 Foreclosure or Deed-in-Lieu ........................................................................................................................ 321 Fraudulent Legal Documentation ................................................................................................................. 321 Straw Buyers .................................................................................................................................................... 322 Straw Sellers .................................................................................................................................................... 323

Mortgage Application Documentation Fraud ........................................................................................ 323 Falsified Applications and Documentation ................................................................................................... 323

Borrower Identity Fraud ........................................................................................................................ 323 Social Security Numbers..............................................................................................................................324 Credit Score Improvement Scheme ............................................................................................................. 325 Identity Theft ................................................................................................................................................ 325 File Segregation ........................................................................................................................................... 325 Income Documentation Fraud ...................................................................................................................... 325 Self-Employed Borrowers ............................................................................................................................ 326 Tax Return Authenticity Verification ............................................................................................................. 327

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Asset Documentation Fraud ........................................................................................................................ 327 Validating “Cash on Hand” ........................................................................................................................... 328 Asset/Deposit Verification Scheme .............................................................................................................. 328 Pending Rental Scheme .............................................................................................................................. 328

Punishment ........................................................................................................................................... 328 Federal Laws that Address Mortgage Fraud ................................................................................................ 328 Mail Fraud (18 USC Section 1341) .............................................................................................................. 329 Frauds by Wire, Radio, and Television (18 USC Section 1343) .................................................................. 329 Bank Fraud (18 USC Section 1344) ............................................................................................................ 329 Attempt and Conspiracy (18 USC Section 1349) ......................................................................................... 329 Making False Statements to the Government (18 USC Section 1014) ........................................................ 330 Conspiracy (18 USC Section 371) ............................................................................................................... 330 Laundering of Monetary Instruments ........................................................................................................... 330 Federal Sentencing Guidelines .................................................................................................................... 331 Industry Actions to Combat Fraud .................................................................................................................... 331 Prevention.................................................................................................................................................... 332 Common Sense is the Loan Officer’s Best Defense .................................................................................... 332

Chapter 16 – Predatory Lending Practices ............................................................. 335 The Sub-Prime Market as a Catalyst for Predatory Lending ................................................................ 335 Predatory Lending Practices............................................................................................................................. 336 High Cost Loans .......................................................................................................................................... 336 “Higher Cost Loans” and Anti-Predatory Lending (APL) Policies ...................................................................... 337 Loan Flipping- No Financial Benefit – Equity Stripping ..................................................................................... 337 Excessive Fees – Fee Packing .................................................................................................................... 339 Lending Without Regard for the Borrower’s Ability to Pay ........................................................................... 339 Fraud ........................................................................................................................................................... 340 Negative Amortization .................................................................................................................................. 341 Payments in Advance .................................................................................................................................. 341 Prepayment Penalties .................................................................................................................................. 341 Payments to Contractors ............................................................................................................................. 342 Mandatory Arbitration Agreements .............................................................................................................. 342 Due on Demand Clauses - Acceleration ...................................................................................................... 342 Balloon Payments ........................................................................................................................................ 343 Predatory Servicing Practices ...................................................................................................................... 343 Deceptive Practices ..................................................................................................................................... 344 Encouraging Default .................................................................................................................................... 344 The Federal High Cost Loan Law ..................................................................................................................... 344 High Cost Loans .......................................................................................................................................... 345 Disclosures .................................................................................................................................................. 345 Prohibited Loan Features on Section 32 Loans ........................................................................................... 345 Additional Legislative Solutions and Impacts .................................................................................................... 346 Counseling ................................................................................................................................................... 346 Inclusion of Assignees in the Prohibition...................................................................................................... 346 Effect on Neighborhoods ............................................................................................................................. 346 Best Practices – Internal Training Program ................................................................................................. 347 Potential Federal Regulatory Cures ............................................................................................................. 347 Penalties and Enforcement...............................................................................................................................347 State Predatory Lending Laws.......................................................................................................................... 348 National Bank Exemption............................................................................................................................. 348 Blaming Brokers .......................................................................................................................................... 349 Pressure to Compromise .................................................................................................................................. 351 A Code of Ethics .......................................................................................................................................... 351 Principle 1 – Put the Borrower’s Interests First ............................................................................................ 352 Ethical Quandaries ........................................................................................................................................... 353 Pricing Issues – Rate Lock-in ...................................................................................................................... 353 Pricing Issues – Opportunistic Pricing.......................................................................................................... 353 Approval Issues – Pre-Qualified vs. Pre-Approved ...................................................................................... 354 Approval Issues – Loan Denial .................................................................................................................... 355 Approval Issues – The Counter-Offer .......................................................................................................... 356 Processing Issues – Financial Privacy ......................................................................................................... 356 Pricing Issues – Hide the Origination/Doc/Broker Fee ................................................................................. 356 Processing Issues – Undisclosed Loan Terms ............................................................................................ 357

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Approval Issues – Insufficient Income.......................................................................................................... 357 Approval Issues – Low Appraisal ................................................................................................................. 358 Business Practices – Kickbacks and Referral Fees ..................................................................................... 358 Business Practices – Advertising ................................................................................................................. 359 Origination Issues – Buyer Over-Reaching .................................................................................................. 359 Origination Issues – Documents Signed in Blank ........................................................................................ 359 Origination Issues - The Unsigned Document ............................................................................................. 360 Other Ethical Behaviors .................................................................................................................................... 360 Harassment/Sexual Harassment ................................................................................................................. 360 Business Courtesies .................................................................................................................................... 360 Compliance with the Letter, Not the Spirit......................................................................................................... 360 Truth-in-Lending .......................................................................................................................................... 361 Unethical Treatment of the APR Disclosure................................................................................................. 361 The Real Estate Settlement Procedures Act................................................................................................ 361 Unethical Treatment of RESPA Rules ......................................................................................................... 361 The Equal Credit Opportunity Act and the Fair Housing Act ........................................................................ 362 Unethical Treatment of the ECOA/FHA ....................................................................................................... 362 Ethics - When in Doubt ..................................................................................................................................... 362

Conclusion ................................................................................................................. 362 Mortgage Terminology .......................................................................................................................... 365

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Introduction Since the first publishing of this book in 1991, the mortgage industry experienced three complete cycles of boom and bust. The last bust grew so large that it threatened the global financial system. The repercussions of this last collapse include a hyper-vigilant level of regulatory oversight and risk-averse guidelines so tight as to constrict lending to pre-1990’s levels. In fact, with the exception of technology, the industry looks a lot more like the industry I joined in 1983 than we have seen since. Because of these changes, this book carries more importance now than ever. Many people who came into the industry since 2002 do not know about the fundamentals of borrower financial qualification - low and no documentation loans made it easy to get a loan without qualifying. This means fewer mentors teaching new loan originators the “right way” to make loans. This book teaches financial qualifying as a skill, but also as an ethical selling process. We would not have experienced the crisis we now face if the industry had insisted that borrowers could afford the loans they took. Loan officers or originators are an oft-maligned group. Lenders put them in charge of bringing in the business. They are the consumer’s only advocates in the home loan process. They must possess that delicate balance of salesmanship and sledgehammer. Invariably, we also view them as a “necessary evil” - because they push the system. We rarely accuse loan officers of strictly adhering to guidelines. A significant number of homeowners would never have achieved their goal if their loan officer followed a set procedure. Due to limited personnel resources, many mortgage firms find themselves forced to offer loan officer training on a “sink or swim” basis. Handed a binder with program specifications, you must become an expert immediately. Your livelihood depends on how quickly you can make an impact. We have structured this book to bring the neophyte, “haven’t touched a calculator since high school,” non-real estate practitioner up to speed in a matter of weeks instead of months. The SAFE Act and (NMLS) Nationwide Mortgage Licensing System The SAFE (Secure and Fair Enforcement for Mortgage Licensing) Act became law as a reaction to the Sub-Prime Mortgage Meltdown and the global financial crisis. This law was a reaction to the mortgage industry’s failure to self-regulate in a market environment that facilitated the financing of nearly anyone who applied for a loan. Many believed unregulated mortgage brokers were largely to blame for the crisis. SAFE targets these loan originators and creates a universal licensing law. The law mandates that states require pre-licensing and continuing education, as well as registration through the NMLS, for non-bank mortgage originators. Examining the required training elements reveals an emphasis on regulatory compliance. The Federal requirements understate the vocational (skills-based) training needs of new entrants. 20 hours is not a sufficient amount of vocational education to prepare an originator for work in this complex industry. To address the SAFE Act requirements we have combined two texts; “The Loan Officer’s Practical Guide to Residential Finance” and “The Loan Officer’s Practical Guide to Compliance.”

Introduction - Page xi


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Together these textbooks contain all of the information required by the Federal law, as well as providing instruction on job skills required to execute the duties of the loan originator. In addition, this material arms the originator with the information required to pass the Federal sections of the National Mortgage Originator Exam. Once you obtain a license to practice mortgage origination you will find that your success depends far more heavily on your skills. 20 hours of compliance education may prepare you to take an exam, but job proficiency requires that you study longer. Introduction to the Business A Mortgage - the paper itself - is a document recorded among permanent land records. This document enforces the Note - a borrower's promise to pay - and allows a lender to take a property back from the owner if he or she does not keep that promise. This is why we call it the mortgage business. Sounds simple, but the simplicity ends here. This piece of paper forms the basis of a thriving and dynamic industry. However, for all of the sophistication that has evolved over the last 70 years, the loan officer still holds the primary responsibility for performing the function of structuring residential home mortgage transactions. There is no substitute for practical experience. However, learning through practical experience is a nice way of saying, “learning it the hard way.” The phrase "a little knowledge is very dangerous" is a description of what can happen when we apply facts without appropriate framework. We have attempted to distill the introductory training of a loan officer in a way that gives an understanding of how, physically, things work. Knowing how and why we do things provides a context for all of the facts that the loan officer must commit to memory or have readily available. There is a LOT to learn. Because of this challenge, we have organized this book in the way that we feel an individual would learn this information chronologically, as he or she would if going through a loan process from beginning to end. Our unique program understands that the originator must calculate and explain monthly payments and programs in order to progress to the loan application, so our instructions follow the timing of the process. In addition, we have attempted to compress a vast amount of information into a relatively small package. Mark Twain once said, “I didn’t have time to write you a short letter, so I wrote you a long one…” which illustrates what our industry suffers most from – verbosity. In compressing information, the instruction can start to appear jumpy. We know the challenge of learning this business in a short time, and we try to eliminate as much filler as possible. Today, More Than Ever… Today’s mortgage industry resembles the 1980’s, with few products and super vigilant underwriting. More than ever, we need that person who can step in and take the time to structure a transaction for a borrower's best interests utilizing all of the options available. We can lend our way out of this crisis. That is the loan officer’s job - this is what I hope you will learn from this book.

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

SAFE Act Curriculum Syllabus - Nationwide Licensing System We have designed this text to encompass all of the information that could be on a National Test, as well as that which is required to perform the originator’s function. For those who require SAFE Act (Secure and Fair Enforcement for Mortgage Licensing Act) initial and continuing education credit, we are providing this Syllabus to guide you to the required topics. Pre-Licensing/Continuing Education Required Courses/Topics SAFE Topic Federal Laws (3 Hours Total)

Ethics (3 Hours Total)

Course Title Understanding Federal Laws RESPA – Understanding the Real Estate Settlement Procedures Act Truth-in-Lending Regulation Z

Chapter 11 12

Hours 1 1

13

1

Fraud - Understanding Mortgage Fraud Understanding Federal Credit Laws Ethics in the Mortgage Business

15 14 17

1 1 1

16 2

1 1 8

Lending Standards and Predatory Lending Non-Traditional Loans Understanding Loan Types Total Mandatory Pre-Licensing (PE)

Test Preparation For the national tests, the NMLS has drawn questions from topics listed on the suggested National Test Outline. Within this outline, there are wide arrays of requirements. We provide this guide to assist you in preparing for the National Test. Individual state tests will focus more on state specific laws, requirements and practices. For more information on your specific state, go to www.lendertraining.com for a referral to companies specializing in your state. National Test Preparation Source Reference Topic(s) I. Federal mortgage-related laws (35%) RESPA, Equal Credit Opportunity Act (Reg. B), Truth-in-Lending Act (Reg. Z and HOEPA), SAFE Act, Home Mortgage Disclosure Act (HMDA), Fair Credit Reporting Act, Privacy protection / Do Not Call, FTC Red Flag Rules (Fair and Accurate Credit Transactions Act of 2003) II. General mortgage knowledge (25%) A. Mortgage programs; 1. Conventional/conforming; 2. Government (FHA, VA, USDA); 3. Conventional/nonconforming (Jumbo, Alt-A, etc.); a. Statement on Subprime Lending; b. Guidance on Nontraditional Mortgage Product Risk B. Mortgage loan products; 1. Fixed; 2. Adjustable; 3. Balloon; 4. Other (home equity [fixed and line of credit], construction, reverse mortgage, interest-only) C. Terms used in the operation of the mortgage market; 1. Loan terms, 2. Disclosure terms, 3. Financial terms, 4. General terms III. Mortgage loan origination activities (25%) 1. Application accuracy (truthfulness) and required information (e.g., 1003); a. Customer, b. Loan originator, c. Verification and documentation, A. Application information and requirements

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Chapter(s) 11 - Understanding Federal Laws (Overview) 12-14 Specifics 3. Understanding Loan Plan Specifications 2. Understanding Major Loan Types Mortgage Terminology

7 – Understanding the Application Process


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Topic(s) 2. Suitability of products and programs 3. Disclosures, a. Accuracy, b. Timing

B. Qualification: processing and underwriting; 1. Borrower analysis; a. Assets, b. Liabilities c. Income, d. Credit report, e. Qualifying ratios (e.g. housing, debt-to-income, loan-to-value), 2. Appraisals, 3. Title report; 4. Insurance: hazard, flood, and mortgage C. Specific program guidelines; 1. VA, FHA, USDA, 2. Fannie Mae, Freddie Mac, 3. Other (e.g., Mortgage insurance, HUD) D. Closing, 1. Title and title insurance, 2. Closing agent, 3. Explanation of Fees 4. Explanation of Documents, 5. Funding E. Financial calculations used in mortgage lending 1. Interest per diem, 2. Payments (principal, interest, taxes, and insurance; mortgage insurance, if applicable), 3. Down payment, 4. Loan-to-value (loanto-value, combined loan-to-value, total loan-to-value), 5. Debt-to-income Ratios, 6. Temporary and Fixed interest rate buy-down (discount points) 7. Closing costs and prepaid items 8. ARMs (eg., fully indexed rate) IV. Ethics (15%) A. RESPA, B. Gramm-Leach-Bliley Act, C. Truth-in-Lending Act, D. Equal Credit Opportunity Act, E. Appraisal, F. Fraud detection, reporting, and prevention, G. Ethical behavior, 1. Consumers, 2. Appraisers 3. Underwriters, 4. Investors, 5. Warehouse lenders, 6. Real estate licensees, 7. Closing agents, 8. Employers

Chapter(s) 2 - Understanding Major Loan Types 7 – Understanding the Loan Process; 11Understanding Federal Laws 6 – Asset Qualifying 4 – Ratios, Debts and Credit History 5 – Income 1 – Mortgage Math 7 – Application Process 3 – Loan Plan Specifications 7 – Application Process 6 – Assets and Closing Costs 7 – Application Process 1 – Mortgage Math

2 - Major Loan Types 6 – Assets/Closing 2 – Major Loan Types

11 – Federal Laws 15 – Fraud 16 – Predatory Lending; 17 – Ethics

The required knowledge outline reflects the traditional educational approach – lumping topics together – that create a challenge in teaching to a regulatory requirement. The order of this book provides a more logical approach to learning and addresses the knowledge required from a vocational training perspective so that the reader gets job skills, not just test preparation.

Introduction - Page xiv


Chapter 1 – Mortgage Math Introduction When you were in high school math class and the teacher started to explain algebra, did you say, "I don't need to know this stuff. Why would I ever use algebra?" Mortgages are financial instruments. As a result, a grasp of the basic numerical calculations is required. Many people have an aptitude for numbers and may know some of this material. We designed the first part of this chapter to be remedial for the sufferer of “math phobia.” The second half of this chapter focuses on the use of the financial calculator. We will develop an easy method for qualifying borrowers, calculating mortgage formulas, and solving for any unknown. This will minimize the need for principal and interest factor tables, reduce computer reliance and allow the individual to perform calculations interactively. Decimals and Fractions - Converting Decimals to Fractions Interest rates and points have their genesis in fractions. In the mortgage business, we talk in fractions, but write in decimals. When discussing numbers, particularly interest rates, we express them verbally in fractions, but write them in decimals, which can be confusing for the uninitiated. For instance, you might say that an interest rate of eight and one-half would carry two and one quarter points. Numerically, however, it looks like 8.5% with 2.25 points, which is exactly the same thing. Your high school math textbook would show you how to convert decimals to fractions like the following example: To achieve the decimal equivalent of a fraction, you simply divide the numerator by the factor and the result is the decimal equivalent. While fractions in the mortgage lending business, particularly in the secondary marketing aspect of the business, can go into the 32nds (1/32 = .03125), the smallest fraction commonly found is 1/8th. (1/8 = .125) As an aid to future conversions, following is the conversion table converting fractions to decimals

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Another way of thinking about fractions and decimals is by converting fractions to fractions that you understand. For instance, if you understand that 1/8 = .125, think about 1/2 as being 4/8ths - 4 times .125 is .500. Understanding the Mortgage Business The mortgage business today is the product of 70 years of evolution in process, technology and products. Despite this evolution, the roles personnel play in the process remain relatively unchanged. The loan originator, loan officer, or other advisor still is the primary interface between the customer and the company. The SAFE Act defines an originator as the individual who takes a residential mortgage loan application and offers or negotiates terms of a residential mortgage loan for compensation and gain. This is true even though there are many business models that alter the way in which the customer deals with the loan officer, if at all. The functions of the loan process – processing, underwriting, and closing – have all been affected by automation, but still exist to support the completion of the loan process. Types of Lenders/Primary Originators The way different types of mortgage businesses operate is a function of the funding mechanism – where the money to make the loan comes from and whether we subsequently sell the loan. There are four major types of lending entities, referred to as primary originators, whose businesses practices change based on how they fund loans. These include small and mid-size traditional mortgage bankers and finance companies that fund loans by borrowing money on a credit line and resell the loans to investors. Large, national mortgage bankers, generally bank owned or conglomerate subsidiaries, perform mortgage banking functions but fund loans from their own cash. Mortgage brokers, almost exclusively small, privately owned companies, sell loans prior to closing (they are “table funded” or closed by the wholesaler) to wholesale mortgage bankers or lenders (referred to as investors) on a pre-approved basis. (Brokers, by definition, do not lend money). Smaller local or community banks, savings banks and Credit Unions, originate loans from their existing customers as their only line of mortgage business, often for their own portfolio. Entity Mortgage Bankers – including banks, savings banks, credit unions

Description Traditional mortgage banking firms use funds borrowed on “warehouse” lines of credit to make loans. Secondary market investors purchase these loans as 1.) “Whole loans” – which means that the individual loan is sold, along with the right to collect and remit payments (referred to as “servicing”) or 2.) as “Mortgage backed securities” where a number of similar loans are “pooled” together. While the underlying security transfers, the mortgage banker keeps the right to collect the monthly payments (“servicing retained”).

Chapter 1 – Mortgage Math - Page 2

Features Strengths: 1.) Able to control funding process and some approval issues 2.) can also broker loans, if needed, for competitive purposes. Weaknesses: on servicing retained loans, pricing is less optimal at origination.


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Entity Correspondent lenders

Description Close loans using own funds or lines of credit with the intent of selling the entire loan, including servicing rights, to a 3rd party lender, normally referred to as an investor.

Mortgage Brokers

Mortgage brokers do not make loans. They work with other lenders – wholesale mortgage bankers and banks (sometimes referred to as “investors”) – who offer their products at “wholesale pricing”. The mortgage broker fulfills the origination and processing functions and submits individual loan requests to the wholesaler. The wholesaler, who is often a mortgage banker or bank, approves and closes the loan.

Features Strengths – able to control funding process and deliver customer service. Able to achieve best pricing by sale of servicing Strengths – able to be price competitive with small margins, able to place many different types of loans giving borrower more choices and better chance of approval. Disadvantage – no control over approval and funding. Correspondent

Process - Assemble borrower file documentation and coordinate underwriting and closing. Underwrite - Commit to make a specific loan Close/Fund - Prepare Loan Documents and Deliver Funds Servicing - Collect and disburse payments for principal, interest, taxes and insurance

Mortgage Banker

Originate - Meet with customer, describe and negotiate terms, receive application and supervise application process

Mortgage Broker

Services Performed by Business Type

x

x

x

x

x

x

x x x

x x

Retail Lending In retail lending, the lender approves, closes and funds the loan, in addition to the functions that a mortgage broker conducts – taking the application, collecting borrower documentation, preparing the file for underwriting (referred to as processing). The advantage for a borrower in working with a direct retail lender is that the lender controls the entire process, so control of issues with service delivery, problems with contingencies, and pricing, rests in the hands of the lender. One potential disadvantage of working with a direct retail lender is that some lenders only offer the loan products offered by the Mortgage Company, bank, or credit union. However, many direct lenders do make selected specialty products available to meet their customer’s needs on a brokered basis. Retaining “servicing: (collecting payments from borrowers and forwarding the interest to the investor) rights is a long-term income source fundamental to the business plan of mortgage bankers. Reading the Rate Sheet Decimals and fractions are part of everyday life in the mortgage business. We express the most pivotal numbers in this way – our interest rates. Inter office or among clients, lenders most frequently communicate rates via a rate sheet or rate bulletin. This is the way we discuss mortgage pricing on an everyday basis.

Chapter 1 – Mortgage Math - Page 3


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Points One point is one percent (1%) of the loan amount. Points can be discount points, origination fees, origination charges and broker fees. Regulation of originator compensation and the changes to disclosure rules affect the way in which we disclose pricing, but the underlying mechanism of pricing remains the same regardless of the circumstance. While we give “points” many names, they represent fees that incorporate the costs of the originating and selling the loan.

Example 1 - "Par" Price Interest Rate Discount Cost (Price) Plus origination Fee Quote to Customer

4.5% 0.00 (100.00%) +1.00% 0.00 + 1.00

Example 2 - Above Par (Rebate) Price Interest Rate Discount Cost (Price) Plus origination Fee Quote to Customer

4.75% -1.00 (101.00%) +1% 0.00 + 0.00

Charging discount points enables the lender to offer a lower interest rate on a mortgage. For lenders, we generally disclose points to the genExample 3 - Below Par (Discount) Price eral public first as origination charges and then as discount points. Brokers charge an origination Interest Rate 4.00% charge or collect the difference between the Discount Cost (Price) 2.00 (98.00%) wholesale cost of the loan and their set margin. Plus origination Fee +1% However, to the consumer, points are points. A Quote to Customer 2.00 + 1.00 Table 1 Various pricing options reflecting origination borrower may choose a price option with or withcost out costs. As a lender, the number of points quoted to the customer represents the price, and any markup required to cover the cost of originating the loan. In the examples shown here, we use a one-point origination fee as the charge the lender is adding to the loan cost as the fee for taking the loan application or originating the loan. This is a simplified example of pricing. We give it as an illustration of the concept of the origination fee. Generally, the lender provides a range of pricing available at various discount fee charges. The concept of a discount fee is exactly what it sounds like - you pay a fee up front to discount the rate over time. It does not make any difference to the lender which price the customer selects. It is important to understand how we communicate these numbers. You will generally see two formats on pricing sheets, with hybrids of each depending on the preference of the lender; the "Fee/Rebate" format and the "Purchase Price" format. The "Fee/Rebate" Format This format identifies the cost, in points, required for certain rates. This is the way lenders distribute retail rate sheets real estate agents. An example: In this example, the lender is simply showing that they will charge 2 percent of the loan amount (or 2 points) for a mort- Table 2 - Fee/Rebate Format gage with a rate of 7.75%. At the same time they will pay (or rebate) 2 percent of the loan amount (or 2 points) for a mortgage with a rate of 8.75%.

Chapter 1 – Mortgage Math - Page 4


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

The "Purchase Price" Format You will more likely see this format among inter- or intralender communications, like a corporate mortgage bank communicating to its branch or a wholesaler. The idea is that the lender will purchase a loan at a certain percentage of its face value, thereby determining the price. A lender will purchase a specific loan at a certain percentage of its face amount. The difference between the face amount of the loan and the price determines how many discount points to charge to make the price whole. For example, a $100,000 loan at 7.75% in the Table 2 sells at 98% of its face value, requiring 2 discount points.

Table 3 - The Purchase Price Format

100,000 x 98% 98,000 = Amount Funded/Purchase Price -100,000 = Actual Loan Amount 2,000 = Discount Cost, or 2% Figure 1 Calculating Discount Cost from Purchase Price Format

You will notice that the pricing in Table 2 and Table 3 are the same under both formats. We just communicate them differently. Common Wholesale Pricing Formats

Interest Rate

Pricing Shown in Fee/Rebate Format

Pricing in Purchase Price Format

"Mix and Match" Pricing

8.500% 8.375% 8.250% 8.125% 8.000% 7.875% 7.750%

-2.000 -1.500 -1.000 -0.500 0.000 0.500 1.000

102.000 101.500 101.000 100.500 100.000 99.500 99.000

-2.000 -1.500 -1.000 -0.500 100.000 99.500 99.000

Table 4 - Comparing Pricing Communication

The Origination Fee/Discount Points "What do I have to charge?" is the loan officer's question. Above we provided examples of pricing, as it is most likely to be distributed. We call pricing with -0- discount "par.” Pricing "below par” connotes that the rate must be discounted, while “above par” means that the lender/investor will pay a premium/or rebate money to the originator or borrower. At par (0 discount) the quote would be 0 (discount) plus 1-point. In the example of Table 4 that would mean the rate would be 8.25% plus a 1% fee , to the customer, OR 7.75 and a 3% total fee, OR 8.5% with 0 fees.

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Loan Type Each loan type has different pricing

Lock Terms Here you see the lender has offered rate lock periods of 10 days, 25 days and 40 days. Loans must close AND FUND (refinances have a 3 day rescission period) prior to the expiration of the lock period

Adjustments Add-ons, price bumps, premiums all refer to features that may affect the price of the loan.

Loan Price This lender is using the “Purchase Price” format. In this case, a 10 day lock-in at a rate of 5.875% would “cost” 1.155 points, or slightly less than -1.125. A loan officer who needed to collect 1.5 total points on a transaction would have to charge the borrower 0.345 to meet that threshold.

Table 5 - Wholesale ratesheet components showing samples of pricing.

The Mortgage Broker Business Mortgage brokers are individuals or companies that do not underwrite, approve or fund loans. Mortgage brokers contract with wholesale lenders who approve, fund and prepare closing documentation. Mortgage brokers usually work with at least several, but often hundreds of different wholesalers. This business model allows the loan officer of a mortgage broker to seek out the best rates and terms – and can pass the most competitive rate on to the borrower. In addition, the mortgage broker has the ability to seek through the hundreds of products available to find spe-

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

cialty products that help borrowers with unusual circumstances or special needs. A borrower working with a broker may find a competitive advantage if the broker passes these benefits through to the consumer. The broker will select a lender and then work with the borrower to obtain all the necessary documentation to consummate the loan – referred to as processing. Since the broker doesn’t actually approve loans, prepare closing documentation, or provide funding, a potential disadvantage facing a borrower is that the wholesaler’s service may not be as responsive as a direct lender’s. Since the broker is the intermediary between the wholesale lender and the public, the public may never learn the identity of the final lender until closing. Since the wholesaler is insulated from the public in this way, the borrower has no recourse for service with that wholesaler. In addition, until the loan is funded, the wholesaler may continue to add loan contingencies creating delays.

Table 6 - Adding 1.5% in costs

Brokers earn money by adding fees to the wholesale cost of loans. The net cost to a borrower would be competitive with the price of a retail lender, depending on the margin that the broker is trying to achieve. Originator Compensation and its Impact on Pricing These pricing examples are shown to illustrate the net effect of how to help a customer understand how pricing is determined. There are a range of rate and point options when considering the concept of “Above Par Pricing” or “Borrower Paid” points. Depending on whether you work for a lender or a broker, and what your compensation arrangements are, the individual loan originator may not have all of these pricing options for all loan types. Please see the Loan Originator Compensation lesson of the Understanding Federal Law section for an explanation of how pricing is affected by Originator Compensation Rules. What is a BP? A basis point (BP) is 1/100th of a point. Normally this description is used when discussing yields or rates in the secondary market, because this is the smallest common interest rate denomination. However, the term is often applied colloquially. It sounds so much more professional to say, for example, “275 basis points” or “275 “bips” instead of “two and three-quarters percent” - even though it means the same thing. Understanding Interest Rate Lock-in Terms

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

While the actual price format may change between the “Fee/Rebate” format and the “Purchase Price” format, the basic cost of the loan remains the same. What does change the pricing of the loan is the length of time that the loan is “locked-in.” Lenders provide a guaranteed rate for a certain period of time which is known as a “lock-in.” Borrowers have the option of guaranteeing their interest rate by reserving an interest rate, or “locking-in,” or they may defer the decision to reserve an interest rate, which is referred to as “floating” or “floating at market.”

Expired Lock-in Rule Market Rate OR Original Lock-in Whichever is HIGHER Because interest rates change from moment to moment (most lenders price on a daily basis with intra-day price changes dues to substantial fluctuations in the market), the longer that an interest rate is guaranteed, the more risk of unfavorable rate change a lender is exposed to. As a result, locking in for 15 days costs less than locking in for 60 days. When the borrower’s lock in expires, standard industry practice is to give the borrower the market interest rate or the original lock-in rate, WHICHEVER IS HIGHER. This is an extremely important concept for loan officers and borrowers to understand. The loan officer must choose a lock period that meets the borrower’s need for closing time frame. A lock-in that is valid for 30 days does not help a borrower who is closing in 60 days. Reading the Pricing Sheet Regulators and state licensing authorities report that the largest percentage of complaints about mortgage lenders derive from the issue of rate disputes between borrowers and lenders. These complaints happen most frequently when interest rates rise and borrowers are unable to meet their expected closing date. The lock-in the borrower originally received is no longer valid, and he or she believes that the lender should honor the original lock-in. Technically, the lender is under no obligation to honor the original lock-in if the expiration occurred due to situations beyond the lender’s control. However, most regulators also believe that the lender has a professional responsibility to anticipate delays based on a borrower’s circumstances. If it is obvious that the lender delayed the closing in order to avoid funding a loan when market conditions deteriorate, the state regulator often will force the lender to honor the original lock-in terms. When this is the case, the loan officer can easily see how important it is to provide the borrower with a lock period that is appropriate for their needs. Principal and Interest or Interest Only - Amortization

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Figure 2 - Illustration of Amortization - As principal balance decreases, amortization speed increases.

When someone talks about a loan term being 30 years or 15 years, and how that affects the monthly principal and interest payment, they are referring to the fact that the loan payments leave the loan balance at -0- at the last scheduled payment. When we devote a scheduled payment partially to principal on a fixed term loan, the intent is to reduce the balance to zero steadily. We refer to this process as amortization. It works on the concept that on a mortgage, interest accrues on the balance outstanding. At the end of a period, the interest is due. We apply an additional amount to the balance. Because the payment reduces the loan balance, each subsequent payment splits less to interest because the remaining principal is slightly smaller. The process accelerates through the life of the loan so that the last payment consists almost entirely of principal. Solving for X - Mortgage Math and the Financial Calculator Keystrokes to Compute Payment 1.) Enter Present Value (Loan Amount) 2.) Enter Interest Rate (per period) 3.) Enter Loan Term (number of years) 4.) Compute Payment (principal & interest)

Learning to use a financial calculator will save you hours of time and will increase the accuracy of your calculations. As an additional benefit, you can substitute each component of an equation with another component to modify the result. Because subsequent entries change the initial result, you can "fine-tune" results to solve for subsequent unknowns. However, the first step is always learning how to compute Principal and Interest Payments (P&I).

Once you have learned to use the financial calculator to calculate monthly payments for principal and interest, you know the keystrokes required to manually calculate an amortization schedule, solve for a maximum loan amount, interest rate, or payment - you can even determine APR. The benefit of a calculator is that it allows you to adjust formulas with information you have already

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

entered, without having to start from scratch. Particularly in qualifying, we call this process “solving for the unknown” - an algebraic equation called solving for "x.”

Algebra uses the process of isolating unknown quantities within an equation by substituting known numbers. This is also known as “solving for x”, an algebraic process by which the known quantities are moved to the left of the equals sign to solve for the unknown “x.” To solve for x, you need to make a complete formula, or move x to the other side of the equal sign. This is exactly the process utilized for qualification calculations: taking the information that you know and trying to find acceptable solutions. The financial calculator allows you to plug in what you do not know and insert what you do know - in effect, solve for x. As pointed out above, there are four components of the qualification equation, and we use each one to solve for any variable. The samples in the following pages describe the financial calculations most commonly needed to compute basic mortgage equations. Think of each of the entry keys on the financial calculator as one of the variables of the pre-qualification equation. In any scenario where you are trying to achieve an answer, you know some of the variables. In some cases, you will need a range of results and can generate those results by modifying one element of the equation.

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Choosing a Financial Calculator

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On a financial calculator, each of the components of the qualification formula relates to one of the input numbers. Substitute numbers for the loan amount, the number of payments, the interest rate and payments are the components that to generate each answer. As you learn how to make these keystrokes, practice with the numbers seeing how the changes affect the outcome. There are only a few calculations you use daily. With experience and practice, you will manipulate the results to provide customers with the information they need to make an informed decision. “What is the Payment?” A customer wants to know what the monthly payment for a $100,000 mortgage is. Enter the known information and solve for the unknown payment. This is one way of avoiding giving mortgage interest rate quotes by giving an array of payments for different rates. Or try a different loan term to determine the monthly payment. See what the difference is with a slightly larger mortgage or a smaller mortgage. Enter Loan Amount Enter Interest Rate Enter Number of Payments Press Compute Record Result

$ 100,000.00 4.38% 360 (CPT) $499.29

(PV) (i%) (N) (PMT)

Table 7 - Calculating the Principal and Interest Payment

What is the Balance over Time?

Enter Loan Amount Enter Interest Rate Enter the Number of Payments Press Compute Record Result Enter remaining # of Payments Press Compute Record Result

$ 100,000.00 8.75 360 (CPT) $786.70 300 (CPT) $ 95,688.92

(PV) (i%) (N) (PMT) (N) (PV)

Amortization is the process by which you apply monthly payments first to interest then to principal to pay off the loan in a specific period. To determine the balance of the loan at any given time, repeat the payment calculation, and then enter the months remaining on the loan at the time that you wish to calculate. (In this example, we are using 5 years or 360 months - 60 months = 300 months.) Then, compute the loan amount. With a variable rate or changing payment mortgages, the term of the loan does not change, so the amortization/balance calculation stays the same. This is a way the Loan Officer can show the borrower the financial planning aspect of a mortgage. This is also a critical calculation to show the effect of prepayment.

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What is the Maximum Loan Amount I Qualify For? Using the Pre-Qualification worksheet, calculate the total monthly income, monthly debts and determine the maximum P&I payment for a sample borrower. In this example, our borrower has an annual income of $48,000/year or $4,000 per month. Assume that he has no other debts. In this case, we can record a series of results by changing one factor - the interest rate. Take this one-step further by dividing the loan amount by the approximate down payment percentage, and see what the maximum sales price is. For instance, if the borrower is looking for a 5% down payment loan, you would divide the result (120,758) by the LTV required (95%) to achieve the maximum sales price.

Monthly Income Multiply by Ratio Equals Maximum PITI Subtract Tax & Insurance Enter Result (P&I) as Payment Enter a term Enter a rate Compute Loan Amount Record Result

$ 4,000.00 28% $ 1,120.00 $ 170.00 $ 950.00 360 8.75 (CPT) $120,758

(PMT) (N) (i%) (PV)

“I Know How Much I Need to Borrow. What is the Maximum Rate?” Using the above borrower whose maximum payment is $950, imagine he needs to borrow more than what we have shown he can afford above. He wants to know what rate would qualify him for the loan he needs. In this case a rate of 6.5% would qualify the borrower for the loan requested.

Maximum Payment Loan Needed Loan Term Compute Maximum Rate Record Result

-$950.00 $ 150,000.00 360 (CPT) 6.52%

(PMT) (PV) (N) (i%)

This formula is used to determine whether a reduced payment program will help the borrower afford the loan being requested. It also helps to determine which type of payment or interest rate reduction product is suited to the customer’s needs. How Much Income is Required for a Certain House? Someone who does not want to volunteer financial information may want to know how much Chapter 1 – Mortgage Math - Page 13


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

income is required to finance a specific property. Once again, fill in the information that you know to learn the information that you don’t know. In this case assume a Property Sales price of $200,000 with a 10% Down Payment. Sales Price (200,000) x 90% x LTV Ratio and Enter as Loan Amount Enter Interest Rate Enter Loan Term Compute Payment Result Add Tax and Insurance Total Divide by Qualifying Ratio Monthly Income Required

$ 200,000.00 $ 180,000.00 8.75% 360 (CPT) $ 1,416.06 $ 250.00 $ 1,666.06 28% $ 5,950.22

(PV) (i%) (N) (PMT)

By using the financial calculator you can confirm the borrower’s income based on what they are trying to achieve. This is also the same basic calculation the loan officer would perform to prequalify a house - advise the buying public of the financing options and income requirements for a specific property. This is also known as an open house financing option spreadsheet. What is the Maximum Loan Term with a Specific Payment? We have put each of the variables of the pre-qualification computation at the end of the equation to compute the result. One of the most frequent customer requests is how many months will my loan be if I make a specific prepayment. In this example, a customer has a payment of $665.30, but he wants to make a $900 payment – how does this affect his loan term? We see that the loan term goes from 360 months (30 years) to 179.59 months (less than 15 years).

Loan Amount Rate Loan Term Compute Payment Enter Payment w/ Prepayment Compute Number of Months Record Result

$ 100,000.00 7% 360 CPT -$665.30 -$900.00 (CPT) 179.59

(PV) (I/Y) (N) (PMT) (PMT) (N)

There will be other opportunities for you to expand the scope of various calculation results manually. For instance, in Chapter 2 - Loan Types, you learn about prepayment and the value of points; in Chapter 8 - Property Types, there is an Investment Property pre-qualification model. When refinancing, you make many of these computations again under various scenarios to generate comparisons. Obviously, in Income Qualification there are many opportunities to use these

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calculations. While you may rely on computers for more detailed computations, it is important to be quick with the hand-held calculator. It will allow you to gauge a potential borrower’s financing viability easily. Understanding Ratios – Loan to Value - LTV A Ratio is simply one number as compared to another. Ratios are an objective way to express guidelines. For instance, if you were buying a home and you were putting 5% down, the Loan to Value ratio would be 0.95:1.00 (a fraction again - 95/100 converted to decimals is 0.95 or 95%) This is the Loan to Value Ratio (referred to by the acronym LTV). If there is more than one mortgage, then the 1st and 2nd Mortgage together divided by the sales price would result in the Combined Loan to Value (CLTV).

Understanding Ratios – Qualifying Ratios The other important ratio guidelines are the Housing Expense Ratio, also known as the “Front” or “Top” ratio, and the Total Debt Ratio, also known as the “Back,” “Bottom” or “DTI” (debt to income) Ratio. The Front Ratio measures the percentage of a borrower's monthly income that can be devoted to housing expense (Principal & Interest, Taxes, Insurance and HOA Fees, also known as PITI). The Back Ratio measures the total obligations; the housing expense (front ratio) PLUS all liabilities such as car payments, credit cards, student loans and any other recurring required payment.

Illustrating Change in Qualification using Different Programs Interest Rate Borrower Income Real Estate Taxes/Ins/HOA

$ $

7% 5,000 200

FNMA/ FHLMC

FHA

VA

Jumbo

ALT A Choice

Housing Expense or "Front" or Top Ratio Total Debt, Back or "DTI"

28% 36%

31% 43%

41% 41%

33% 38%

45% 50%

Maximum Housing Expense Total Debt (Including Housing) Maximum Loan Amount Maximum Debts

$1,400 $1,800 $180,369 $400

$1,550 $2,150 $202,915 $600

$2,050 $2,050 $278,069 $0

$1,650 $1,900 $217,946 $250

$2,250 $2,500 $308,131 $250

Program

Different investors have different guidelines - For example, if the housing expense ratio is 28% and a borrower makes $1,000 per month, the most the borrower can afford to pay for housing is $280 per month ($1,000 x 28% = $280). The chart shows how the amount the borrower qualifies for increases simply by increasing the qualifying ratio. The Effect of Computer Automation on Qualifying Practices With the popularity of computer based underwriting models, many companies and loan officers Chapter 1 – Mortgage Math - Page 15


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

have de-emphasized the importance of pre-qualifying a borrower in the analysis process. The loan officer simply applies the borrower’s information against the model and reports the result back. This is an unfortunate development for both the loan officer and the borrower. The qualifying process is a sales system for the loan officer. Without qualification, the borrower must actually apply for a mortgage to receive any information – and many borrowers are not ready to supply a social security number initially. The loan officer’s only other opportunity to build rapport is through personal conversations or by committing interest rates or programs for which the borrower may not be eligible. The qualifying process is educational for the borrower. Having an understanding of the basic limits of what he or she can afford – from the perspective of the percentage of income most people devote to a housing expense – can temper how much that borrower tries to borrow. For example, in the past loan officers structured programs which allowed almost any borrower to obtain a mortgage approval. This did not mean that the borrower SHOULD obtain that financing or that it is appropriate for their circumstance. Today, most loan originators must prove that the borrower can afford the mortgage for which they apply. The loan officer’s detailed analysis will allow the borrower to choose the option that best suits them. Completing the pre-qualification or qualification process is a natural lead in to the further discussion that solidifies the loan officer’s relationship with the borrower – which product is best for me? "Pre" and "Re" Qualifying - Doing the Math There is no substitute for practice in learning how to qualify a borrower. In fact, qualification calculations themselves are simple. It is not until you learn more about the business that you realize that the information you use to determine qualification is far more important than just determining the ratios. Using a Pre-Qualification Worksheet The “Qualifying Worksheet” walks you through determining the ratios for a specific transaction. In other words, what are the ratios? When pre-qualifying, instead of starting with a sales price and determining ratios, you work backwards from income, using pre-determined ratios. When "Pre-Qualifying,” you are determining how much a borrower can afford before they buy. This is perhaps the most valuable service lenders provide. Often we must re-check this information or "Re-Qualify" the borrower. Borrowers may resist being re-qualified, but this questioning process may uncover real needs or deficiencies. It is useful and critical to keep a written record of each qualification the loan officer performs. At a minimum, the qualification should address the income, debts and asset qualification of the borrower and assure that the computations are within guidelines.

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Qualifying and Pre-Qualification – Two Different Things The pre-qualification is an important step in the home buying process. This is when the borrower gets an idea of how much they can afford BEFORE they start shopping for, or contract to buy, a property. It also allows the loan officer to avoid focusing on interest rates and on what the bor-

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

rower is trying to achieve from a needs analysis perspective. When a borrower has already got the property they are trying to finance, then the loan officer must qualify them for a loan for that property - hence the “pre” means qualifying before the borrower has a property. Reverse the Ratio to Achieve the Result When you have a ratio in an equation, you normally expect to multiply it against a number to achieve the measure. You can reverse this by dividing a result by a ratio. For instance, if you know the payment is $1,000, and the ratio is 28%, you can divide the numbers to determine the monthly income ($3571 in this case). You can apply the same technique to LTV’s. Advanced Concepts - The Concept of Leverage Leverage, in the context of home finance, is utilized to maximize the potential return of an investment. Thinking of a home as an investment can assist a purchaser in rationalizing a cash investment against bank investments. A simple example: If you put $10,000 in the bank at 10% it will yield $1,000 yearly. If you purchase a $100,000 home with a $10,000 investment, and the property appreciates at a rate of 2.5%, it will yield $2,500 yearly. The leverage of financing allows a smaller amount of cash to purchase a larger investment. Even though the yield of the larger asset is lower, the leverage creates a higher overall yield. Obviously, there is a carrying cost for the leverage - or the mortgage - plus the costs associated with acquisition and sale. The downside is that values can go down. The same math with the market going down 10% will cost the borrower $7,200. Leverage works both ways. The idea of leverage in this context is that, whether you rented your residence or owned it, you would still be paying for shelter. Understanding Appreciation Dollar Amount of Investment Value of Investment Rate of Return Total Return Total Rate of Return

$ $ $

CD Mutual Fund Real Estate 10,000.00 $ 10,000.00 $ 10,000.00 10,000.00 $ 10,000.00 $ 100,000.00 3% 5% 2% 300.00 $ 500.00 $ 2,000.00 3% 5% 20%

Advanced Concepts - The Concept of Taxable Equivalency When dealing with the exchange of dollars there is always the issue of taxation and how it impacts the actual cash flow. Tax implications affect theoretical cash flows in the following situations: 1.) Determining the comparable rent payment to the mortgage payment after the mortgage interest and real estate tax deductions; 2.) Determining the increased impact for qualifying purposes of income that is not taxed. It is important to note that these calculations are prospective. Prospective income, while not actually utilized to qualify a borrower, can be a compensating factor. Increasing the amount of non-taxable income used for qualifying purposes is referred to as “grossing up”

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non-taxable income. Not every lender allows the use of “grossed-up” non-taxable income. Tax Deduction – The Mortgage Payment and Rental Equivalent Mortgage interest and real estate taxes are deductions that can be itemized on Federal 1040 tax form Schedule A. As a result, to compare a rental payment to a mortgage payment, the impact of these deductions must be factored in. This answers the question "I am paying a certain amount in rent. What does that work out to in Mortgage Dollars if I own instead?" It is the same method we use in determining the degree to which we can increase non-taxable income for qualifying purposes. Here we have illustrated that a $1,707 mortgage payment is the same, on a tax basis, as paying $1,278 in rent. There are two methods for determining rental equivalency and taxable equivalency. The first method is illustrative and makes assumptions that ignore the borrowers other tax implications. Only use this as an approximation. The idea is that home mortgage interest, real property taxes are deductible expenses, and the borrower will itemize these at tax time and realize a lower taxable income. Because this calculation does not take into consideration the borrower's actual income - except to the extent that we know their tax bracket - it is inaccurate. Method 2 – Actual Withholding Table Computation The second method examines the borrower’s monthly income tax withholding status and takes the actual tax withholding tables comparing the current situation to the withholding adjustments that would be accurate after the transaction is complete. Theoretically, a borrower could legitimately adjust withholding allowances with their employers based on this computation. This method is suggested only because there is no way of knowing precisely how much to withhold for Federal Income Taxes. It is important not to under- withhold because there are severe penalties for under- estimating taxes by more than 10%. In this example you can see how the impact on regular withholding allowances moves the borrower to a level where there is a higher take home pay because of lower monthly withholding. In these cases, we are trying to achieve an understanding of what the borrower's current situation and consider the tax consequences of the new situation. If a borrower currently rents his or her home, he or she does not receive the tax benefits of the mortgage deduction, and loses: 

The inflation hedge provided by real estate because today's dollars will be worth less than tomorrow's in an inflationary environment.

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

2. With $800/mo. in deductible interest and real estate tax, monthly tax burden decreases to 612.87 – a savings of $407.70

3. The borrower could claim higher exemptions on form W-4 and increase monthly cash flow immediately.

1. Pre-Mortgage Tax burden with 1 exemption @ Income of $5400/Mo. = 1,020.57 Figure 3 - Use tax witholding tables for the current year to determine the exact amount of the cash flow benefit of the mortgage deduction.

Any appreciation they might gain by the property value increase.

However, they also expend the costs of closing, and realize the loss of the use of the funds they apply as a down payment. We Are Not Tax Advisors These calculations are ways to help a borrower understand the tax implications of the home financing process. The mortgage interest deduction only minimally influences a person’s tax situation. Second homes and investment properties involve different criteria. What these calculations allow is a “relative basis” computation - comparative with another individual or the current situation.

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Have a Worksheet The use of a worksheet will help the new loan officer guide any of the customer conversations and keeps the calculations reviewed in this chapter on hand. Available with the purchase of The Loan Officer’s Practical Guide to Marketing. www.quick-start.net

Would you like more practice on Mortgage Math? Try the online course – The Loan Officer Boot Camp. All of these calculations and more are included as the basis for that course. www.lenderbootcamp.com

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Chapter 2 - Major Loan Types Introduction Before 1938 and the inception of the Federal Housing Administration (FHA) Mortgage Insurance program there was no fixed rate, regularly amortizing mortgage. (Amortization is the process of applying a portion of a payment towards interest and principal as well, thereby paying a loan off over its term.) Loans were generally interest only, may have had a short term - such as five years, and may have had a "call" provision - where the lender could require loan repayment on short notice at the lender's sole discretion. With the FHA Insurance program, and the subsequent Veteran’s Administration (VA) Loan Guaranty programs, long-term fixed rate, regularly amortized loans became prevalent, if not ubiquitous. With the long period of low interest rates that followed World War II, there was no reason to take a mortgage other than a 15- or 30-year fixed rate loan when buying a house. However, in late 1968, interest rates began to rise, and when fixed rate mortgages started carrying double digit interest rates, lenders and borrowers alike needed a wider variety of loan programs in order to afford housing and protect against future interest rate increases or decreases. Today we have the genesis of 60 years of mortgage evolution. There exists nearly every possible mortgage repayment plan. The programs offered often reflect the current market conditions as to interest rates, but most importantly, it is now easier than ever for the professional loan officer to interview a prospective applicant and find a loan program that specifically suits a borrower's needs. Choosing a Fixed Rate Mortgage Fixed rate mortgages are the most popular financing instruments because they combine the safety of fixed payments with an affordable amortization schedule for a given time period. The interest rate cannot change and, because of their wide availability, rates offered by various lenders are extremely comparable and competitive. Term/Amortization Fixed rate mortgages can vary by the length of time over which the payments are due. 15 YEARS: The 15-year term features a major savings over the 30 YEARS: This term maximizes the affordability of the loan in monthly life of the loan because there are 180 payments instead of 360. payments while maintaining a large The program achieves interest savings at the cost of higher proportion of the initial payments monthly payments. Because of this, the mortgage interest tax towards interest, thus enhancing the deduction benefits may quickly diminish. The rate available may “home mortgage interest deduction”. be lower, generally, than the same 30-year mortgage.

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

You can customize the loan term of many fixed/regularly-amortizing loans to the needs of the borrower. For instance, instead of a 30-year term, 25-, 20- and 10-year terms are available too. You can even make a 12-year or 27-year loan. While some lenders place restrictions on the terms offered, even though there is non-standard amortization, lenders sell these loans in the secondary market just like standard repayment plans. When pricing non-standard terms, the interest rate is usually determined by the next longest loan term. For instance, a 25-year loan has the same rate as a 30-year loan and a 10-year loan may have the same rate as a 15-year loan. Depending on market pricing, pricing that is more favorable may be available for loans with shorter terms. Interest-Only (Non-Traditional Loan Type) “Interest-Only” or “Simple Interest” refers to a repayment Determining the Interest Only schedule without amortization. Traditionally, interest only Payment financing was only available for adjustable rate loans. The $100,000 principal balance is multiplied by the annual interest rate Loan Amount and divided by the number of payments in the year. The Times Interest Rate x 7.5% $7,500 benefit of interest only financing is that the minimum pay- Annual Interest Divided by Months 12 ment is lower owing to the fact that there is no principal be- Monthly Payment $625.00 ing applied. The interest only loan may have a balloon payment at the end of the term, or may be turned into a 15or 20- year amortized loan at the end of 15 or 10 years for a total term of 30 years. Prepayment as an Interest Savings Tool

One of the most popular features of a fixed rate loan is the ability to "prepay,” or reduce the principal balance of the mortgage, without any penalty. While prepayment is generally available without penalty, the benefit of prepaying a fixed rate loan is that subsequent payments are devoted more to principal and less towards interest, paying down the loan balance prior to scheduled maturity. A prepayment strategy looks at ways of paying off a loan as quickly as possible while still keeping a proportionately small payment and reducing the maximum amount of interest costs. Effect of Monthly Prepayment on Loan Term Loan Amount Interest Rate Amortized Term Principal and Interest

$

$

100,000.00 7.50% 30 699.21

Loan Term in Loan Term In Total Payment Months After Extra Years After Extra Extra Monthly Prepayment Amount with Prepayment Payment Payment $0 $20 $50 $75 $100 $150 $200

$ $ $ $ $ $ $

Chapter 2 – Loan Types - Page 24

699.21 719.21 769.21 844.21 944.21 1,094.21 1,294.21

360 326 269 216 174 136 106

30.00 27.19 22.39 18.03 14.51 11.33 8.82

Total of Payments as Scheduled $ $ $ $ $ $ $

251,717.22 234,628.57 206,677.98 182,696.81 164,350.06 148,703.80 137,003.18

Interest Savings $ $ 17,088.66 $ 45,039.24 $ 69,020.41 $ 87,367.16 $ 103,013.42 $ 114,714.05


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Other Prepayment Strategies - The Bi-Weekly Mortgage Monthly prepayment is not the only strategy to achieve interest savings. The same effect can be achieved by making an "extra" mortgage payment each year. This reduces the loan term between 5 years and 15 years, depending on interest rates. This concept - making an extra payment every year - forms the basis of the bi-weekly mortgage. Making a payment every two weeks is tantamount to making an extra mortgage payment every year because there are 26 bi-weekly periods in a year (13 months). The Bi-Weekly Mortgage is a fixed rate or adjustable rate loan with a payment plan that allows borrowers to make a payment every two weeks instead of once a month. This theoretically helps people who are paid every two weeks manage their cash flow. However, it may be more practical to utilize an independent prepayment strategy as opposed to taking out a bi-weekly mortgage because: 1.) There is a greater potential for the incidence of late payments (twice as many payments); and 2.) The rates for the bi-weekly loan are not as competitive as those for standard monthly plans.

Bi-Weekly Mortgage Comparison Loan Amount Interest Rate Loan Term

$

Monthly Payment $ Bi-Weekly Payment $

200,000 7.50% 30

1,398.43 699.21

Results in Annual Prepayment of Effective Monthly Payment

Other "Fixed Rate" Mortgages

Number of Payments year

Total Payments

12 26

$ 16,781.15 $ 18,179.58 $ $

Loan Effective Term in Loan Term Months in Years 360 279.839

30 23.31991

1,398.43 1,514.96

Conditional Refinance Provisions 1. Must live in property (owner-occupied) 2. No second mortgages/liens 3. Must be current/no late payments in past 12 months 4. Rate cannot be more than 5% over note 5. Pay fees/sign documents

A fixed rate loan is pretty simple to understand. What you see is what you get. But there are many borrowers whose needs are not met by a fixed rate loan. It is for these customers that there may be a creative "hybrid" fixed rate loan that provides a solution. Under the SAFE Act any loan that is not a 30 Year Fixed Rate mortgage is considered be a non-traditional loan. Balloon Mortgages The term “balloon” illustrates the feature of this loan plan. The payments are fixed for a certain period, and then there is one large payment - a "balloon" in the payment schedule. This feature may also be referred to as a "call,” a "demand" or a "bullet.” The loan is generally based on a long amortization term such as 30 years, with a balloon in 5, 7, 10 or even 15 years. There may be a feature for converting the loan to a fixed rate loan after the balloon. This is referred to as a conditional refinance. It is important for customers to understand that a balloon is not an ARM Chapter 2 – Loan Types - Page 25


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Keystrokes to Compute Balance of Balloon Payment Enter Loan Amount Enter Interest Rate Enter Amortization Term Compute Payment Enter # months remaining at Balloon Date Compute Loan Balance

$

100,000.00 7.75% 360 CPT 300 CPT

PV %int N PMT N PV

that a conditional offer to refinance at maturity does not guarantee financing. This feature is the same as provisions contained in ARMs with a “conversion option” – the ability to convert to a fixed rate. The Two-Step ARM Like a balloon this loan offers a fixed period at a rate that is lower than that of prevailing 30-year loans. However, there is no balloon feature. There is a single rate adjustment at the end of the term, which is what makes this an ARM. The terms of the adjustment may vary, but are generally 2.5% (margin) over the then prevailing 10-year Treasury Bill averaged to a constant maturity (index) with a maximum change of 6% (cap). The Balloon and the Two Step ARM may seem similar, but the Two Step is a 30-year loan while the Balloon only exists until the call date. There is no consumer protection on the Balloon, so the lender is not exposed to future interest rate changes as with the ARM. As a result the Balloon may offer much lower interest rates than the ARM. It is important that borrowers understand the reason for the distinction in price between the two. Buydowns - The Low Down on Interest Rate Reduction A Buydown is not really a loan program. In fact, the underlying mortgage can be any fixed rate or adjustable rate program. A Buydown is exactly what it sounds like - paying fees (or buying) to reduce (down) the payments on a mortgage. The beauty is that there is no fixed or required temporary Buydown arrangement - each one is a work of art and subject to the needs of the transaction. A Buydown may permanently or temporarily reduce the payments on a mortgage. A permanent Buydown is also known as a rate discount - paying discount points to permanently reduce the rate of the mortgage. For example, a lender may offer a rate of 10.5 % with no points, or 9.75 with 3 points. 9.75% in this example is a "discounted" rate. This is quite different from a temporary Buydown. Permanent Buydowns can be achieved by viewing a rate sheet and seeing how low the permanent rate will be by paying discount points. "Points,” then, become closing costs, which are covered in a later chapter. Temporary Buydowns A temporary Buydown is created when funds are placed in escrow - outside the control of the borrower or then lender - to offset the monthly payment required by the terms of the note. The funds in escrow reduce the effective payment rate but not the note rate. To illustrate this, take an Chapter 2 – Loan Types - Page 26


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

example where a typical 30-Year Fixed Rate mortgage at 10% interest can carry an effective payment of 8% in the first year, 9% in the second year and revert to the note rate in the third year.

Buydown Cost Calculator Use this worksheet to determine the actual buydown cost. Loan Amount $ 300,000 Loan Term Note Rate 7.25% Loan Type

Payment Rate Reduction 2.000% 1.000% 0.000%

Payment Rate

Buydown Payment

5.250% $ 6.250% $ 7.250% $

# Mos

1,656.61 1,847.15 2,046.53

30 Years 30 Year Fixed

Note Payment 12 $ 12 336

2,046.53 $2,046.53 $2,046.53

Monthly Annual Cost Cost $ 389.92 $ 199.38 $ -

$ 4,679.01 $ 2,392.53

Total Cost $ 7,071.54 Point Cost 2.357%

The Buydown cost may be borne by a seller or a borrower. In some cases the Buydown funds may be paid by the lender in what is known as a "lender subsidized" Buydown where the note rate of the loan is increased to reduce the up front cost of the subsidy. This is a "reverse" discount. The example above might be 8.5-9.5-10.5 % with one point and no Buydown cost. You can "tailor" a program to meet very specific needs, but the concept remains the same. There are as many variations of a Buydown as you can create in your imagination. These are not limited to buydowns on fixed rate mortgages either - you may, depending on guidelines, elect to utilize a permanent Buydown on an Adjustable Rate Mortgage. Get creative!! Mix and match the concept and even try a Buydown on an ARM. Some variations include: “1.50-.50 Buydown”: Reduces the payment in increments of less than 1% per year. The objective is to achieve a specific qualifying rate without increasing the Buydown cost any more than necessary. (Not every lender allows qualification at the lowest rate.) “Compressed Buydown”: Changes payments every 6 months instead of every year. The classic example is a 3-2-1 Buydown where the buyer qualifies at the second year rate, but also has the benefits of lower payments. “1-1-1 Buydown”: The payments are reduced a smaller amount for a longer time period. Full Principal and Interest Subsidy/Buydown is also known as the "Live Free" Buydown. The effect is to completely reduce the principal and interest payment in total for as long as the subsidy account will allow. With a Live Free Buydown, the borrower makes only the Tax and Insurance portion of the monthly payment. This is used to advertise those “move in and make no payments for 6 months,” new home builder specials. Primary Reason for Buydowns – Qualify for More The primary reason for utilizing a Buydown is to qualify for a larger loan. Obviously, if your monthly payment is lower, you can afford a larger mortgage as the example illustrates. Chapter 2 – Loan Types - Page 27


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

The temporary Buydown can also offer a psychological benefit by allowing a borrower to ease into a higher housing expense. If a borrower is accustomed to paying $1,000 a month, but wants to purchase a more expensive home, a larger mortgage is required and the monthly payment will be higher. A Temporary Buydown can offset the difference between the desired payment and the required payment. In fact, the Buydown can be customized to meet the exact payment requirement of the borrower. A popular application of the Temporary Buydown utilized frequently among the homebuilding community is to advertise dramatic temporary interest rate buydowns as an enticement to purchase a new home. If interest rates are in the 10% range, a Buydown can allow you to offer a fixed rate mortgage as low as 7%. Alternately, a full principal and interest Buydown can mean that the builder can advertise "no payments for six months.” It is important to remember that the subsidy rate is not the real interest rate of the mortgage. The Qualify for a Larger Loan Using a Temporary Buydown Monthly Income Housing Expense Ratio Housing Payment

$

Interest Rate Mortgage Amount

9.00% $139,196

$

4,000 28% 1,120

Borrow how much more? Percentage Increase

8.00% $152,638

7.00% $168,344 $29,149 21%

money for the reduction in interest rate has to come from somewhere and can increase the cost of a transaction dramatically. So temporary buydowns should only be used when deemed necessary, as there are no real interest rate savings involved. Another facet that should always be considered is that temporary Buydown funds, once committed to the Buydown escrow account, are not refundable - even if the loan is paid off early. Using Discount Points to Create Beneficial Programs If a Temporary Buydown achieves a short-term payment reduction, a “Permanent Buydown” can be achieved by “discounting” the interest rate – or paying points. All loan types offer a range of rate and point options. The ability to compare the short term and long-term costs are an important component of helping the borrower select an appropriate loan type. Often, the first question a prospective borrower asks when they begin shopping for a mortgage is how many "points" they must pay. A point is 1% of the mortgage amount. For example, a lender offers a rate of 6.75% with 3 points or 7.5% with 0 points. Which scenario is better for the borrower? The answer lies in the borrower's motivation - how long will you be in the property? The loan officer must perform the “Breaking Even on the Point InBreaking Even on the Point Investment vestment” calculation. Loan Amount Interest Rate Points Point Cost

Chapter 2 – Loan Types - Page 28

$ 100,000.00 7.50% 6.75% 0.00% 3.00% $ $ 3,000.00 $ 3,000.00

Payments $ 699.21 $ 648.60 Cost Divided by Savings equals number of months to break even

$

50.62 59.27


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

In this example, a borrower would invest $3,000 in points to save $50.62 per month, showing that it would be 59.27 months before the cash investment at closing would begin to be worthwhile. This means that if the loan were in effect for less than 5 years the borrower would lose money. Measuring Annual Percentage Rate (APR), or loan fees, against monthly payments, determines the actual cost of your credit. The following example shows the APR of loans with points and Computing the effect of Point on APR based on Time Loan with 3 Points Aggregate Point Cost Cost

Loan With No Points Aggregate Point APR Cost Cost

APR

Rate

$ 236,495.31

7.050%

7.5

$

-

7.500%

$ 251,715.60

$ 3,000.00

$ 197,579.43

7.086%

7.5

$

-

7.500%

$ 209,763.00

6.75

$ 3,000.00

$ 158,663.54

7.143%

7.5

$

-

7.500%

$ 167,810.40

180

6.75

$ 3,000.00

$ 119,747.66

7.240%

7.5

$

-

7.500%

$ 125,857.80

120

6.75

$ 3,000.00

$

80,831.77

7.437%

7.5

$

-

7.500%

$

83,905.20

60

6.75

$ 3,000.00

$

41,915.89

8.033%

7.5

$

-

7.500%

$

41,952.60

36

6.75

$ 3,000.00

$

26,349.53

8.816%

7.5

$

-

7.500%

$

25,171.56

24

6.75

$ 3,000.00

$

18,566.35

9.774%

7.5

$

-

7.500%

$

16,781.04

12

6.75

$ 3,000.00

$

10,783.18

12.503%

7.5

$

-

7.500%

$

8,390.52

6

6.75

$ 3,000.00

$

6,891.59

17.387%

7.5

$

-

7.500%

$

4,195.26

Term

Rate

360

6.75

$ 3,000.00

300

6.75

240

without. Consider, though, that this also impacts on a prepayment strategy. If a borrower buys a new home without selling a previous home there is the potential for a large gain in the future. When that home is sold and the proceeds are used to prepay the new mortgage, this can impact the value of having paid points. Those points are suddenly inflated in relation to a paid down mortgage. ADJUSTABLE RATE MORTGAGES (Non-Traditional Loan Types) Understanding a fixed rate loan is easy, even when adding features such as Buydowns and other variations. Adjustable rate mortgages can create confusion for new originators and the public alike. It makes it easier to understand Adjustable Rate Mortgages (ARMs) if we can approach them with the knowledge that fixed rates loans are different from ARMs in that an ARM interest rate CAN change - ARMs are different from EACH OTHER in HOW the interest rate can change. A frequent characterization of ARMs paints them as very risky financing alternatives. In the past ARMs have been associated with increased foreclosure rates when interest rates rise, often add-

Chapter 2 – Loan Types - Page 29


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

ing to calamity when housing markets adjust downwards. This was the case in the early 70’s, the late 80’s and again during the credit crisis beginning in 2007. The risk starts as an unfortunate by-product of combining an uneducated loan officer and an uneducated borrower. When a loan originator takes the time to explain a complex loan program, he or she actually builds further rapport and trust with a customer. A customer can make a choice that may significantly improve his or her financing costs. The lender also benefits from adjustable rate mortgages because the institution can share the risk of changing interest rates with the borrower. An adjustable rate loan allows lenders to offer a rate below the current fixed rate mortgage market. Future interest rate risk (up OR down) is shared with the borrowers. One pitfall is “Payment Shock,” where borrowers are not aware of how much the interest rate changes and suddenly face unaffordable payments. The market is aware of this risk and generally constructs products that mitigate these risks. Caps (maximums) on rate changes in lieu of payment caps, maximum life interest rates, and a number of qualification guidelines address these risks making today's ARM, in general, a more reasonable risk for an educated and suitable borrower. ARM Components - The Basic Four ARMs are different from fixed rates in that the interest rate changes. How the interest rate can change is how ARMs differ from each other. There are four major components - frequency of changes, Index, Margin, and Caps. Frequency of Changes The most important question from a borrower’s perspective is “how soon before I am subjected to interest rate changes and how often can the rate change?” The frequency of rate change usually is what we call the program. For instance, we call a 1-Year ARM with annual rate changes (not surprisingly) a 1-Year ARM. However, when the program fixes the rate 3 years, then turning into a 1-year ARM, we know these as a 3/1 ARM. It would take a long time to catalog each type of ARM ever devised. A Federal Home Loan Mortgage Corporation (FHLMC) negotiated commitment representative once said that FHLMC had purchased over 10,000 different types of ARMs from institutions throughout the country. In fact, matching terms to a customer’s desires and needs represents the pre-eminent feature of ARMs. 1 Year ARMs are available with initial fixed periods of up to 10 years. At the other end of the spectrum is the monthly ARM, the most commonly known variety of these are the “pay Option” ARMs. Home Equity Lines of Credit and credit cards are also monthly adjustable rate loans. The greater the frequency of adjustments, the greater the risk associated with an ARM. An unfortunate phenomenon is that as one moves out longer along the maturity curve (the longer the loan is fixed), the higher the initial rate. The Comparative Rates and

Chapter 2 – Loan Types - Page 30

Shorter term rates are lower


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Maturities follow the yield curve that measures the market’s perception of future interest rate risk. There is also a diminishing return for accepting an intermediate term fixed period as compared to a fixed rate or longer term ARM. Longer-term rates are higher such as very low The shorter the adjustment term, the lower the initial rate (unless other factors caps or margins apply). Because ARMs with longer adjustment periods begin to replicate fixed rate products in terms of the lender’s risk, the initial "teaser" rate factor begins to diminish.

Use the frequency of rate changes to tailor the repayment plan to the borrower’s risk tolerance, the length of time that the loan will be in place and the borrower’s view of future interest rate movements. If a borrower wishes to accept absolutely no risk, in order to accept an ARM he must have an absolute time frame in which he will be using the loan. Most customers focus on Frequency of adjustments in conjunction with the maximum rate changes in deciding whether to use ARM financing. We refer to this rationalization method as the worst-case scenario analysis. The Role of the Index in the Interest Rate Change Frequencies of payment/rate adjustments dictate how often the rate can change. How the interest rate can change is a function of the index added to the margin. The index of an ARM is the basis of future interest rate changes. From the borrower's point of view the Index should: 1.) 2.)

Be regularly published in a source accessible to the public. Be beyond the lender’s control. If the index is linked to the lender's performance, or risk experience, theoretically they could increase the index whenever they needed to make more money.

As there are many adjustment periods, the indices to which we link ARM interest rate changes must provide similar terms. The characteristics of these indices can impact other features of the loan. The variables of each index are a factor in analyzing the future performance of an adjustable rate mortgage. For instance, if the index is stable, future interest rate increases may not be dramatic, but there is less likelihood that there would be an improvement in the event of future interest rate decreases. Index Name Treasury Bill Constant Maturity (TCM)

LIBOR (London Inter-Bank Offered Rate) COFI (Cost of Funds Index) – Also known as COSI (Cost of Savings) or CODI (Cost of Deposits)

Chapter 2 – Loan Types - Page 31

Description The Treasury Bills are the most common index. They have a large array of maturities (90 days, 6 mo, 1 Yr., 2 Yr., 3 Yr, 5Yr, 7Yr and 10 Years, among others). The securities themselves are traded from minute to minute, so it is a dynamic index. The Constant Maturity is a yield computation that takes the volatility out of the fact that the securities themselves are issued daily so they do not all mature on the same date. This is the rate at which different money center banks in London loan each other money. Associated with the 11th Federal Home Loan Bank Board, (California) this number is derived monthly and reflects the aggregate rate at which California Savings and Loans pay on deposits.


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Certificate of Deposits (CDs) Prime

FNMA 60-Day Mandatory Delivery

This is an index recently derived by FNMA which is the median rates paid by banks for six-month certificates of deposit. The Prime Rate published in The Wall Street Journal is the rate at which money center banks lend to their best customers. It is important to note that The Wall Street Journal publishes a compiled number. Each bank, however, can charge whatever it likes for prime. This is an index for loans that will convert to fixed-rate loans for the remaining term at a future date, such as Balloons or Convertible ARMs. It is based upon FNMA's actual required net yield for 30-Year fixed rate mortgages that must be delivered within 60 days.

The Margin – The Spread Over Market The lender sets the margin. It represents the amount above the index that the interest rate can adjust at the time of adjustment. The result of the index plus margin formula is the new “real” interest rate.

The ARM with the Lowest Margin Offers the Lowest Cost Initial Rate Index Margin New Rate

Loan 1 5.5 4.875 2.5 7.375

Loan 2 5.5 4.875 3.75 8.625

This is the "real" or "true" interest rate of the ARM. It is important to consider this real cost because most ARMs - particularly short term ARMs - are "discounted.” A discounted rate indicates that the points paid in Figure 4 - Comparing Margins to Determine Lowest conjunction with the loan artificially reduce the initial Cost interest rate to attract borrowers. We refer to the result of the Index plus Margin Equation as the Fully Indexed Accrual Rate (FIAR). Each loan may offer a different Margin. This is a critical part of analyzing the ARM. In Figure 2, all things are equal except the margin. The Margin is higher on loan 2, which means that the FIAR (or the true rate of the loan) is higher on the second loan. This means that, regardless of what happens with interest rates, the customer who chooses loan 2 will pay a higher interest rate over the life of the loan. This is true of any ARM. Note that an ARM’s APR will continuously change in the future. However, we always base the payment schedule provided to the borrower on the current FIAR – NOT the worst-case scenario although the payment schedule does take rate caps into consideration. Interest Rate Caps & Payment Caps – Limiting the Change

The above example shows the actual mechanics of how ARM rates can change. This illustrates how, if indices rise as they did in the late 70's and early 80's, people could experience huge in-

Chapter 2 – Loan Types - Page 32


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

creases in their monthly payments. As a borrower contemplates accepting a loan program that entails interest rate changes as opposed to a fixed rate, they focus on risk - "What is the worst case?" Obviously, if interest rates could change unimpeded, there would be great risk to the borrower. In order to make ARMs more appealing to borrowers, and to provide some consumer protection, most of today's ARMs offer maximums, or "caps,” on the amount that rates can change. Rate Adjustment Caps: Life of Loan Caps:

This is the maximum - up or down - that the interest can change per period above the previous period. The maximum that the interest rate can change over the initial rate over the life of the loan.

The caps modify the ARM interest rate change formula The Adjustment Cap Limits the Rate from Index plus Margin to Index plus Margin or Rate Change Per Adjustment Plus Cap, WHICHEVER RESULTS IN A Loan 1 Loan 2 SMALLER CHANGE. This facet of the ARM changInitial Rate 5.5 5.5 es the analysis process. Instead of comparing only the Margin 2.75 3.25 fully indexed rate, the borrower now must compare the Index 5.375 5.375 Year 2 Rate 7.5 7.5 impact of caps too. The caps are most frequently utiYear 3 Rate 8.125 8.625 lized in an unsophisticated analysis referred to as the "worst case scenario.” The Worst Case Scenario basically assumes that the worst possible event will occur and then send the ARM rate through the ceiling. This only examines the caps, allowing the borrower to examine the absolute risk. Initial Adjustment Cap Particularly in programs where the initial interest rate is set for a longer period of time, the transitional cap - when the first rate change occurs - may be different from the caps addressed as the loan adjusts annually thereafter. The initial caps may allow the rate to increase to the lifetime caps immediately, and this may become the basis for subsequent adjustments. Investigate the intermediate cap feature and its impact on the worst-case scenario. Payment Caps A payment cap feature affects not the interest rate, but the rate at which the borrower must make payments. The inimical aspect of payment capped ARMs is that interest rates may increase dramatically and almost immediately from the initial offered rate. The borrower may not be aware that, while the required payment has not changed or can only change a certain amount, the payment may not be sufficient to pay all of the interest (or even principal) due. When this occurs, we refer to this as “negative amortization”. Negative amortization means that the lender adds the shortfall in monthly payments to the principal balance of the loan. Most loan programs (with the exception of GEMs, GPMs and interest only loans) are positive amortizing, meaning that the portion of the balance is retired with each payment. Negative amortization is the reverse - instead of paying the loan down, the balance increases. An additional risk is that, when limiting his payments to the minimum in a rising rate environ-

Chapter 2 – Loan Types - Page 33


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

ment, the borrower must redraw the loan documents when the original balance exceeds 120% of the original balance. This is unlike the GEM or GPM where the borrower knows there is the potential for negative amortization and the loan payments are scheduled to increase enough to create positive amortization. The cycle can then start again, and be recast until the loan matures. Some positive features of this loan are that the borrower may have up to 3 options making payments that will: 1.) Positively amortize the loan, 2.) Cover only the interest due, or 3.) Meet the minimum required payment. The borrower can maintain some control over personal cash flow as well as mitigating interest rate shock. However, before choosing such a loan, all components must be analyzed and compared. The “Option” ARM – The Ultimate Non-Traditional Loan We have all seen the rate sheets and advertisements shouting about great low rate Adjustable Rate Mortgages, but when the numbers start to seem too good to be true, a closer look at the loan program is warranted. In theory, there is nothing wrong with a “teaser” rate. A borrower may be able to use the low introductory rate for specific benefit. For instance, using the period when the interest rate is low to pay additional amounts towards the loan principal is a time tested strategy, particularly when the borrower also is able to identify a finite period of time that the loan will be in place. The difficulty is that many Loan Officers do not understand the basic functions of an ARM, and so are not very good at explaining loan mechanics to borrowers. As a consequence any borrowers enter into loan contracts they do not understand. As an example, a loan officer offering a 1 Year ARM helps the borrower understand that the interest rate will change every year. The borrower then hears of an incredible 1% 1 Year ARM. Because the public has been taught that lower interest rates are better, the borrower is compelled to request the low rate product. How different could the terms be?

Balances on Amortized, Interest Only and Payment Capped ARMs 105000

104000

103000

102000

Loan Balance

In this case, the terms are quite different. A 1 Year ARM offers an interest rate that is fixed for one year. The 1% 1 Year ARM offers PAYMENTS that are fixed at the 1% level, but that do not reflect that the underlying interest rate is changing. The introductory rate and subsequent payment rate changes are based on the payment rate NOT THE INTEREST RATE. The deficit between the payment rate and the actual interest rate carrying cost on the

101000

100000

99000

98000 Option 1 Balance

97000

Option 2 Balance Option 3 Balance

96000

95000 1

2

3

4

5

6

7

Months

Chapter 2 – Loan Types - Page 34

8

9

10

11

12


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

loan can result in principal being added back to the loan – a process known as negative amortization. Payment Caps = Negative Amortization In the illustration shown here, the borrower’s loan balance increases far more dramatically with deferred interest than it decreases with amortization. This is because negative amortization is compounded interest – interest on interest. While this isn’t horrific in itself, this illustration only shows what happens when interest rates increase moderately – at the rate of 1% per year. In today’s rising short term interest rate environment, rates are likely to rise much more rapidly, adding more to the loan balance. Is This a Bad Option for Borrowers? There are many loan officers who advocate the use of the teaser rate ARM to bridge a particular situation:    

An investor purchasing a property to sell in a short period of time (flip) A borrower who is purchasing a home and who has to make two mortgage payments (old home and new home) for a defined period of time A borrower who believes their home will appreciate faster than the loan balance accrues and so borrows from appreciation to offset deferred interest A borrower who is using the option ARM as a modified version of a reverse equity loan

These are all rational justifications for accepting this type of loan. A sophisticated borrower will appreciate that he or she has multiple options – amortized, interest only, or deferred interest - for making payments. They will be aware and capable of handling the consequences of each choice. An uneducated borrower may choose this product for the visceral appeal of that very low payment. This type of loan doesn’t suit that borrower, as the pace of negative amortization will soon sweep the equity away from the property, even at a high rate of appreciation. A senior citizen should never choose this option. Consider a reverse mortgage instead.

Chapter 2 – Loan Types - Page 35


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Comparison of Payments and Loan Balances for Option Arms Rate Formula

Initial Loan Term Intro Rate

Index Margin New Rate Option 1 Fully Amortized Option 1 Balance Option 2 Interest Only Option 2 Balance Option 3 Payment Rate Option 3 Balance

1 3.97 2.75 6.72 $ 646.61 $ 99,913.39 $ 560.00 $ 100,000.00 $ 357.24 $ 100,202.76

100000 360 1.750% 2 4.12 2.75 6.87 $ 657.13 $ 99,828.26 $ 572.50 $ 100,000.00 $ 357.24 $ 100,419.17

Index Margin New Rate Option 1 Fully Amortized Option 1 Balance Option 2 Interest Only Option 2 Balance Option 3 Payment Rate Option 3 Balance

13 5.35 2.75 8.1 $ 740.30 $ 98,978.08 $ 675.00 $ 100,000.00 $ 384.04 $ 103,512.67

14 5.46 2.75 8.21 $ 747.85 $ 98,907.41 $ 684.17 $ 100,000.00 $ 384.04 $ 103,836.84

3 4.24 2.75 6.99 $ 665.14 $ 99,744.63 $ 582.50 $ 100,000.00 $ 357.24 $ 100,646.87

4 4.39 2.75 7.14 $ 675.18 $ 99,662.93 $ 595.00 $ 100,000.00 $ 357.24 $ 100,888.48

5 4.48 2.75 7.23 $ 681.23 $ 99,582.17 $ 602.50 $ 100,000.00 $ 357.24 $ 101,139.09

6 4.6 2.75 7.35 $ 689.30 $ 99,502.81 $ 612.50 $ 100,000.00 $ 357.24 $ 101,401.32

7 4.72 2.75 7.47 $ 697.41 $ 99,424.80 $ 622.50 $ 100,000.00 $ 357.24 $ 101,675.30

8 4.8 2.75 7.55 $ 702.82 $ 99,347.53 $ 629.17 $ 100,000.00 $ 357.24 $ 101,957.76

9 4.91 2.75 7.66 $ 710.28 $ 99,271.41 $ 638.33 $ 100,000.00 $ 357.24 $ 102,251.35

10 5.02 2.75 7.77 $ 717.76 $ 99,196.43 $ 647.50 $ 100,000.00 $ 357.24 $ 102,556.19

11 5.13 2.75 7.88 $ 725.26 $ 99,122.57 $ 656.67 $ 100,000.00 $ 357.24 $ 102,872.39

12 5.24 2.75 7.99 $ 732.77 $ 99,049.79 $ 665.83 $ 100,000.00 $ 357.24 $ 103,200.11

15 5.57 2.75 8.32 $ 755.41 $ 98,837.75 $ 693.33 $ 100,000.00 $ 384.04 $ 104,172.73

16 5.68 2.75 8.43 $ 762.99 $ 98,769.10 $ 702.50 $ 100,000.00 $ 384.04 $ 104,520.51

17 5.79 2.75 8.54 $ 770.59 $ 98,701.42 $ 711.67 $ 100,000.00 $ 384.04 $ 104,880.31

18 5.9 2.75 8.65 $ 778.20 $ 98,634.70 $ 720.83 $ 100,000.00 $ 384.04 $ 105,252.29

19 6.01 2.75 8.76 $ 785.82 $ 98,568.90 $ 730.00 $ 100,000.00 $ 384.04 $ 105,636.59

20 6.12 2.75 8.87 $ 793.46 $ 98,504.03 $ 739.17 $ 100,000.00 $ 384.04 $ 106,033.39

21 6.23 2.75 8.98 $ 801.12 $ 98,440.05 $ 748.33 $ 100,000.00 $ 384.04 $ 106,442.83

22 6.34 2.75 9.09 $ 808.79 $ 98,376.94 $ 757.50 $ 100,000.00 $ 384.04 $ 106,865.10

23 6.45 2.75 9.2 $ 816.47 $ 98,314.69 $ 766.67 $ 100,000.00 $ 384.04 $ 107,300.36

24 6.56 2.75 9.31 $ 824.17 $ 98,253.27 $ 775.83 $ 100,000.00 $ 384.04 $ 107,748.80

The Option ARM – with three payment options – suits particular borrower situations.  

A borrower with variable income who receives most of his or her income at more sporadic intervals than monthly, such as an attorney receiving annual or quarterly distributions. A seasonal business owner or worker, such as a landscape or pool contractor, might benefit from the low cash flow requirement in the winter months.

Drawbacks of Potential Negative Loan Balances Prepayment Penalties: Option ARMs normally have a prepayment penalty to prevent the borrower from refinancing within the first 2 or 3 years. Being saddled with negative equity, and being unable to refinance Effect of Negative Amortization on 2nd to more favorable loan terms, tend to exacerbate the impact Mortgage Lendable Equity Property Value $ 200,000.00 a loan that grows to be unaffordable. Lendable Equity % 80% a. Gross Lendable Equity

$ 160,000.00

Loan Amount $ 100,000.00 Negative Amortization Cap: The loan balance can grow Original Max Negative Balance 125% as deferred interest gets added to the principal balance. This b. Max Potential Loan $ 125,000.00 cannot proceed unabated, and the lender normally caps the Net Lendable Equity a - b $ 35,000.00 negative amortization to 110% – 125% of the original principal balance. Once this cap is reached, the monthly payments are re-cast (new monthly payments established) as a fully amortizing loan. Even if the negative equity balance is not attained, many loan documents require that the loan be re-cast every five years. A re-cast means the monthly payments are re-established to make sure the loan amortizes over the original loan term.

Subordinate Liens: Many second trust lenders are unwilling to accept 2nd lien position behind a loan that will potentially erode the equity in the house. At best, the lender will determine if there is any “lendable equity” if the loan reaches is full potential negative amortization, and base their loan amount calculations on this amount. Homeowners and Title Insurance: Title Insurance policies must offset potential negative amortization and will include a rider that protects the loan up to its full potential balance.

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Benefits of Monthly ARMs and Potential Negative Amortization Ultimately, if the loan offers a favorable margin, it may still be competitive with an intermediate term adjustable rate mortgage. Compare the terms of other interest only ARM products available, such as the 3/1 or 5/1 ARM. One of the risks lenders assume is the danger of rising or falling interest rates affecting the value of the lender’s investments. In the case of the Option ARM, the lender is taking virtually no interest rate risk. Because of the mitigated interest rate risk, the lender is able to absorb more credit risk, on an actuary basis. As a result, these loans may offer more expanded criteria than other investment grade loans. Comparing ARMS The stigma of ARMs as risky can be offset by a careful analysis of the loan terms. Depending on 1.) the amount of time the mortgage is needed and 2.) the borrower’s view of future interest rates, an ARM may be a suitable alternative to a fixed rate loan. Most borrowers can understand how a fixed rate loan works. To help the borrower understand the adjustable rate mortgage you can compare it to a fixed rate loan on the basis of what is referred to as the “worst-case scenario.” The “worst case scenario” is what would occur if the interest rate on the mortgage went up as high as the terms allowed – to the cap at each adjustment. The “worst-case comparison” is performed by comparing the fixed interest rate to the average interest rate on the adjustable rate mortgage to. To achieve the “average interest rate” for a period, add the interest rate amount and divide by the number of years. Various Scenarios Indicate that ARM Performance Changes Based on the Index (Market) Performance of 1 Year ARM 2/6 3rd Year 4th Year 4 Year Index Initial 2nd Caps & 2.75 Margin Average Rate Rate Year Index Rates Stay at Today’s Rate 5.3 5.5 7.5 8.125 8.125 7.31 Index Rates Go up 2% (Somewhat) 7.29 5.5 7.5 9.5 10.125 8.15 Index Rates Go up Significantly 14.9 5.5 7.5 9.5 11.5 8.5

30 Yr Fixed 8 8 8

In the above example, in a current or even somewhat increasing interest rate environment, an ARM may be more favorable than a fixed rate loan. This is because short-term rates are lower and, depending on the term of the adjustment, the borrower may gain an interest rate benefit that, when averaged over time, provides a lower overall interest cost. This comparison is then tailored to the amount of time that the borrower intends to be in the property. In the following example use the worst-case scenario average to conclusively prove that 1.) a 1year ARM has an average interest rate advantage over a fixed rate loan for the first 3 years (not just the first year) and 2.) that a 5/1 ARM has an average interest rate advantage for the first 7 years (not just the first 5). This scenario assumes the worst case and so can be used to help borrowers who are extremely risk averse and perceive ARMs as risky.

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Worst Case Scenario Comparison - Fixed vs. ARM Worst Case Rate 30-Year Fixed Average Rate 1-Year ARM Worst Case Rate Average Rate 2/6 Caps 5/1 ARM 2/6 Worst Case Rate Average Rate Caps

Year 1 6.5 6.5 3.75 3.75 5.125 5.125

Year 2 6.5 6.5 5.75 4.75 5.125 5.125

Year 3 6.5 6.5 7.75 5.75 5.125 5.125

Year 4 6.5 6.5 9.75 6.75 5.125 5.125

Year 5 Year 6 Year 7 6.5 6.5 6.5 6.5 6.5 6.5 9.75 9.75 9.75 7.35 7.75 8.03571 5.125 7.125 9.125 5.125 5.45833 5.98214

Year 8 6.5 6.5 9.75 8.25 11.125 6.625

Conversion Options A Conversion Option (Convertibility) is a feature that provides the borrower with the ability to convert to a fixed rate at a specified point or time frame during the life of the loan. It is easy to misunderstand the option, believing that this offers the ability to convert to a rate based upon the initial ARM rate. Unfortunately, this is not the case. The conversion option is basically a conditional refinance. This means the current market determines the interest rate. There may be a cap on the conversion option, but the terms for conversion are similar to those of the Balloon (see Balloon, this chapter). The benefits of the conditional refinance, or conversion, are: 1. 2.

Borrowers may take advantage of dips in interest rates to fix their mortgage rate without the cost of refinancing or the risk of re-qualifying. An appraisal may not be required - alleviating concerns over property values.

Disadvantages 1.

2.

The conversion interest rate equation is a margin plus index equation. The conversion formula is based on current rates for 30-year mortgages, plus a margin - a borrower may almost always obtain a better rate for a fixed rate loan by shopping for a refinance. Because fixed rates are always higher than ARM rates, the rate on the ARM may be lower than the conversion rate.

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Second Mortgages The term "Second Mortgage" simply refers to the timing of the recording of security instruments such as a mortgage or deed of trust. "Second" alludes to the fact that there is another mortgage recorded prior in a first lien position, or before any other second mortgage is recorded. This means that during a forced sale the second lien holder receives proceeds after the first mortgage lender's claim has been satisfied. Second priority also means that foreclosure proceedings cannot be initiated without the consent of the first mortgage lender. As a result second mortgage loans are considered riskier investments for lenders than first mortgages. Second Mortgages come in two varieties. The fixed rate or term loan offers repayment terms similar to first mortgages. Fixed term loans normally have the entire loan proceeds disbursed at closing. The advantage of a fixed term loan is that it allows payments to be scheduled and the rate may be fixed. Home Equity Lines of Credit are open-ended loans that act like a credit card. The balance may be drawn up or paid down and interest is due on the balance owed. These loans are like ARMs, in that the interest can change regularly. The benefit of the line of credit is that you don’t pay interest for money that you don’t need to borrow. There is more flexibility in borrowing and repaying because if there is a significant over-payment, that money may be accessed right back. A whole class of financing has initiated from this practice. Ordinarily the basis for approval of a second mortgage is the equity, or down payment, in a property - hence it is also known as equity lending. In the terminology of the current residential first mortgage lending, second mortgages connote "creative financing.” Home equity lenders, banks, conduits and private individuals (a home seller who accepts a loan against the subject property in lieu of part of the down payment is a lender too) are all second mortgage sources. While they may be riskier for lenders, they are useful tools to do things that cannot be achieved with a first mortgage alone. A Home Equity Line of credit, for instance, is a second mortgage that allows a borrower to advance and repay a credit line to manage their cash flow. Many banks now offer car loans secured by homes so that the interest is tax deductible. Piggybacks or Blends (Non-Traditional Loan Type) 1st & 2nd Mortgage Comparison Sales Price Down Payment

$

250,000.00 10%

Standard Transaction 1st Trust Amount 1st Trust Payment 1st Trust PMI

Loan Term in Years Interest Rate

30 8.75%

1st & 2nd Mortgage $ $ $

Standard Payment Monthly Savings

Chapter 2 – Loan Types - Page 39

$

225,000.00 1,770.08 97.50

1,867.58

1st Trust Amount 1st Trust Payment 1st Trust PMI 2nd Trust Rate 2nd Trust Amount 2nd Trust Payment

$ $ $ $ $

Combined Payment

$

200,000.00 1,573.40 9.50% 25,000.00 210.21 1,783.61 $83.97


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

It may be possible to structure a lower rate package by using secondary financing. The most inexpensive mortgages available have loan amounts below those set by FNMA and FHLMC. Many people have a need for larger (jumbo/non-conforming) loans. These Jumbo or Larger loans generally carry a higher rate. A rate reduction may be achieved by using the “Tandem” strategy. The Tandem may also be referred to as a “piggyback,” “combo” or “blend.” This example shows there is a significant saving in monthly payments ($83.97/mo.) utilizing the Tandem 1st & second Mortgage Combination. This is due to the cash flow savings from avoiding Private Mortgage Insurance. PMI, unlike mortgage interest, is not tax deductible. Even if there were no dollar for dollar monthly payment savings, more of the payment is tax deductible, hence there is a benefit. Computing the Blended Rate One powerful tool to help cusComputing the "Blended Rate" tomers understand the relative 1. Add the payments for both loans $1573 + $210 = rate impact of the first and 2. Enter the total as the Payment $ 1,783 PMT second mortgage strategy is to 3. Add the two loan amounts $200000+$25000 = show the effective, or “blend4. Enter the total as the Loan Amount $225,000 PV 5. Enter the Term 360 N ed,” rate of the two loans to6. Compute Interest Rate CPT I% gether. Comparing this to the 7. Record Result 8.830% first mortgage with PMI can enlighten a customer as to the real comparison and can be a tremendous selling tool. This formula is just like computing the maximum interest rate for a given payment and loan amount. Bridge Loans and Reverse Bridge Loans - 2 Strategies A bridge loan is a second mortgage on a property that is pend- A Bridge Loan is a Poor Solution ing sale. There are reasons that bridge loans are risky. A lender is freeing up the equity in a current home to allow a - A transaction in another area of buyer to purchase a new home. This works badly for a num- the country beyond your control ber of reasons. The home may not sell, even if it is under con- - A second closing with more tract. Often, the costs of a bridge loan, because of the per- opportunities for errors - More closing costs ceived risk, are much higher than traditional financing. Bridge loans normally come due within 90-270 days, which could put undue pressure on a home seller to dispose of the property at a loss. One solution is not to rush to try and sell the previous home. Leverage the proposed transaction as much as possible using a Piggyback first and second mortgage. Then, when the previous home does sell, pay down or pay off the second mortgage and be left with the original mortgage that was intended. This is a “reverse bridge loan.” Similarly, if there is the likelihood of significant prepayments in the early years of a loan, a first & second mortgage combination can be a good way to plan to have a lower payment in later years.

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Often a borrower is making a substantial down payment towards a new home. While the result is a low loan to value transaction that is easy to approve, you can increase the borrower’s access to their down payment by placing a Home Equity Line of Credit at the time of the purchase closing. This can assure that there is the ability to access the down payment equity in an emergency. Imagine – the borrower could even pay the first mortgage with the second mortgage. Seller held Mortgages, Assumptions and Wraps Sellers can become lenders when they agree to an installment sale. This practice was more widely used when interest rates were higher. A seller may entertain financing a property to a new purchaser if there is significant equity in the property or will allow the borrower to assume an existing loan. One type of assumption is a borrower approved by the lender taking over an underlying mortgage and the payments. This is normally done only if the terms on the existing mortgage are very attractive. A wrap is an assumption where the loan isn’t officially in the borrower’s name. The concept is the same as a land installment sale, a deferred purchase money loan, or more recently it has been known as a contract for deed. The seller’s old loan remains in place and the payments continue to be made by the seller. The buyer pays the seller a negotiated amount until the underlying mortgage is paid off. The seller may hold part of the financing, or may just take the difference of cash at closing. It is called a wrap because all financing is wrapped into one payment that the buyer makes to the seller. There are numerous problems with settlements that occur under these terms, but they generally serve the purpose of disposing of a piece of difficult-to-sell property. Reverse Mortgages for Seniors The most popular reverse mortgage is the federally-insured reverse mortgage, called the FHA Home Equity Conversion Mortgage Program (HECM). The other major product is the Home Keeper reverse mortgage, developed by FNMA. One "jumbo" private reverse mortgage product is offered by Financial Freedom Senior Funding Corp., of Irvine, CA. Each loan type has different withdrawal, repayment and settlement plans. A reverse mortgage is a payment plan. Instead of making payments, the borrower receives equity from the property in 1 of 5 ways. The loan has no repayment for as long as the borrower lives in the property they own. While there are nuances, all Reverse Mortgages follow the FHA template. The FHA insured HECM reverse mortgage can be used by senior homeowners age 62 and older to convert the equity in their home into monthly streams of income and/or a line of credit to be repaid when they no longer occupy the home. The loan is funded by a lending institution and insured by FHA. FHA charges a 2% initial premium and .5% annually based on the balance of the loan. The HUD reverse mortgage does not require repayment as long as the home is the borrower's principal residence. Lenders recover their principal, plus interest, when the home is sold. The remaining value of the home goes to the homeowner or to his or her survivors. The heirs have the choice of refinancing the property to payoff the balance of the reverse mortgage, paying it off from any

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other assets, or selling the property. The borrower can never owe more than the home's value. In the event that the sale of the home doesn’t satisfy the outstanding mortgage HUD insurance pays the lender the difference. Homeowners 62 and older, currently living in their home with a large equity position are eligible to participate in HUD's reverse mortgage program. The only other borrower requirement is participation in a consumer information session given by an FHA approved counselor. The program allows homeowners to borrow against the equity in their homes using one of five plans: 5 Payment Plans offered under FHA’s Reverse Mortgage Program Tenure equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence Term equal monthly payments for a fixed period of months selected Line of Credit unscheduled payments or in installments, at times and in amount of borrower's choosing until the line of credit is exhausted Modified Tenure combination of line of credit with monthly payments for as long as the borrower remains in the home Modified Term combination of line of credit with monthly payments for a fixed period of months selected by the borrower

The mortgage amount cannot exceed current FHA insurance limits, and is based on the age of the youngest borrower and actuarial tables, so older borrowers will receive larger payments. The current interest rate and the actual closing costs affect the amount of the loan. Sample Loan Amounts based on 9% Interest Home Value Borrower's Age 65 75 85

Chapter 2 – Loan Types - Page 42

$ $ $ $

300,000.00 Loan Amount 66,000.00 123,000.00 174,000.00


Chapter 3 - Loan Plan Specifications Program Specifications - Understanding Guidelines In 2008, after decades of increasing sophistication, the credit markets for mortgage backed securities contracted in a way that had never occurred before. The public saw the previously murky workings of the secondary market brightly lit. The risks posed by aggressive underwriting – lenient standards for approval – came back to haunt the industry. The result was a massive pullback in lending guidelines that left a mortgage markets resembling that of the late 70’s or early 80’s. Today’s mortgage professionals must return to a creative approach to loan packaging and an intricate knowledge of program guidelines is even more important than ever before. The types of loans offered - the products - each offer a specified return on financial investments for lenders. They represent a way for investors to lend money, secured by real estate, where they can obtain a reasonable return. These instruments offer a risk as well as a return. The risk of default – also known as credit risk - may preclude an investor from being repaid and is the first concern of lenders. One way to lessen the risk is to establish standard guidelines that allow lenders to easily determine what an “investment quality” loan is. These types of guidelines establish what investors deem as a prudent risk, and constitute the basis for the majority of mortgages provided today. These guidelines are also known as loan plan specifications. For the Loan Officer, learning loan plan specifications is the first step in establishing a conceptual understanding of the products that are offered. Specifications are the first step in underwriting because they represent the basic absolutes that the eventual purchaser or guarantor of a mortgage will accept. Think of the loan specifications as a sieve - the first grid through which a borrower must pass in the process of obtaining a loan. Loans are made based on risk – the amount of risk the lender is willing to accept comes from experience with areas of a borrower’s profile that lenders have identified as having an impact on risk. The guidelines are used to limit exposure to higher risk aspects of a profile. While every program guideline has a nuance, they all address these basic elements. The loan officer must understand what these mean.

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Criteria

LTV/Occupancy

Transaction

Eligible Properties Multiple Properties Mortgage Insurance Assumption Programs Offered

Documentation Types

Qualifying Ratios Employment History Trailing Spouse Non-Resident Aliens Non-Occupant Co-Borrowers

Seller Contributions

Definition/Explanation Owner occupancy (O/O) is the primary driver of risk. If the borrower lives in the property he has more incentive to make the payment than someone who rents the property. Likewise, if the borrower makes substantial cash investment, he or she is less likely to walk away from the property. Program guidelines are more restrictive as to LTV when owner occupancy is not present. 2nd Homes are vacation properties where no rent is used in qualifying the borrower – so may be treated more leniently. Investment property (NOO) is the riskiest Occupancy. Purchase Transaction – Risk + - when a borrower is making a cash investment in a purchase transaction, there is a positive risk aspect. In addition, when a property is being purchased, valuation is based on the truest indication of property value – what someone is willing to pay for a property – purchases are less risky. Rate/Term R/T (No Cash Out /NCO) Refinance – Risk = - when a borrower refinances to reduce the rate or term of a loan, the new loan is obviously more beneficial to the borrower and, hence, less risky. However, the borrower is likely extracting equity from the property to pay for the refinance, and that tempers the benefit of improved terms. In addition, valuation is based on an appraiser’s estimate, so value is subjective. Rate/Term Refinances are risk neutral. Cash Out – or Equity Recapture – When a borrower refinances to take equity out of the property, this erodes the equity position and increases the risk. This is compounded by the valuation issue. Property Types affect the risk of the loan. Condos and 2-4 Family (Income) properties are riskier than Single Family Detached (SFD) properties. Many investors limit the number of properties they will finance for one borrower. PMI or other mortgage insurance is required for loans with higher LTVs. Investors will specify the limits of coverage required which may be higher for riskier loans. Assumption is a feature that allows a buyer to take over payments on a loan with the lender’s permission. Most lenders do not allow this. The type of loan programs – fixed, ARM, Balloon, and repayment plans such as Interest Only, buydowns – affect the risk of the loan. Full Documentation – Direct Verification of Income/Assets Alternative Documentation – Using Borrower’s documentation i.e.; W-2’s, Pay stubs, Bank Statements Reduced/Stated/NIV – Borrower States Income – Doesn’t verify, Verifies Assets No Documentation – Borrower States Income/Assets Doesn’t Verify No Ratio – Borrower Doesn’t State Income/Assets – Doesn’t Verify The Debt Ratios used to qualify borrowers. Ordinarily, debt ratios will not be as important when Automated Underwriting is used. Normally, lenders want a 2 year history to verify stability as well as income. When a borrower is being relocated by his or her company, the non-relocating borrower is referred to as a “trailing spouse”. In some cases this borrower’s income can be used to help qualify. Citizenship may be required on certain loan programs, but many lenders now allow non-permanent resident aliens if they have a 2 year work and credit history. A co-borrower is a non-occupant if they are buying a property, but will not live in the property. Even though the transaction is considered owner occupied from an occupancy perspective, the borrower who lives in the unit is perceived to be the one who will really be making the payments. They must have to have enough income to support the request individually. The amount that the seller gives to the buyer to help pay for closing costs. Can substantially reduce borrower cash requirements. Excessive contributions can indicate value concessions so are limited by lenders

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Criteria Cash Reserves

Gift Letters

Secondary Financing Borrowed Funds Credit Scores Mortgage History Major Derogatory Credit

Definition/Explanation Borrowers cannot divest all their cash for closing and down payment. Lenders require that there are some post closing reserves as a contingency. Normally measured as a number of months of PITI. Bona-fide gifts that don’t have to be repaid are a major source of funds. Verifying that the gift is not expected to be repaid normally means identifying the relationship between the donor and recipient, verifying the source of funds and making sure that the funds actually comes from the source listed and that those funds are deposited into the borrowers account. The risk of a gift is that it must be repaid and the repayments are not counted in the overall debt analysis. 2nd mortgages must not cause potential problems for the borrower such as a short balloon, negative amortization. If they are allowed, they must be counted towards borrower’s debts FICO credit scores are an indication of a borrower’s statistical likelihood of default on unsecured obligations. Because scores are based on statistical models, lenders use scores as another indication of a borrower’s desire More than overall history, the mortgage payment history is a reflection of the borrower’s commitment to maintain residence payments. A borrower who has been unable to do this is a questionable risk for the lender. Judgments, Tax Liens, Major Collection actions, Charge Offs, and Credit Counseling are all indications of current issues that could impair the borrower’s ability to make future payments.

Conventional Loans - What is Conforming? Any loan that is not related to a government agency is considered a conventional loan. Sources of conventional loans can be banks, savings and loans, credit unions, life insurance companies, private lenders, and mortgage bankers. These loans may be held in the institution's portfolio or sold into the secondary market in pools of Mortgage Backed Securities (MBS), Collateralized Mortgage Obligations (CMOs) or Real Estate Mortgage Investment Conduits (REMICs). While the private market has struggled since the crisis, recent conduit issuers like Redwood Trust, have emerged. The issuer determines the underwriting guidelines. In 1938, the federal government chartered the Federal National Mortgage Association (FNMA - known as Fannie Mae) whose job was to create a secondary market to buy mortgages secured by homes. This action was in response to the banking crisis that brought on the Great Depression. Being able to sell mortgages to FNMA created for banks and would, hopefully, alleviate another crisis. Originally FNMA purchased FHA-insured and VA-guaranteed loans as well as conventional loans. Today, however, the majority of loans FNMA purchases are conventional. FNMA was taken public as a private sector stock corporation in 1968 in tandem with the creation of the Government National Mortgage Association (GNMA - known as Ginnie Mae). GNMA took over FNMA's job of being the principal buyer of FHA and VA Loans. The savings and loan crisis of the late 60’s and 70’s precipitated the need for a secondary market for seasoned loans – a place for struggling thrift institutions to sell their home loan portfolios and gain liquidity. This need prompted congress to charter a competing secondary market corporation - the Federal Home Loan Mortgage Corporation (FHLMC - known as Freddie Mac) - to purchase conventional loans. Until September of 2008 these were private corporations owned by stockholders. The financial crisis of 2008 decimated these firms’ liquidity forcing the Federal Housing Finance Agency (FHFA) to place the corporations into receivership.

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Over the course of the receivership the US Treasury injected $181 billion into the GSEs allowing the GSEs to continue to serve their primary mission of creating a secondary market for residential mortgages. Because of the dearth of other sources of financing in the secondary market, understanding these institutions and the guidelines they establish remains critically important. FNMA has historically been the nation’s single largest purchaser of mortgages. It stands to reason that FNMA guidelines for loans they will purchase would be the model for all guidelines for all purchasers of mortgages, since theoretically any loan could be resold to FNMA. FHLMC’s guidelines, with some exceptions, mirror FNMA's. Today they are referred to generically as "conforming" or “Fannie-Freddie” guidelines. A loan is referred to as conforming if it meets either FNMA or FHLMC guidelines. Any loan that exceeds Congress’ sanctioned maximum loan amount ($417,000 for 1 unit as of December 1, 2013 – or the temporary maximum of $625,000 authorized by Congress) is referred to as a Jumbo Loan or “non-conforming”. This is not the only criteria that make a loan nonconforming – any aspect of a borrower’s profile that does not meet FNMA or FHLMC’s specifications make it ineligible for sale. Borrowers should strive to meet “conforming” guidelines because the rates and terms of these loans tend to be the most attractive, due to the implied guaranty of the securities they backed. Loan program highlights, guidelines or specifications can vary from company to company so that even a "conforming loan" can have different attributes from lender to lender. FNMA and FHLMC are "quasi-governmental agencies" referred to as government sponsored entities (GSEs). They publish standard guidelines. These guidelines have become a blueprint for underwriting investment quality mortgages that are intended for sale into the secondary market. As a result many specifications for other loan programs intended for sale in the secondary market simply state "Follow FHLMC and FNMA guidelines,” and note exceptions. Because of this, FNMA and FHLMC are good places to start understanding guidelines. Lenders can negotiate special arrangements (commitments) with secondary market investors like FNMA and FHLMC. These commitments can override standard specifications. This is referred to as a “niche.” Locating these exceptions and utilizing them can help borrowers who fall outside standard guidelines. FHLMC and FNMA offer specialized programs that address the needs of borrowers with above or below average credit and risk profiles.

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Investor

FNMA/FHLMC - "Generic" Conforming LTV Matrix

LTV/Occupancy Transaction

Owner Occupied

LTV 95% Purchase or Rate and Term 90% 80% Refinance 80% Cash Out 75% High Cost Area* thru 10/1/12 90%

CLTV 90% 90% 80% 80% 75% 90%

2nd Home Investor LTV 90% N/A N/A N/A 70% n/a

LTV 70% 70% 70% 70% 65% n/a

Property Type

Loan Amount

Single Family, Condo $ 2 Unit $ 3 Unit $ 4 Unit $ Single Family, Condo $ Single Family, Condo $

417,000 533,850 645,300 801,950 417,000 625,500

(AK, HI) $ $ $ $ $ n/a

625,500 800,775 967,950 1,202,925 625,500

Streamline or Limited Qualifying to 95% LTV if current loan is FNMA Serviced – Over 90% cannot Include Closing Costs or Prepaid Items. Existing 2nd Mortgages must be "seasoned" for 12 Months or payoff is considered "cash out". Limited Cash Out < $2,000 or 2% back to borrower. Single Family Detached (SFD), Single Family Attached (SFA), 2-4 Unit Residential, Planned Unit Eligible Properties Developments (PUDs), Condominium - New PUDs, all condos have eligibility criteria - see Chapter 8 - Property Types for Eligibility Multiple Properties Owner Occupied No Limit Investment/2nd - no more than 4 financed (FNMA) Conventional Private Mortgage Insurance required for all owner-occupied properties and second homes with loan to values greater than 80%. In some cases required for investor loans over 70% Mortgage Insurance and, when allowable, 80-10-10 secondary financing. Assumability Conventional loans all have a due-on-transfer clause - this precludes assumption 95% All Occupancy Types 30, 20, 15, 10 Year Fixed 7 & 5 Yr 2 Step, 2-1 Buydown, Interest Only, 3/1, 5/1, 7/1 Programs Offered Owner/2nd Only 95% ARM 90% Owner/2nd Only 1 Year ARM, 7/23 & 5/25,3-2-1 Buydown Documentation Types Full/Alternative - Actual Income Verification method may be assigned by DU/LP Income/Borrower Restrictions 95% LTV – 28/36 or DU/LP (40/40 FNMA ARMs Qualify at 2nd Year Rate Qualifying Ratios Buydowns Qualify at Start Rate 75% LTV – 33/38 or DU/LP Employment History Minimum 2 Years History, 2 Years in same business for Self-Employed Corporate Sponsored Relocation Only. 80% LTV Max, 6 Months Reserves, 25-50% of spouse's Trailing Spouse income may be used if it can be documented that former employment is available in new location. Non-Resident Aliens No restrictions - must have 24-month work, asset and credit history. Max LTV for using non-occupant co-borrower's income for qualifying is 90% LTV. Occupant Non-Occupant Co-Borrowers borrower must still have 38/45 ratios and have 5% of own funds invested. Asset Restrictions 95% LTV - 3% Seller Contributions Investor - 2% 90% LTV - 6% 75% LTV - 8% 95% LTV - 3 Months PITI 2 months – May be waived under affordable gold, Cash Reserves 90% or Less - 2 Months community homebuyer Refinancing

Gift Letters Secondary Financing Borrowed Funds

80.01 - 95% LTV borrower must have 5% of own funds invested into transaction. < 80% LTV - No limit. Source, transfer and receipt must be documented. Donor must be "family" member. Maximum LTV for 1st Mortgage is 75% (i.e. 75-15-10 is o.k.) 2nd mortgage maturity must be at least 5 years; payments must cover minimum interest. 2nd may not be ARM if 1st is ARM. 1st Mortgage may not be a balloon. Must be secured/counted for qualifying Credit Restrictions Eligible for Enhanced Criteria

Over 700

Credit Scores

Cautious Bureau Scores are applied. Take the middle of the three scores take the middle. Scoring regimen is not Not Eligible for Max Financing absolute but follows the following guideline.

Mortgage History

0 x 30 days late for last 12 Months Must have 2 years RE-ESTABLISHED history. Time elapsed since resolution Bankruptcy - Chapter 7 - 4 Years; Chapter 13 - 2 Years; Foreclosure 4 years.

Major Derogatory Credit

Maximum Loan Amounts are adjusted as to high cost areas – visit https://www.efanniemae.com/sf/refmaterials/loanlimits/jumboconf/xls/loanlimref.xls

Chapter 3 – Loan Plan Specifications – Page 47

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Investor

Jumbo - Generic Non-Conforming LTV Matrix

Transaction Owner Occupied Purchase Rate/Term Refinance Owner Occupied Cash 2nd Home Purchase Rate/Term Refinance 2nd Home Cash Out Refinance Investor Purchase Rate/Term Refinance Programs Offered Buydowns Eligible Properties Secondary Financing

Refinancing

Private Mortgage Insurance Assumability

Qualifying Ratios

Documentation Types

Non-Occupant CoBorrowers Self-Employment Trailing Spouse Seller Contributions Cash Reserves Borrowed Funds Gifts

Credit Scores Multiple Properties Non-Resident Aliens Derogatory Credit

LTV

CLTV

Property Type

95% 90% 80% 70% 60% 75% 90% 80% 75%

90% 90% 90% 90% 90% 75% 90% 90% 90%

1 Family, Condo 1-2 Family, Condo 1-4 Family, Condo 1 Family, Condo 1 Family, Condo 1-2 Family, Condo 1 Family, Condo 1 Family, Condo 1 Family, Condo

Maximum Loan $ 400,000 $ 500,000 $ 650,000 $ 750,000 $ 1,000,000 $ 650,000 $ 300,000 $ 400,000 $ 500,000

Maximum Financing $ 650,000 $ 650,000 $ 650,000 $ 750,000 $ 1,000,000 $ 650,000 $ 500,000 $ 500,000 $ 500,000

70%

70%

1 Family, Condo

$

300,000 $

300,000

70%

70%

1-4 Family, Condo

$

300,000

300,000

$

30- and 15- Year Fixed Rate Allowed. 2-1 and 1-1. SFD, SFA, PUDs, Condos must meet FNMA Guidelines - Max 4 stories Maximum LTV for 1st mortgage is 80% (i.e 80-10-10 is o.k.) 2nd mortgage maturity must be at least 5 years; payments must cover Up to 95% LTV Over 90% cannot include closing costs or prepaid Items. Existing 2nd mortgages must be "seasoned" for 12 months or payoff is considered "cash out". Amount of cash out is limited. To 75% LTV - Max cash is $50,000; 70% $100,000; 60% - $200,000 Required for > 80% LTV. 35% Coverage for 95% LTV; 22% for 90%; 12% for 85%. No - Conventional loans all have a due on transfer clause. Income Restrictions 90.01 - 95.00% LTV - 28/36 < 90% - 33/38 Buydowns qualify at start rate Full, Alternative and Reduced Documentation Reduced Documentation LTVs Maximum Maximum LTV CLTV Property Type Loan Financing 70% 90% 1 Family, Condo $ 300,000 $ 650,000 65% 90% 1 Family, Condo $ 400,000 $ 650,000 60% 90% 1 Family, Condo $ 650,000 $ 650,000 Max LTV for using non-occupant co-borrower's income for qualifying is 90% LTV. Occupant Borrower must still have 38/45 Ratios and have 5% of own funds invested. Minimum 2 Years - Self-Employed/Commissioned Not Allowed Asset Restrictions 95% LTV - 3% Investor - 2% 90% LTV - 6% 95% LTV - 3 months PITI 90% or less - 2 months Must be secured. Secured loans must be counted in ratios. 80.01 - 95% LTV borrower must have 5% of own funds invested into transaction. < 80% LTV - no limit. Source, transfer and receipt must be documented. Donor must be "family" member. Credit/Borrower Restrictions 680 Minimum Borrower may have no more than 4 properties financed. Not allowed 0 x 30 last 24 Months on Mortgage. NO bankruptices, foreclosures or major derogatory credit allowed

Chapter 3 – Loan Plan Specifications - Page 48

Important note – This guideline is very generic and is designed to show the selectivity of lenders who purchase loans above the limits set by FHLMC and


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

“Generic Jumbo” Non-Conforming Non-conforming loans also referred to as "Jumbo.” The basic Jumbo program guideline (shown here as “Generic Non-Conforming”) is similar to conforming, but the loan limits are higher. These guidelines vary from lender to lender. Jumbo loans are not widely available in 2011. When lenders offer them, guidelines are highly selective. Do not confuse Jumbo with “Conforming Jumbo” which is FNMA/FHLMA loans extended to the “High Cost Limit”. The “High Cost Limit” is set by law (the Housing and Economic Recovery Act of 2008) at 115% or 125% of the conforming loan limit. Automated Underwriting – Electronic Decision Engines Risk is assessed by the use of automated underwriting (A.U.) models. While relying on published guidelines, these models define standard acceptable risk and which loans are eligible for purchase. FNMA’s model is known as Desktop Underwriter or “D.U.” FHLMC’s A.U. model is based on its Gold Measure manual risk assessment system and is called Loan Prospector or “L.P.” Because of these advancements it is possible to receive an underwriting approval electronically for a loan application that does not appear to meet standard underwriting guidelines. Desktop Underwriter – “D.U.” – FNMA Conventional Loans, some Jumbo Loans

Loan Prospector – “L.P.” – FHLMC Conventional Loans, some Jumbo Loans, FHA and VA Loans

Approved Approve – Eligible: The loan is approved and a live underwriter must simply review required conditions or exhibits.

Accept: The loan is approved and a live underwriter must simply review required conditions or exhibits.

Suspended Approve – Ineligible: The loan meets guidelines and receives an approval recommendation, but due to one or more characteristics, a human underwriter must approve it. Refer: The loan meets guidelines and receives an approval recommendation, but due to one or more characteristics, a human underwriter must approve it.

Declined Ineligible: The loan does not meet A.U. parameters and must be underwritten and approved by a human underwriter.

Decline: The loan is ineligible for sale to FHLMC; must be underwritten to other guidelines by a human.

There are several results you can expect from Desktop Underwriting or Loan Prospector. Besides these two major decision engines, most major lenders have adopted some sort of credit decision engine and have a private label for it. The important issue to note is that if a file does not meet the decision engine’s credit guidelines, the loan is then underwritten to more rigorous “manual” underwriting guidelines as set forth in these pages. Simple Troubleshooting Strategies A common error made by new loan officers is to rely on the initial approval from the engine as a “firm” approval. The approval really is still subject to underwriter review of the underlying documentation. Ordering a full appraisal instead of a limited appraisal prior to receiving findings can

Chapter 3 – Loan Plan Specifications – Page 49


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

result in adverse underwriting of the appraisal. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) the Appraiser Independence Rule requires appraisal ordering to be handled by non-origination staff. These personnel should wait until completed findings before ordering since appraisals may be waived by the underwriting engines. Variance Tolerance An unexpected problem in the underwriting submission Post Submission Variance Tolerance flip-flop occurs when the underwriter validates data. If in D.U. there are significant changes in the information between Tolerance what was used to derive the initial approval – initially Debt Ratio Increase < 2% submitted data – and the final verified information, the Income Decrease < 5% loan findings can change because of increased risk ratings. DU is sensitive to undisclosed or improperly disclosed information. There is a stated tolerance for changes, and care should be taken in loan submission to insure that debts are not understated and income is not overstated. When an adverse decision is received from one of the engines, the common approach is to resubmit the request to another approval engine hoping for a more favorable outcome. For example a loan officer may submit to Desktop Underwriter and receive a decline. To attempt to solve the problem, the loan is submitted to Loan Prospector in order to reverse the decision. To avoid additional charges enter the LP Key number for each subsequent submission ($20 each). LP allows credit reports from any source – even DU, or a third party. Prior to simply submitting it to an alternative engine, analyze the findings first. Evaluate whether the initial information input to the system was correct, and resubmit before seeking alternative approvals. Common Problems with AU (Automated Underwriting) Most often a loan is declined or referred by A.U. due to input error; name and address mistakes, incorrect calculation of total debts; underwriting discrepancies, un-reconciled liabilities between credit report and submission, mortgages/HELOC’s incorrectly coded, "stale" mortgages not omitted, HELOC's not "paid at closing", student loans without a payment (use 1% if deferred), active debts without a payment amount, collections and 30 day accounts without paid in full balance, "closed" accounts with an active balance not included, duplicate debts, auto lease payments excluded, undisclosed debts from the 1003 like alimony/child support, or private mortgages, amounts entered for liens, mortgage balances and debts to be paid off do not match the credit report, "free and clear" property without taxes/insurance. DU or LP? Guideline Condominium Warranty Condominium Documentation Non-Occupant CoBorrower Multiple Properties

DU or LP LP DU LP

Description Less restrictive guidelines Condo limited review option can generate new business (high investor condo projects). Allow occupant borrower more flexibility

LP

No maximum number for owner occupied/stated debts for A Plus

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Guideline Low Credit Score, Good Trades High Credit Score, Poor Trades Expanded Approval - ABankruptcy

DU or LP DU

DU DU

High Reserves

DU

Low Reserves

LP

Debt Ratios to 65%

DU

Debt Ratios over 65% High Debts Multiple Investment Properties

LP LP DU

Second Homes Multiple Properties Cash Out used for Reserves Unseasoned Lot Value Elderly Parent/Disabled Child Seller Contributions Self-employed

LP

Description DU evaluates balanced debts to evaluate risk. Slow accounts a problem. LP evaluates FICO score to assess risk. Slow accounts may be acceptable. More aggressive A- offering through DU - EA 1, 2, 3 Bankruptcy & Foreclosure guidelines allow loans to be originated 24 months from the file date (lower LTV and strong reserves could generate approvals). Adding at least 2 mos. PITI reserves can positively impact risk analysis. Investor - need 2 mos PITI on 1 Unit (6 Mo. DU 2 - 4 Unit, LP 1-4 Unit) Use cash out funds as reserves. DU Lack of reserves (cash out refinances) can result in adverse findings Enter all liquid assets, including 401k, retirement accounts - 70% of balance. Lower LTV's - very high total expense ratios. AcceptPlus - no leases or tax returns. Use stated debts. Qualify "new" borrowers purchasing or refinancing investment property with the total PIT1 (subject net cash flow);with approve eligible this overrides the 2 yr. management, history rule and avoids rent/loss insurance. No limit on number of financed properties on second home.

LP

Enter the cash out amount as reserves in LP - reduced risk.

LP DU

Permanent or Construction Permanent Children purchasing a home for elderly parents or parents purchasing a home for a disabled child. On 1st & 2nd Combo DU uses CLTV; L.P. still uses LTV. Self-employed - one year history with 6 months of income on filed tax returns. LP - if self-employed borrower receives Accept Plus, period of self employment not considered. Contractor w < 25% ownership of business NOT considered self employed. Contractors, Commissioned - < 2 Year History may only need 6 months of income on filed tax returns. Bonus & Overtime average by 12 mos, not 24 Use FLEX guidelines allowing unsecured loans from acceptable sources when a gift is not an option. Rental income from boarders is allowed on CHP loans.

LP

LP DU

Commissioned/Variable

LP

Commissioned/Variable

DU

Source of Funds

DU

Boarder Income Community HELOC/2nds

DU DU

Reduced Doc Shorter Term Loans

LP

Re-subordinate - use current balance, not max line, to compute LTV $1 of income with strong borrowers; accept plus allows stated income/debt approvals 25 or 20 year Term Lower Risk. DU does not consider.

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

First Time Homebuyer Programs The impetus for large financial institutions to participate in first time homebuyer programs has been huge. In this litigious society no bank, savings and loan, Mortgage Company, or other financial institution wants to have a record of discriminating against lower-income borrowers. Penalties for discrimination are quite severe, and may cause difficulty in regulatory approval for future consolidation or merger. As a result, there has been a proliferation of first time homebuyer/affordable housing programs offered by the secondary market, mortgage insurers and private institutions. While some may offer below market rates, most of these programs offer relaxed guidelines for first time homebuyers instead of rate or other incentives. FNMA’s introduction of so-called “FLEX” guidelines, which offer lower down payments, reduced qualifying criteria, and reduced PMI costs, have eroded the excitement that these “Community Homebuyer” programs created. However, for the loan officer, the ability to offer the first time homebuyer training program as a value added service for referral sources, while still meeting the requirements of the community homebuyer loan program, can increase the borrower’s choices. Private Mortgage Insurance (PMI) Private Mortgage Insurance protects lenders against actual losses in the event of default and is required when the proposed down payment is lower than allowed by guideline. Borrowers pay for the mortgage insurance as an inducement for a lender to approve a loan with a smaller down payment. A number of private mortgage insurance companies (MI's) entered the market to insure loans in the early 70's as a cost effective alternative to the Government's mortgage insurance program administered by FHA. Before PMI it was difficult to induce conventional lenders to make loans in excess of 80% loan to value. It has made this country's real estate market much more dynamic. Until the early 80's obtaining mortgage insurance was a "rubber stamp" formality. But the prevailing dire economic conditions - hyperinflation, the oil belt's demise, and the end of rampant real estate speculation - caused the insurers to lose money. High interest rates, negative amortization and uncapped ARMs took their toll on portfolios and default rates skyrocketed. Insurers had relied on lenders to make prudent underwriting decisions and had issued insurance certificates more or less in concurrence with the lenders approval. Since it is the MI who pays the preponderance of the loss in the event of default, their only recourse was to begin to diligently review and approve each submission independent of lender review. The result is that there is a second "matrix" of guidelines that a NonGovernment insured loan must meet before Top Private Mortgage Insurance Companies it can be fully approved. Meet the Insurers At one point, there were over 20 private mortgage insurance companies. Today, with the consolidation and contraction in the in-

Chapter 3 – Loan Plan Specifications - Page 52

Radian Guaranty Genworth United Guaranty Insurance Company (UGI) Mortgage Guaranty Insurance Corp. (MGIC) CMG Insurance Group (Credit Union) Essent Guaranty, Inc. National Mortgage Insurance Corporation


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

dustry, there is only a handful. Mortgage insurance is a state regulated industry, so premium schedules, rate cards and policy performance has to be filed and approved with each individual state insurance commissioner. As a consequence, there is great uniformity in rates and plans. The loan originator needs to be aware of the differences in underwriting standards and rates as part of the loan plan specification learning process. Because mortgage insurance offsets the riskiest part of a mortgage, the 2007 – 2008 credit crises has gravely affected the companies’ survivability. Premium rates have increased and guidelines have become strict. Mortgage Insurance Coverage Requirements It is a common belief that PMI coCalculating Mortgage Insurance Coverage Requirements vers the amount of the mortgage Sales Price $ 100,000 above 80% loan to value because Down Payment 5% $ 5,000 that is the level over which PMI is a.) LTV/Loan Amount 95% $ 95,000 b.) Exposure Allowed 75% $ 75,000 generally required. This is not the c.) % of Loan Insured/Coverage (c/b) 0.21 $ 20,000 case. Depending on the risk, a lender may require "deeper" coverage. For instance FNMA requires basic coverage which reduces its exposure (the amount of the loan that the lender is liable for in a loss) to 70% LTV. Coverage requirements vary substantially. The best source of information is a PMI representative. While lenders traditionally are responsible for obtaining mortgage insurance coverage, brokers should be aware of the guidelines. Some companies now prohibit broker ordered PMI. Several PMI companies no longer accept broker originated loans. Mortgage Insurance Premium Plans Mortgage insurers, just like other insurance companies, are regulated by individual states for consumer protection purposes. Premiums charged cannot change without the insurer filing for a rate change within a state. In addition, premiums charged are reviewed against loss experiences for uncompetitive or predatory pricing practices. As a result, PMI premiums are remarkably similar from MI to MI. One distinction is that certain companies may discount their premiums to lenders whose loss experience is minimal or exemplary. Although the homebuyer doesn't normally get to participate in the decision of to which company the mortgage insurance application should be sent, they should have the opportunity to review all of the premium plans available.

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Mortgage Insurance Premium Plans

survey date 10/1/08

PLAN TYPE

Standard Coverages

Traditional/Split Plan w here a lump sum premium is paid to cover year 1. Subsequent Renew als are at a low er rate

Coverage 30% 25% 12%

LTV 95% 90% 85%

Monthly Plan where each month is paid as it is accrued. True pay as you go. Ensures lower escrow and closing costs.

35% 30% 25% 12% Coverage 30% 25% 12%

97% 95% 90% 85% LTV 95% 90% 85%

One Time Premium - may be paid in cash or financed on top of loan amount if LTV's are not exceeded. Lender Paid Mortgage Insurance Increased interest rate pays for PMI instead of borrower.

LTV 95% 90% 85%

1st Year Rate

30Fix 1.5 1.25 1

ARM 1.5 1.25 1

n/a n/a 0.94 1.04 0.62 0.73 0.38 0.39 One Time Premiums 3.05 3.4 2.1 2.25 1.25 1.3 30 Year Fixed 0.875% 0.625% 0.375%

Renew al Rate Years 2-10

ARMI n/a n/a n/a

30Fix 0.4 0.18 0

ARM 0.64 0.33 0.26

ARMI n/a n/a n/a

n/a n/a n/a n/a 1.08 0.94 1.04 1.08 0.78 0.62 0.73 0.78 0.44 0.38 0.39 0.39 - Cash Financed One Time Premiums 3.6 n/a n/a n/a 2.4 3.05 3.4 3.6 1.45 2.15 2.25 2.4 15 Year Fixed 0.625% 0.375% 0.250%

ARMs 1.250% 0.750% 0.500%

Choosing the Right Plan - Premium Plan Options The borrower must choose a plan that suits his needs in the same way he chooses a loan plan. The "traditional" premium plan has existed in its original form since the inception of PMI. There is an initial premium that is generally higher than the renewal premium. This reflects the fact that most defaults occur within the first year of the loan. The insurer collects premiums annually from the lender, but the lender collects 1/12 of the renewal premium monthly from the borrower and holds it in escrow until due. Until recently there were no other choices. In 1992, “One Time”, or single premium, plans were offered as an alternative to large up front premiums with monthly renewals. In a single premium plan, the premium may be paid in cash or financed - similar to the FHA MIP. One advantage of this plan is that, if the premium is added to the base loan amount - or financed - the additional interest may be tax deductible, whereas PMI is not. The monthly payments are devoted to Principal and Interest instead of PMI which means that the more competitive the rate, the more affordable premium financing is. A financed premium may result in a lower payment that could enhance qualifying. If the payment is made in cash there is a definite monthly payment savings. Beginning in 1993, Monthly Premium Plans, where the insurer collects monthly payments from the lender in lieu of the annual escrow plan, were offered as an additional option. Benefits: There is no up front, or initial, premium payment, making cash requirements far lighter than earlier plans. This is the only plan that works in conjunction with the higher LTV programs. The premiums are level throughout the life of the loan, which could result in higher payments over time than the "classic" plan. The most recent innovation is "Lender Paid MI" (LPMI) where the lender increases the interest rate, but waives collection of premiums. Benefits: The higher interest payment is tax deductible where PMI is not. A shortcoming is that, while you can petition a lender to cancel PMI, Lender

Chapter 3 – Loan Plan Specifications - Page 54


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Paid MI means the borrower will pay the higher interest rate for the life of the loan. Comparing PMI Plans Home Price Downpayment Base Loan Amount

Premium Total Loan Premium at Closing Principal and Interest PMI Renewal Escrow Monthly Payment Tax Benefits at Net Cost

$ 200,000 10.00% $ 180,000 Single Traditional Financed 0.65% 2.85% $ 180,000 $ 185,130 $ 1,170.00 $ 7.50% $ 1,258.59 $ 1,294.46 0.34% $ 51.00 $ $ 1,309.59 $ 1,294.46 $ 10.04 28% $ $ 1,309.59 $ 1,284.41

Monthly 0.52% $ 180,000 $ 156.00 $ 1,258.59 $ 78.00 $ 1,336.59 $ $ 1,336.59

$ $ $ $ $ $ $

To calculate the mortgage insurance premiums mulPMI Premium Calculation tiply the loan amount by the premium. If the premiLoan Amount um is an annual plan, divide the result by 12 months Multiply by Premium Rate for the premium to be collected monthly. If the Premium premium is a one-time payment, multiply the loan Divide by 12 for Monthly amount by the premium, and if the premium is to be financed instead of paid in cash, add it to the loan amount.

LPMI 0.625% 180,000 1,336.49 1,336.49 21.81 1,314.68

$ $ $

250,000 0.52% 1,300.00 108.33

PMI Underwriting Guidelines Because MI underwriting is "risk-based,” as opposed to underwriting for loan salability or "secondary marketing,” it can be subjective. As a result any restrictive guideline set forth may be overridden by compensating factors, depending on the insurer’s risk experience with a specific profile. HOPA and PMI Cancellation Independent of the individual lender’s guidelines or property value, The Home Owner's Protection Act (HOPA) of 1998 provided for mortgage insurance cancellation once a property achieved these benchmarks.   

Guidelines for Canceling PMI The decision to allow a mortgage insurance contract to be cancelled rests with the servicing lender. However, a borrower may petition to cancel PMI if the following conditions are present: PMI has been in force > 24 Mos. LTV is 80% with Principal Reduction LTV is 75% with Appreciation Still Owner Occupied No Late Payments in 24 mos.

Loan balance has declined so that LTV is 78% of original sales price/value or Loan has reached the chronological “midpoint” such as 180 months into a 30 year loan and There are no 30 day late payments in the last 12 months or 60 day late payments in the last 24 months

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Although VA and FHA loans are not covered by the law, the guidelines for FHA mortgage insurance have been changed to meet the law. Any loan other than conforming is considered a “high risk” loan – including jumbo or other non-conforming loans – and the LTV must be 77% for PMI cancellation. The Federal Housing Administration (FHA) The FHA program, as it is referred to, is not a loan program but a mortgage insurance program implemented by the US Department of Housing and Urban Development (HUD) in 1934 to encourage banks to make home loans after The Great Depression. FHA insurance completely protects lenders against potential default. Borrowers pay for the insurance through monthly and lump sum mortgage insurance premium plans (MIP). Although banks, savings and loans and other private lenders could utilize this insurance for non-agency holdings, most FHA loans are sold into the secondary market in Government National Mortgage Association (GNMA - also known as “Ginnie Mae”) pools. Many state bond loan programs for first-time/lower income home buyers utilize FHA insurance in lieu of Private Mortgage Insurance (PMI). The FHA insurance program bears all the idiosyncrasies of any politically motivated program. As the country develops new housing needs or challenges programs are added to address the need. Loan amounts vary from county to county (See https://entp.hud.gov/idapp/html/hicostlook.cfm). The program is continually changed. Changes are effective with new applications, a policy that protects existing approvals/commitments. Although automated underwriting is utilized, lenders can still make subjective underwriting decision, with much emphasis placed on helping first time or otherwise disadvantaged buyers. Program/Section of Housing Act 203 (b) 234 ( c ) FHA Secure 203 (h) 255 HECM 203 (k) Energy Efficient Mortgages 251 245 Title I

Description Single Family Housing Individual Loan Insurance Program – the standard FHA program – 30 year fixed Financing for Owner Occupied Condominiums Allows the refinancing of delinquent ARMs 1 Unit, 100% Financing for victims of National Disasters Reverse Mortgage (Home Equity Conversion Mortgage) allows the property to be used as collateral for Seniors – various payment plans Substantial Rehabilitation/Renovations – Streamline 203(k) limited repairs where the borrower can move in within 90 days. Purchase a home and finance energy efficient improvements Adjustable Rate Mortgage programs – 1 year ARM - 3/1 and 5/1 (Hybrid) ARMs Graduated Payment and Growing Equity Mortgage Insurance Manufactured Housing Loans – purchase of new or existing manufactured housing.

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Insurer - Guarantor

Federal Housing Administration (FHA)

4/1/2012

LTV Matrix Owner Occupied

Transaction

LTV

CLTV

2nd Home

Investor

LTV

LTV

Property Type Loan Amount

High Cost Loan Max (by county/SMSA)

Single Family, $ 271,050 $ 729,750 Condo Purchase or Rate and Term N/A N/A 2 Unit $ 347,000 $ 934,200 Refinance - LTVs effective 4/9/12 Rate Refi N/A N/A 3 Unit $ 419,400 $ 1,129,250 97.75% N/A N/A 4 Unit $ 521,250 $ 1,403,400 85% N/A N/A N/A SFD, Condo $ 271,050 $ 729,750 Cash Out 30-, 20-, 15-, 10- Year fixed (Sections 203b & 234c). 1-Year ARM with 1/5 caps, 3/1 and 5/1 ARM (Sec 251), Rehabilitation/Construction Permanent loan (Section 203k), Reverse Mortgage (Home Programs Offered Equity Conversion - no high cost areas 1 family only), FHA Secure, Energy Efficient, Disaster Recovery 96.5% Base

>100% only with government agency or refi

N/A

N/A

Assumability Feature

Mortgage Origination Date

Assumability

Mortgage Insurance (for monthly add .25 for loans over $625,500 (effective 6/11/12)

Automated Approval Refinancing Eligible Properties Qualifying Ratios Documentation Types Non-Occupant Co-Borrowers Self-Employment Trailing Spouse

Secondary Financing

Cash Reserves Gift Letters Seller Contributions Required Contribution Borrowed Funds Credit Scores Multiple Properties Non-Resident Aliens Major Derogatory Credit

prior to 12/1/1986 12/1/86 - 12/14/89

Fully Assumable for $125 Fully Assumable for $125 for owner occupants, Investors must put 25% down

12/15/89 - present

Assumable by approved substitute Owner Occupants only for $500

Loan Term

Upfont MIP

16 to 30Year 5 to 15Year

1.75 1.75

Monthly Premiums Based LTV 90% or Less 1.20 0.35

90.01 - 95% 1.20 0.60

over 95% 1.25 0.60

Yes - "Total Scorecard" / DU/LP or other y ( AUS ) g g py y and payment reduction, borrowers do not requalify. No income/asset documentation is required. Loan amount can only be increased for closing costs with new appraisal. UFMIP is 1.00% Refi of loan originated before 5/31/09 - is only .01 effective 6/11/12 . May subordinate existing debt regardless of LTV. SFD, 2-4, Condo, PUD - Condo Units must be approved https://entp.hud.gov/idapp/html/condlook.cfm Income Restrictions 31/43 ARMs and buydowns qualify at 2nd Year rate if LTV is greater than 95%. Or TOTAL Scorecard, DU or LP. May exceed with documented factors FULL and alternative documentation No Restrictions - May not be used for qualifying on 2-4 family properties, Cash-out Refinance or loans over 417,000 Minimum 2 years, recommend 5 Years Not considered. CAUTION - may only have one FHA insured loan. 1.) must still make required down payment 2.) cannot exceed statutory sales price/mortgage amount, 3.) No Prepay Penalty 4.) regular payments 5.) Min term > 10 yrs. Refinancing existing debt or FHA Secure may subordinate excess payoff into 2nd lien. Count monthly payments unless no repayments required for >36 mos. May exceed with state agency assistance programs/financing Asset Restrictions 15-days interest - borrowers with alternative credit files need 2 months Acceptable from any non-interested source. FHA "prefers" buyer has 25% of own cash. Donor may borrow (secured) funds for downpayment. Must still verify gift, transfer and receipt of funds. NonProfits funded by sellers are closely watched - may be eliminated. 6% of Sales Price, including discount, buydowns - NOT prepaid items. Borrower MUST invest 3.5% downpayment, excluding closing costs or downpayment. Must be secured/counted for qualifying. Credit/Borrower Restrictions Below 580, Max LTV 90% - Other scores dependent on lender/secondary market (usually 620 min) ONLY ONE PROPERTY WITH minimum down payment. No restrictions Significant derogatory credit may be tolerated with documented extenuating circumstances. Refer by TOTAL on Bankruptcy, Chapter 7 - 2 Years from discharge; Chapter 13 - 1 Year from discharge. Foreclosure - 3 Years from liquidation.

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The Direct Endorsement Program (DE) DE allows approved FHA lenders delegated authority to commit FHA insurance. This speeds the loan process and takes the approval authority out of the government's hands. DE means that, in addition to approving a borrower, the lender is also approving the property. The Substantial Rehabilitation (203(k)) program is not authorized for DE in most regions. Using Automated Underwriting – FHA TOTAL Scorecard In conjunction with any automated underwriting system, such as DU, LP or other proprietary model, FHA loans may be underwritten by “calling” the FHA TOTAL scorecard. This evaluates the risk of the loan pursuant to FHA’s standards. TOTAL will result in either an “accept” or “refer” finding. Refers are triggered by excessive housing or debt ratios, credit files, foreclosure within 3 years, bankruptcy discharged within 2 years and late mortgage payments (3 x 30, 1 x 60 and 1 x 30, or 1 x 90) within the last 12 months. The Direct Endorsement underwriter may override the Total Scorecard Findings. Credit Scoring and FHA – The “Decision Score” FHA was one of the last areas in the mortgage industry to eschew the use of predictive scoring in underwriting, preferring to rely on the subjective decisions of human underwriters. Even though the agency didn’t establish minimum guidelines, purchasers of mortgage backed securities and servicers often require an industry minimum credit score of between 600 and 640. Effective with the implementation of risk based underwriting on July 14, 2008, LTV ratios and premiums are now driven by “Decision Scores.” Having a substandard score doesn’t mean ineligibility, but requires a larger down payment. FHA Mortgage Insurance Premiums FHA is motivated and influenced by politics and the agenda of the incumbent administration. Current government insurance rate premiums reflect this. FHA Mortgage Insurance Premiums (MIPs) have changed over time to reflect the needs of the marketplace and the solvency of the FHA Mortgage Insurance Fund. The fund has performed well over time. The government has profited from surpluses in the insurance fund. Beginning in the late 1990s conventional lenders and investors began to dramatically relax underwriting guidelines. Mortgage brokers rushed into the origination business offering ALT-A and sub-prime loan programs that required little or no qualifying. Borrowers who previously would have utilized FHA insured financing weren’t offered FHA programs by mortgage brokers. For lenders and brokers, being approved to offer FHA programs requires a level of cash investment and operational discipline that is not required by conventional investors. Many brokers and lenders stopped offering FHA products even though conventional alternatives carried higher rates and less favorable terms for borrowers. Easy underwriting and large commissions for brokers created an environment where the FHA share of the home financing market fell to 1.9% in 2006 from over 18% in 1995. Then, in 2007, a ripple of delinquencies and foreclosures for alternative products caused a global meltdown in the credit markets. Suddenly alternative products

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were no longer available. The global real estate market experienced a severe downturn. FHA was one of the government’s tools in ending the Great Depression. Today FHA is a cornerstone in the recovery plan for the national housing and credit markets. 2007 – 2010 Transitional Issues with FHA FHA will continue to experience flux in the areas of LTV calculations, Mortgage Insurance Premium (MIP) structure and maximum loan amounts. In addition, the “rescue” programs, such as FHA Secure, had a limited time horizon. It is challenging to print a document in this environment, as it is uncertain what a final outcome will look like. Fortunately, for mortgage industry participants, change does not affect cases in process. FHA changes become effective based on the application date which lies in the future. Risk-Based Insurance Premiums – No Longer in Effect One of the initiatives policymakers at FHA have advocated, as a pathway to increased utilization of FHA insurance, is a system of insurance premiums that reflect the risk of the individual loan being insured. The reform was intended to mirror the private mortgage insurance model. HUD’s system has always been egalitarian – regardless of your profile, you pay the same insurance premium. For HUD to adopt risk-based premiums was a huge departure from this philosophy. Congressional oversight seemed to preclude this change, but FHA, in an unusual maneuver, simply implemented its plan, and dared congress to overturn it. Effective July 14, 2008, FHA’s mortgage insurance premium schedules were based on a combination of credit score and down payment amount. Less than one month later, congress enacted the Homeownership and Economic Recovery Act of 2008 which, among many other things, put a moratorium on risk based pricing and mandated larger down payments for FHA loans. As a consequence, FHA mortgage insurance changed again. And so the pendulum swings, FHA’s guidelines will continue to change reflecting market conditions. Financing Mortgage Insurance Initial Up Front Mortgage Insurance Pre- Financing the UFMIP mium (UFMIP) MUST be financed in ad- Base Loan Amount $ 130,000.00 dition to the base loan amount. Once the Multiply by UFMIP % 1.00% base loan amount has been determined, Total UFMIP $ 1,300.00 $ 131,300.00 the UFMIP is added to determine the total Loan Amount with MIP Financed Equation 1 Check the MIP factor, which may change based upon the loan amount. FHA allows for refunds of date. unused MIP. A portion of the borrower’s upfront cost will be returned if the borrower pays off the loan within the first 3 years.

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The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

The Refinance Conundrum Previously the issue of MIP refund confounded the FHA loan amount calculation on refinances. Since there is no down payment on a refinance, the maximum LTV of 100% is utilized to determine the base loan amount. Equation 2 - Depending on the date, you might use a different MIP factor. Simply, divide the appraised value by the appropriate MIP percentage. The result is the maximum base loan amount without MIP. Cash out refinances are still limited to 95% base LTV. The only products that this calculation applies to are the “Streamline Refinance” and the FHA Secure Refinance. FHA LTV Calculations After 1/1/2009 The Homeownership and Economic Recovery Act of 2008 (HERA) mandated that FHA down payments be a minimum of 3.5%, and that LTV ratios, with Mortgage Insurance Premiums financed, could not exceed 100%. The only programs exempt from these LTV guidelines are refinances and Home Equity Conversion (Reverse) Mortgages. FHA Secure Refinance Program – Cancelled 12/31/08 This program was designed to help borrowers who had non-FHA mortgages and who had been adversely impacted by loan resets. The idea behind the program is to allow borrowers to refinance out of those loans. The only difference between a regular FHA refinance and the FHA Secure is that the existing mortgage may be delinquent. If the existing mortgage is delinquent, the borrower must pay a higher Mortgage Insurance Premium of 3.00%. This program is set to expire 12/31/08. Eligibility is determined by using the following checklist Checklist for FHA Secure Eligibility Delinquent non-FHA ARM that has reset – provide copy of note Maximum mortgage late - 1x90, 3x30 or 1x60, 2x30 0 x 30 prior to reset – provide letter of explanation Max LTV based on 203(b) maximum < max LTV, new loan may include missed payments, no credit line advances of more than $1,000 over last 12 months Over maximum LTV existing lender may 1. ) write off balance 2.) hold 2nd for unpaid costs, 2nd mortgage - must qualify with payments if payments are delayed < 36 months using 31/43 ratios. No ratio exceptions

Documented Underwriting “Compensating Factors” Compensating Factors for exceeding standard ratios of 31/43 must be documented in the loan file. 

Three months reserves - limited debts

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         

10% down Less than 10% housing payment increase Outside income not counted in effective income Non-Taxable income Temporary/Seasonal Income Shorter Mortgage Term by 5 years Smaller Family - higher residual income Energy Efficient Dwelling 2% Ratio increase 25% or more down payment - Ratios not considered important Pre-purchase Counseling (may also result in lower MIP)

The Department of Veteran's Affairs (VA) VA acts as a guarantor and, in effect, co-signs loans for eligible veterans. The program inception in 1944 was designed to help veterans returning A History of Loan Guaranty Entitlement from WWII finance a home purchase with no re1944 - W orld War II - Inception $ 4,000 sources aside from income. (The Act authorizing After 7/12/50 Increased to $ 7,500 the program is called the Servicemen's Readjust- After 5/7/68 Increased to $ 12,500 After 10/2/78 Increased to $ 25,000 ment Act of 1944) The government guarantees it After 10/1/80 Increased to $ 27,500 will pay back the guaranteed portion of a loan on After 2/1/88 Increased to $ 36,000 which an eligible veteran defaults. Increased 12/18/89 for veterans with full entitlement and for purchases $ 46,000 With mounting losses in the late eighties, due to over $144,000 Increased 10/13/94 – basic remains defaults, congress implemented a formula that VA at $36,000 $ 50,750 utilizes to determine how it resolves defaulted Increased 12/01 – basic remains at loans. VA may buy the house from the lender at $36,000 $ 60,000 $ 89,913 foreclosure - for the balance outstanding - and as- Increased 12/04 - 25% of FHLMC Increased 12/05 - 25% of FHLMC $ 104,250 sume the responsibility of disposing of it. Or they may simply pay the lender the amount of the guaranty in cash, at which point the lender is forced to dispose of the property - which is referred to as a “No Bid.” The potential of a loss to the lender is much greater since the adoption of the “No Bid” policy and as a result lenders have taken steps to offset this risk. These include charging higher points for VA loans and instituting more conservative underwriting standards than VA itself promulgates.

VA No Bids aside, the VA Guaranty Program still offers the most aggressive lending guidelines available. The philosophy is "let's get the Veteran in the home.” Entitlement and the Maximum Loan Amount The VA Guaranty program is a kind of employee benefit program. The idea is to help veterans buy homes so that, theoretically, the VA is the veteran's co-borrower. The question is "how much is guaranteed"? Each eligible veteran is given a "loan guaranty entitlement.” The amount of this benefit has increased with time as home prices have increased. The trick is that the entitlement is never exhausted. It may be utilized to guaranty a loan on a veteran’s home, but as

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Insurer/Guarantor Department of Veterans Affairs Transaction

Owner Occupied LTV CLTV

Purchase or Rate and Term Refinance Cash Out Refinancing Programs Offered Mortgage Insurance Eligible Properties

Secondary Financing Automated Approval Assumability Qualifying Ratios Documentation Types Trailing Spouse Non-Occupant CoBorrowers Self-Employment

Seller Contributions Cash Reserves Gift Letters Borrowed Funds Multiple Properties Credit Scores Major Derogatory

100%

N/A

N/A

90%

N/A

N/A

Property Type Single Family, Condo, 2-4 Family Single Family, Condo

Loan Amount at 100%

Hawaii, Alaska*

$

729,450

$ 1,094,175

$

729,450

$ 1,094,175

Streamline Refinance - With 12-month mortgage payment history and payment reduction, borrowers do not requalify. Loan amount can only be increased for closing costs with new appraisal. 10 - 30-Year Fixed Rate. VA Funding Fee is in lieu of Insurance. See "Risk-Based" Premium Charts SFD, 2-4, Condo, PUD - Condo & PUD Units must be approved Servicemen with documented eligibility have at least the following active duty: 90 Days WWII Korea Vietnam

Eligible Borrowers

LTV Matrix 2nd Home Investor LTV LTV

9/16/40-7/25/47 6/27/50-1/31/55 8/05/64-5/7/75

181 Days Pre-Korea Post-Korea Post-Vietnam for Enlisted for Officers

7/26/47-6/26/50 2/1/55-8/4/64 5/8/75 to 9/7/1980 10/16/1981

24 Months Current Active Duty

after 9/7/80 for Enlisted after 10/16/81 for Officers 6 Years Reservists/National Guard Members (Expires 10/99) Also Eligible NOAA Officers; Commissioned Public Health Officers; ESSA Officers; C&G Survey Officers; Veterans discharged prior to eligibility due to service-related disability; surviving spouse of veteran who died as a result of service related injury or disease. Veterans and their Spouses. Eligible Veterans have served continuous active duty for at least the time frames listed and have an honorable release or discharge.

Allowed. Note must be at least 5 years in length. Since VA is no money down formula, 2nd mortgage would only be used to exceed the maximum financing of $240,000/$359,650 Loan Prospector $500 Fee. New borrower must qualify. No Release of Liability (except assumed by another ve Income Restrictions 41/41 Full, Alternative Documentation Not Considered - Veterans regularly relocate Veterans and their Spouses ONLY. Eligible Veterans have served continuous active duty for at least the time frames listed and have an honorable release or discharge. Minimum 2 Years - Recommend 5 Years Asset Restrictions 4% of sales price, not including points. Transaction may be structured so that borrower pays no money at closing, but borrower may not receive cash back at closing. None Required May come from any source not involved in transaction. Must verify donor, transfer and receipt of gift funds. Funds may be borrowed - must be counted for qualifying. Credit Restrictions Number of VA Loans is limited by base entitlement $36,000 - must have full for over 144,000. Not considered. Significant Derogatory Credit may be acceptable with extenuating circumstances.

soon as that home is sold and the loan is paid off the veteran has that portion of entitlement back to use again. This is important because of the issue of partial entitlement and the potential for a veteran to have remaining entitlement even though they may still have a previous home loan guaranteed by the VA. The only way to restore eligibility is to sell the home or have the loan assumed by an eligible veteran who substitutes their eligibility for the original veteran.

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The Maximum VA Insurable Loan The amount of available entitlement a veteran has is important because it determines the LTV or the maximum loan for a property. GNMA requires that its exposure be limited to 75% LTV. This means that the "top" 25% (or riskiest) portion of the sales price must be guaranteed or paid in cash in order for the loan to be eligible for sale. To determine a veteran’s maximum loan, start with the sales price and multiply by the maximum exposure tolerated (75%). Then add the available entitlement to determine the minimum down payment requirement. VA Loan Amount Calculation

Example 1: Full Entitlement

Sales Price X 75% + Eligibility = Base Loan Amount Plus Funding Fee = Loan Amount with Funding Fee.

Sales Price $200,000 x 75% =150,000 Eligibility + 60,000 Base Loan $200,000 = Downpayment 0

Example 2: Partial Entitlement $22,000 Sales Price x 75% Eligibility Base Loan = Downpayment

$100,000 = 75,000 + 22,500 $ 97,500 2,500

Note: Even though not all entitlement is used, the maximum LTV is still 100%

Note: Even though the VA Program is 100% Financing this is limited by Eligibility There are some limitations to the use of loan guaranty eligibility: 1.) Entitlement remains tied to the property it was used to purchase, so cannot be restored until the property is sold. 2.) In high cost areas, the veteran may only use the high cost eligibility (over $36,000) with full entitlement.

The amount of loan guaranty entitlement a veteran has is determined by obtaining a Certificate of Eligibility from the Regional VA Office. It is a little green form - a certificate - that states the amount of entitlement available for loan guaranty. The Veteran MUST have this original form to close on a new VA loan. The Funding Fee The VA Funding Fee is not an insurance premium but a one-time charge. It is tantamount to a user fee. VA allows the funding fee to be financed, or added to the base maximum loan amount up to the maximum GNMA Loan Limit, or $417,000. Because of the losses experienced in the program, the fee schedule has been increased to be, in some cases, prohibitive. In addition, newly eligible borrowers - specifically reservists - pay a higher premium than normal veterans. Disabled Veterans are exempt from payment of the Funding Fee – any percentage of disability entitles the veteran to receive this waiver. Funding Fee Active Duty 2.20% 3.30% 1.50% 1.25% 0.50%

Funding Fee National Guard/Reservist 2.40% 3.30% 1.75% 1.50% 0.50%

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Transaction Type Purchase with less than 5% Down or Refinance Purchase with less than 5% down with Restored Eligibility Purchase with less than 10% Down Purchase with 10% or More Down Streamline Refinance


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

Tax Exempt Revenue Bond Issues and First Time Buyer Programs Affordable housing has long been an “American Dream” paradigm. Promoting homeownership has many benefits. It creates communities, can cost less than renting, but most importantly, the first-time entry buyer is at the bottom of the real estate food chain. Each purchase can create a string of transactions trickling up, so to speak. Federal housing programs are under funding pressure. Higher user fees and insurance have made Characteristics of Bond Programs these programs less attractive than in the past. As a re- Home prices are generally limited to sult a number of initiatives promoting homeownership 90% of average home prices. New homes may be categorized differently have come from the states as well as private industry. The Federal Bond Subsidy Act authorized state governments to issue tax-exempt revenue bonds for the purpose of funding loans to low and middle-income home purchasers. (The act also allows the underwriting of loans in apartment complexes that comply with affordable housing initiatives.) The bonds are attractive to investors because the interest from them is generally exempt from federal and state income tax. Because the interest is exempt from income tax, the effective yield to the bond buyer is much higher than the coupon or actual rate of interest. As a result, these types of bonds can be offered at much lower interest rates than comparable taxable bonds and still be competitive in the credit markets. In turn, a first time homebuyer can obtain a lower rate loan.

than existing homes. Incomes are limited to 80% of median income for the area for moderateincome households or 100% for lowincome households. Targeted Areas: May offer lower rates or ignore guidelines for areas in which the economy is worse. Targeted Areas: Census Tracts in which the median income of 70% or more of families have income that is less than 80% of the statewide median income. At least 20% of funds from each bond issue must be targeted.

In order to qualify for tax exempt financing the borrower must meet certain guidelines. Most important, they must be first time homebuyers - defined as not having had an interest in real estate for the past three years. However, there are specific limitations from state to state, depending on economic circumstances in any area. These programs may utilize FHA insurance, VA guaranty, Private Mortgage Insurance, or the state may offer a Mortgage Insurance fund in which the borrower can participate. In each case, those guidelines supersede those of the bond issuer. If borrower’s utilize tax-exempt revenue bond financing, they will be subject numerous covenants and restrictions. One significant aspect is that the borrower may be subject to a penalty or recapture tax if the home is sold before the incentive period expires (between 5 - 10 years/ tax up to 6.25% of original mortgage amount). Loan Level Price Adjustments – You May See Them or Not When you study credit scoring and risk grading, you will note there is a correlation between risk and the rate that is charged on a loan. One of the advances that came with the sophistication of the secondary mortgage market is the ability, on certain programs, to add features on an “a La Carte” basis. These features expand “niches” or guidelines that are restrictive in the Generic Conforming Specifications and charge a rate or point premium to offset the perceived risk. In

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addition to the major expanded criteria programs, FNMA and FHLMC, and most investors in the secondary market have adopted this methodology for adjusting the price of loan to compensate for specific risk criteria. This makes accurately pricing a loan very challenging and fraught with the possibility of an error. To offset this problem, loan officers should use a price quote worksheet that identifies all possible add-ons. Then the “net price” can be correctly quoted. When these items are not addressed, they can result in unexpected “price-bumps” for the loan officer and possibly for the consumer. The key is in weighing whether an option on a specific loan could be obtained without a pricing option. When this occurs it is what we call a “pricing event.” A pricing event is when a customer knows there is a credit challenge to an area of the loan because other loan officers have told them. Typical pricing events are: 1.) 2.) 3.) 4.) 5.)

Inadvertent late mortgage payment in the last 12 months Adverse credit references High investor concentration in a project Self-employment Investment Property

It is in situations like this where the professional loan officer can add value to the loan by finding a specific program that allows for the nuance without pricing premiums – such as switching the borrower from a conventional loan to an FHA loan. Price Quote Worksheet Base Rate Add on For: Loan Amount Buyup/down Points 0.375 add to price for -0.125 in rate Buyout Pre-payment Penalty Buydown Points Owner Occupied LTV Owner Occupied Cash Out LTV Stated Income LTV No Income/No Asset LTV Investor Cash Out LTV Investor Purchase LTV No Income Investor No Income No Asset Investor No Ratio Investor 2nd Home Purchase LTV 2nd Home Cash Out LTV Condo Low/HighRise 2-4 Family A- Credit LTV NO PMI LTV BK/FC Credit Event Long Term Lock Escrow W aiver Margin Buyup 0.125 add to price for -0.125 in margin 2nd Mortgage Streamline Refinance Net Price

Rate 6.250

Points -0.500

-0.375

1.125

0.500 2.500 -0.250 0.125 0.250

Margin

Explanation The base price from the rate sheet Premium charged for larger or smaller loans Buying up means adding to the rate to reduce the points - buying down means adding to the points for a lower rate A fee may remove a prepayment penalty The cost of a Temporary Buydown (2-1-0) Adjustment for lower LTVs and O/O Price up for Equity Out Reduced Documentation loans pricing increases with LTV Investment property loans are much riskier than owner occupied properties, so as LTV increases and documentation is reduced, price increases.

0.500 0.500 0.375

0.250

7.625

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3.625

2nd/Vacation homes are slightly riskier than residential properties so the price is higher. Non-FNMA condos and those over 4 stories Multi-Unit Properties "Just-Missed" credit is priced up The rate premium for waiving Private MI If a Bankruptcy of Foreclosure is in evidence New Construction-Longer Lock=higher price Fee to not collect Taxes/Insurance Escrows Just like buying up or down the interest rate, the lender may accept a higher ARM initial rate for a lower ARM margin or vice-versa. Rate/point premium for secondary financing Premium for reduced documentation refinance


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Chapter 4 - QUALIFYING Ratios and Credit History Understanding Guidelines Knowing loan program guidelines is critical to loan officer success. You could say that guidelines are the rules by which the mortgage game is played. The strategy of the game is in fitting a borrower into the guidelines. How an individual borrower fits, or fails to fit, those guidelines are the process of qualification. A skilled loan officer isn’t needed to process a transaction where the borrower easily qualifies. When there is a problem with an application, the loan officer needs to be able to fix it. Detailed qualifying is problem solving for insufficient income, excessive debts or insufficient assets. The problem with guidelines is that the rules are only as effective as the information that is applied to them. Seeing if a borrower meets ratio requirements is more than applying income against expenses - the question is what income and what expenses? In this sense qualification is field underwriting that requires judgment about the context of the information the borrower presents. Abandon Pre-conceived Notions Qualifying for a mortgage is one of the biggest fears new borrowers experience when approaching a lender to apply for a loan. This is due to the valuable, but conflicting, free advice that is offered to borrowers when a planned home purchase is announced. In general, care should be taken to actually work through the details of an individual transaction - never use "rules of thumb" or broad estimates to determine qualifications. Even if there is some basis in fact to the estimate or generalization, this does not add credence to the assumption. Start by throwing away these:   

Your home shouldn't cost more than 3 times your annual income. Your closing costs will range between 3 and 7% of the sales price. You shouldn't spend more than one-quarter of your income for your house payment.

The loan officer's job is to make an accurate assessment of borrowing capacity. Unfortunately, no one aspect of qualification is mutually exclusive of another - so that that when we look at qualifying as to income, we cannot ignore assets, credit and other eligibility criteria or viceversa. Qualifying has to be taken as a whole, so while it makes for an extensive treatment, this chapter will address all specific aspects of qualification beyond the guideline matrix. We will Chapter 4 - Ratios and Credit History – Page 67


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

assimilate the information that will be applied against guidelines to see if a borrower qualifies. Owner Occupancy and Qualifying The basis behind the underwriting guidelines, how and whether they may be exceeded, is predicated on one critical risk analysis factor - does the individual live in the property? The theory is that a person has more willingness to repay a loan when times get hard if they are supporting their shelter. As a result, guidelines are more flexible for borrowers who are buying a residence. A second home, or vacation home, is viewed more skeptically. Obviously an investment property is the riskiest loan to make from the lender’s perspective and so is not likely to be flexible on exceptions to guidelines. Can a person have two primary residences? There are certain circumstances where this is possible. Take, as an example, the circumstance we refer to as the Maury Povich/Connie Chung Syndrome. (They are East Coast broadcast journalists - Maury lived in Washington, DC and Connie worked for a network in New York.) Obviously, there were going to be two primary residences in this family. Any individual who spends a predominant amount of time in two separate places may be entitled to two loans utilizing primary residence guidelines. Another instance of multiple primary residences is one where there is a co-borrower situation where one of the borrowers will occupy the property as a home. Ratios In today's lending environment, qualifying ratios determine whether a borrower is eligible for a specific loan program. A ratio measures the percentage of gross income that may be devoted to expenses. Each loan program has specific qualifying ratios allowed for underwriting purposes. Where did ratios come from? As Income Increases Flexibility Increases How can a set of numbers be firmly established to apply to a whole population? For Income $ 4,000 $ 10,000 instance the "conforming" loan qualifying Tax $ 1,120 $ 3,300 ratio guideline is 28/36. If these "conformFamily Support $ 3,226 $ 3,226 ing" guidelines establish industry standards Available for Housing $ (346) $ 3,474 then arguably most homebuyers are expected to meet this test. Ratios may seem arbitrary and may not seem to take into account unique aspects of individual financial structures. Qualifying ratios have evolved to take into account the "general" financial obligations of a prospective borrower.

Their basis is in what people have to spend money on (or pay for), subtracting that amount and analyzing the remainder. The remainder is discretionary - what is referred to as residual income - the amount left over after family support, housing, taxes, maintenance and debts. This is a cash flow method of seeing what a borrower can afford to pay. The original qualifying test was the “Residual Method" and is the precursor of ratios.

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The example on the right shows an "average" moderate income borrower qualifying under the residual method. The family support tables are the Department of Housing and Urban Development's (HUD) estimate of what it costs to live in specific areas of the country. If you compare the results of residual calculation and ratio calculation yields close to the same mortgage payment amount or total debt ratio as conventional qualifying for the low-to-moderate-income borrower. However, a borrower who earns $100,000 per year skews the residual method too greatly. This borrower would have nearly 2 times the amount of money available for a mortgage payment under the residual method as compared to the ratio method. As incomes have grown and housing costs increased, the cash flow approach would be too aggressive as a universal qualifying method. But this is where 28/36 came from - an era dominated by suburban, single income families of moderate means.

U n d erstan d in g R atio s - T h e R esid u al In co m e Ap p ro ach G ross M o n th ly In co m e Less F e d e ra l In co m e T a x 28% S ta te Inco m e T a x 8% S o cia l S e cu rity T a x 7 .6 5 % M on th ly L iving E xp e n se s Food C lo th ing D a y C a re /T u itio n C a r In suran ce G a s & O il R e p a irs A u to m o tive In su ra n ce O th e r T ra n sp ortatio n (P a rking , e tc.) E n te rta in m e n t T e lep h o n e H e a lth , M e d ica l D in in g O u t L a un d ry/D ry C le a n ing G roo m in g/H a ir U tilitie s M o nthly D e b ts Car C re d it C a rd s T o ta l F a m ily S u p p o rt C o st R e m a in in g In co m e

$ 4 ,0 0 0.0 0 $ 1 ,1 2 0.0 0 $ 3 2 0.0 0 $ 3 0 6.0 0 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

4 7 5.0 0 1 0 0.0 0 4 0.0 0 6 0.0 0 2 5.0 0 5 0.0 0 1 0.0 0 1 0 0.0 0 6 0.0 0 1 2 5.0 0 2 5.0 0 2 5.0 0 2 5.0 0 7 5.0 0

$ 2 2 5.0 0 $ 1 0 0.0 0 $ 3 ,2 6 6.0 0 $ 7 3 4.0 0

There are obviously many people who do not meet the typical mold. This is when the loan officer must be prepared to offer the residual/cash L e s s flow method to demonstrate how higher than R e a l E sta te T a x $ 1 5 0.0 0 standard-qualifying ratios may be acceptable. If In su ra n ce $ 2 5.0 0 $ 6 4.0 0 borrowers don’t have children, they don't spend as P riva te M o rtg a ge In s. M ain te n a nce $ 5 5.0 0 much for food or insurance. If they don't have a HO A Fees $ car, not only do they not have to make a car payment, but they don't have to pay for collision in- A m o unt A va ila b le fo r P & I $ 4 4 0.0 0 surance - the most expensive auto insurance. A borrower earning $200,000 per year would have the same level of family expenses as someone making $50,000 per year, because fixed costs don't increase as income increases. Higher income borrowers have more disposable income. This illustration is provided as a backdrop to understanding conventional ratios and where they come from. FHA and VA still utilize the Residual Computation to confirm ratio calculations. Conventional lenders do not set forth any guidelines for residual income. However, this is the primary method for justifying higher ratios than generally allowed under conventional guidelines.

The Mathematics of Qualifying Ratios Income and debt are inextricably blended in the qualification formula. As income increases and debt decreases, the size of payment the borrower can afford grows larger. Because a mathemati-

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cal equation is involved - numerator and factor - the results of these numbers change as any aspect of a personal financial situation change. Debts are the most important aspect of this equation - simply because of the way qualifying is structured. Understanding liabilities and their effect on income underlines why debts must be analyzed prior to income in the qualification process. This is just because of the way ratios work. In this example an additional $100 Debts are Much More Significant in the Ratio Analysis per month in liabilities creates a $ 200 $ 300 $ (100) need for an additional $300 per Monthly Debts Housing Expense $ 840 $ 840 month in income. In order to Total Debts $ 1,040 $ 1,140 qualify for another $100 in month- Income Required $ 2,889 $ 3,167 $ (278) ly debt the borrower’s income Increase in Income 10% would have to increase by 10%. Because it is easier to manipulate components of a debt structure than it is to make a borrower earn more money instantaneously, we are going to address monthly obligations in the qualifying analysis first. Specific Components of the Housing and Expense Ratios An individual's largest debt or obligation is normally the housing expense. Because having a roof over your head takes precedence over anything else, the percentage of your income devoted to housing expenses is called the first ratio, housing expense ratio or front ratio. Then there are the other debts that must be repaid, such as credit cards, car loans, other loans for education and debt consolidation. Any other obligation, such as alimony, child support, or regular payments for maintenance of negative cash flows on rental properties or mortgages must also be considered. The total debt is then added to the housing expense in total. The sum of these two obligations, when compared to income is referred to as the second, back, or total expense ratio. The Housing Expense Ratio Following are the components of the Housing Expense Ratio, also known as PITI:      

Principal and interest payment 1/12 of the annual real estate tax 1/12 of the annual premium for Homeowner's Insurance 1/12 of the renewal premium for Private Mortgage Insurance the monthly homeowner’s association fee for a condominium or a townhouse payment for any ground lease/land lease

Assume, as a starting point, that the maximum housing expense one can afford is 28% of gross monthly income. The question being answered is, "how much can I really afford to pay monthly for my home?” Numbers are only as good as the information you apply against them. For the loan officer, it is important to understand how to manipulate them.

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Playing with Principal Reducing interest rate/payment is the simplest way to achieve additional qualifying power. The example utilizes 28% as the maximum housing expense. A 2% reduction in interest rate can dramatically increase the maximum loan amount. How do you achieve interest rate or payment reduction? 

 

Illustration of Changing Interest Rate Impacting Loan Size Based on Income of Qualifying Ratio % Less Tax & Insurance Maximum Principal & Interest At rate of Results in Maximum Loan of

$

$ 28% $ $ $ 9% 113,902 $

4,166.00 1,166.48 (250.00) 916.48 7% 137,754

Changing program to a lower rate programs: a 7-year or 5-year program may carry a lower than 30 year fixed rate. An adjustable rate mortgage with start rate qualification might achieve the objective. Keep in mind that many ARMs have minimum qualifying rates. Subsidizing the monthly payment for a fixed period of time with a temporary buydown. Extending the amortization period of the loan from 30 to 40 years.

Adjusting Other Components of the Front Ratio We have shown how reducing the interest rate increases the maximum loan amount. There are other factors that can be considered to achieve the same effect. HOA/Condo Fees If financing of a condominium is contemplated, there will be a homeowner's association fee. This fee is for the maintenance of the common elements and for the operation the project. When unit utilities are included in the fee, one can deduct the portion of fees devoted to unit utilities from the condominium fee used to calculate ratios. The loan officer can document that the utility payments for the common elements can be excluded from the condo fee. To determine the amount to be deducted, analyze the project's current year operating budget. Add all utilities that are shown as line items in the budget. Divide the annual figure for utilities by the annual assessments to be collected from unit owners - do not include amounts from other sources, such as parking, laundry, vending etc. - to arrive at the percentage of condo fees attributed to unit utilities. The unit's fee may be reduced by this percentage for qualifying purposes. Another tactic in reducing the fee for qualifying purposes would be to have the seller participate in condo fee abatement by pre-paying a portion of the condo fee for a set period of time. If reflected correctly, by the association or property manager, this can reduce the assessment for qualifying purposes. A ground lease, where the land on which the property sits is not owned, is another component of the housing/front ratio. This may be the same of a cooperative apartment where there may be an underlying mortgage included in the maintenance fee.

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Real Estate Taxes A loan originator can investigate whether real estate taxes can be adjusted for qualifying purposes. If the current tax rate is incorrect or inappropriate for the subject property purchaser, they may be. Often the posted real estate taxes for a property are for a rental unit - thus the property might be taxed at a higher commercial rate. If qualification is a challenge, it is worth checking to make sure the current assessment is correct. Also, read the tax laws for your jurisdiction - do they offer tax break for primary residences or homestead exemptions? Are there breaks for owner-occupied properties, first-time buyers, senior citizens or low-income borrowers? Private Mortgage Insurance Private Mortgage Insurance, or PMI, is generally required whenever the loan to value ratio is greater than 80% (less than 20% down payment). PMI premiums may be reduced or eliminated dependent on circumstances. 1. 2.

3.

Can changing from an ARM to a fixed rate reduce the coverage requirement? Premium financing, while increasing the loan amount, can eliminate PMI from the ratio entirely. This will increase the loan amount, but the dollar for dollar savings to the customer will be magnified, because monthly PMI premiums are not tax deductible, while the interest on financed premiums may be. Can PMI be eliminated to the customer's benefit by utilizing a first and second mortgage combination? (See Chapter 2 - Loan Programs)

The Total Debt Ratio The total debt, back or bottom ratio is the measure of all other obligations a borrower is responsible for in addition to the total housing payment. As an example, if we use qualifying ratios of 28/36 this allows 8% of total income to be devoted to debts. A borrower who has accumulated a large amount of consumer debt can present a qualifying problem. In pre-qualification the loan officer works backward through the ratio analysis to see whether the housing expense will be limited by total debts. To determine this: 1.) Multiply Total Monthly Income by 28%. Enter Result as Total Housing Payment 2.) Multiply Gross Monthly Income by 36%. Enter Result as Total Monthly Obligations. Deduct all debts. Enter Result as Total Housing Payment. 3.) The smaller of these two numbers is the maximum PITI. Subtract all components (taxes, insurance, etc.) from the smaller number. The result is the Maximum Principal and Interest payment.

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In the following Example 1 the debts do not limit the qualification. In Example 2 the maximum housing expense is limited - lower because of higher debts. Some guidelines do not mandate that you compute a front, or housing expense ratio. In any situation a detailed analysis of debts is important. There are many details involved in correct treatment and computation of debts.

Example 1 Step 1 Monthly Income x Housing Ratio Available for PITI

$ 4,000.00 28% $ 1,120.00

Example 2 Step 1 Monthly Income x Housing Ratio Available for PITI

$ 4,000.00 28% $ 1,120.00

Step 2

Monthly Income x Total Debt Ratio Available For Debts Less Actual Debts Maximum PITI

$ 4,000.00 36% $ 1,440.00 100.00 $ $ 1,340.00

Step 2

Monthly Income x Total Debt Ratio Available For Debts Less Actual Debts Maximum PITI

$ 4,000.00 36% $ 1,440.00 $ 400.00 $ 1,040.00

Step 3

Smaller of 1 & 2

$ 1,120.00

Step 3

Smaller of 1 & 2

$ 1,040.00

What is a Debt? Any required monthly payment that can legally be collected from an individual - that must be paid - is considered in the debt ratio. The payments for credit cards, student loans, car loans, signature loans, rental negative on rental properties, alimony and child support or other support obligations, payments for other mortgages. Items that are elective in nature, such as automobile insurance, health insurance, life insurance, library fees, membership dues, savings plans and others are not considered debts, because you can choose not to pay these, and your privileges will simply lapse. You won't suffer a collection action if you don't pay your parking fees, you just don't park in the lot. Understanding the nature of each obligation - how it can be repaid in minimum, and how it impacts other aspects of a personal financial situation is - allows the loan officer to develop the maximum qualification potential of a borrower. We will discuss these in depth here - what the obligation is and how the repayments can be minimized for qualifying purposes. Credit Card Obligations - Credit cards are the single most abused forms of credit available to consumers. This is because many people receive offers to lend money at times when they are inclined to spend it in an ill-advised manner. For example, college students may receive a check from a credit card company saying “just endorse this check.” How can the average college students hope to pay even a minimal payment without income? What may ensue is a growing spiral of debt in which the borrower continues to borrow money to pay obligations, and supporting a lifestyle deficit - enhancing living expenses - with credit card purchases. In some cases, people in this situation can earn their way out of difficulty - their income increases to keep pace with the expenditures. In some cases people discipline themselves to curtail the escalating expenditures. Unfortunately, there is often the sad conclusion where borrowers give up and their credit is destroyed. Why is this description important? Maximizing a borrower's qualification is appropriate for in-

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dividuals who have shown that they can manage their credit, despite complications - it is a measure of character. In other words, someone who has managed his or her debts impeccably is an individual for whom qualification maximization is appropriate. Alternatively, someone who has periodically bailed out, or is in the credit spiral, is not necessarily a good person to whom the maximum amount of money should be loaned. Credit cards are revolving credit lines. Their minimum payments are based upon current balance, interest due and the previous payments. For a thumbnail qualification one would calculate the minimum payment at 5% of the outstanding balance. Actual minimum payments vary from 1 to 10% depending on the cardholder. But think about it. If the credit card company is earning 18% interest on the credit card balance, do they really want you to pay the balance down? Not really, so they encourage you not to make a payment for a month, or allow you to make a smaller than normal minimum payment.

Tactics for Handling High Card Payments 1.) A copy of all credit card statements should be brought to loan application. Occasionally, because of fluctuating balances, the correct minimum payment will not be reported to the credit bureaus. Having the statements at application will allow the loan officer to review that the correct minimum payments are reported. 2.) Involves planning - You may recommend that the borrower make a payment that is slightly higher - approximately 1.5 times the required minimum. Then when the next statement comes, the cardholder may require a smaller than normal minimum payment.

Alternatively, if debts must be paid off for qualifying purposes, it must be determined that the borrowers are not simply going to re-extend themselves with new credit. For this reason, an underwriter may not allow revolving debt to be paid for qualifying purposes. If there is a possibility of paying off revolving debt, the balances should be compared against the monthly payments to get the biggest bang for the buck so to speak. Payoff the lowest balances with the highest minimum payment.

Installment Loans May Be Excluded If an installment debt has less than ten months (6 months for FHA/VA) remaining at the time of application, it may be excluded from qualifying ratios. For example, a borrower considering a home purchase might consider paying the balance on a car loan with 15 or 20 months remaining down to less than 10 months prior to application. This strategy should not be executed at the expense of post-closing reserves - a borrower with no reserves might not be granted the leniency of excluding a low balance installment loan.

Car loans/Installment loans: When there Refinance a Car Loan to Reduce Payments are scheduled payments on a loan, unlike a Existing Refinance credit card or long-term obligation like a stu- Interest Rate 4.75% 8.90% dent loan, the loan served a purpose. If it was Term 60 60 a car loan, the purpose is obvious. However, Balance $ 12,500.00 $ 12,500.00 if it was a consolidation loan, or a signature Payment $ 470.64 $ 258.87 loan, watch for the credit spiral. On the other Payment Reduction $ 211.76 hand, if the debt was established some time ago, there is a likelihood that the debt will be repaid soon. As with any loan, the balance may be refinanced. Car loans may be structured initially with 24- or 36- month payment schedules. This can make the payments troublesomely high. If a short-term car/installment loan is a problem, investigate the terms being offered by banks for similar loans - and the borrower’s own bank too. You can refinance home loans - why not refinance all the borrower's loans to get a lower pay-

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ment? Student Loans: Recent college graduates almost always have incurred some student loan debt to complete their education. Generally, the repayment terms are fairly favorable. However, student loans also have deferments that can allow a borrower to graduate from college, and wait for a period of 12 or more months before beginning repayment. From a qualification standpoint the question is, if the borrower is in a deferment period, can they afford to make the payment after the deferment is over? However loans that begin maturing more than 12 months into the future can be eliminated if the borrower has the assets to offset the payments once they take effect. If excessive student loans are a qualifying issue, Sallie Mae - the major student loan lender - does offer consolidation loans, which may reduce the overall debt service for a borrower. Rental Properties: Income properties often create problems for potential homebuyers. Aside from the difficulties of managing rental real estate, lenders may have a disparaging view of the impact rental real estate has on the prospective borrower. Restrictions on rental income include: 

  

Exclusion of 25% of the gross rental income as a vacancy/loss factor. Although a property may carry a positive cash flow, lenders adjust this income significantly to take into account the potential for the property being vacant with no rental income for an extended period of time. This is known as a vacancy/expense factor. While most rental properties experience a 5 - 10% vacancy factor, an additional expense must generally be considered to determine the wear and tear on the property. The exception to this is FHA/VA loans, in which the borrower can demonstrate a lower vacancy factor, or previous experience as a landlord. Then the vacancy expense factor can be as low as 7%. If this is a factor, then examine the actual cash flow of the property. Has it been rented for more than two years? If so, can you examine the borrower’s Schedule E, Rental and Royalty income, from their tax returns? Adding the actual income, less actual expenses (depreciation and depletion added in) may result in a more favorable net rental income than a 25% vacancy factor. In many lease situations, properties are rented on a month-to-month basis. If this is the case, the tenant must be contacted to provide a letter attesting to the fact that they intend to continue residing in the property. How many properties are financed? If a purchaser owns more than four 1-4 family properties that are financed, and the subject property is an investment property, they are generally ineligible for financing on conforming loans. Each property's mortgage must be verified. Also, the taxes and insurance must be obtained separately, either by proving that they are held in escrow, or by providing copies of the paid bills for the obligation.

Alimony/Child Support/Separate Maintenance: Ironically, in this case, what is a debt to one person is income to another. Since half of all marriages end in divorce, understanding the financial obligations and legal documentation of marital dissolution is requisite for lenders. If there is a support obligation, is it either child support or alimony. If it is alimony, it is taxable to the recipient. This means that it is tax deductible for the payer. If this is the case it will appear as a deduction on the front page of the tax returns. This can be viewed not as a debt, but as a deduction from gross income, which can drastically reduce the qualifying impact of the

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Tips for Working with Divorces

obligation. Remember the example of how it takes $3.00 of income for every $1.00 of debts. This is another example of how it is more efficient for a borrower to reduce debt load to qualify for a mortgage than to increase his or her income. Nothing in the following examples changed except for the treatment of the alimony as a reduction in income instead of a debt. This treatment results in an additional $220 a month of towards qualification.

1.) While a divorce can work against a borrower who must pay support, the opposite is true of the recipient. This can work to the benefit of the creative loan officer who can add income and remove debts of one borrower by implementing advantageously a divorce situation. 2.) Be sure to examine tax returns, bank statements and credit histories for evidence of these liabilities. There are many instances in which these debts can easily be concealed by a borrower, which could circumvent the intent of maximizing qualification.

Treating Alimony as an Income Deduction Increases Qualifying Power Alimony as a debt Step 1

Step 2

Step 3

 

Monthly Income x Housing Ratio Maximum PITI Monthly Income x Debt Ratio Max Total Debt Less Alimony Result

Alimony deducted from income $ $ $ $ $ $

4,000 28% 1,120 4,000 36% 1,440 (750) 690

Step 1

Step 2

Monthly Income Less Alimony "Net" Income x Housing Ratio Maximum PITI Monthly Income x Debt Ratio Max Total Debt

$ $ $ $ $ $

4,000 (750) 3,250 28% 910 3,250 36% 1,170

If it is child support, how long will it continue? Are the children going to be old enough so that the obligation disappears soon? If so then an argument can be made for excluding the obligation. Can the balance be paid off or down to reduce the amount owed? Depending on the circumstances a legal separation agreement, post-nuptial agreement, divorce decree, court order, and/or property settlement agreement must be reviewed to determine the extent of obligations.

Regular Business Expenses/Self Employed Borrowers Self-employment presents a separate challenge from an inSelf-Employment Tip: If an expense come point of view. These borrowers may be able to deduct is actually paid by the business, providing many of their normal living expenses from their incomes. 12 months canceled checks will allow the to be deleted from the borrower's perThis allows them to achieve a higher standard of living by debt sonal qualification calculation. reducing taxable income. From an underwriting point of view, however, you cannot tell the federal government that you earn one amount, and expect your lender to count a higher amount. It is important to obtain all income documentation from the borrower, and to attribute debts owed by or paid by a business to the business. Doing this allows the lender to exclude business debts from the borrower’s individual total debts. Self-employed borrowers often utilize personal credit to establish a new business. While a new business may not have been established for at least 2 years – long enough to have income that can be utilized for qualifying - it may present an excellent compensating factor for a borrower whose profile looks risky because of excessive debts.

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When an applicant is receives mostly commission income, he or she may write off or deduct his or her business expenses. Do these debts or expenditures reduce gross income or are they simply allowable deductions? This is a delicate question. For instance, you can argue that union dues must be paid to ensure continued employment. This might be construed as a debt. On the other hand, a commissioned sales person might deduct un-reimbursed employee business expenses, such as mileage. Because these expenses are generally the result of additional efforts to achieve additional income, these are deducted from gross income to determine what the actual net income is or was. However, the actual amount of the expenditure must be evaluated to determine what income was actually earned. Co-signed Loans It sure seemed like a good idea to help your friend or daughter buy that car. The bank just needed a co-signer to make the loan. Surely the original borrower would be responsible for the debt? This is significant. If a borrower is a co-signer on someone else’s loan it must be substantiated that the primary borrower is making the payments in a timely manner. If not, the co-signer is called upon to make the payments, and this debt is counted as the co-signer’s liability.

Credit History More and more, the most critical aspect of the loan approval process is the review of the credit history. In 1987 the mortgage industry - in a revolt against the massive, time-consuming paper monster created by verifying all aspects of an applicant's personal history - began to trend towards reducing documentation. Dependent on the relative amount of down payment, many loans were approved entirely upon the strength of credit reports. While some lenders made poor decisions by not verifying more information, time has proven that a perfect credit history is the most reliable indicator of future willingness and ability to repay an obligation. A large emphasis on credit is appropriate and, in fact, a credit report is the first thing a loan reviewer sees. Credit Bureaus vs. Credit Repositories The credit repositories provide direct reports. This is the report that a car dealer or bank will examine when deciding to grant credit. These reports are referred to in the mortgage business as an "in-file" report. This report is the "raw" data contained in the database. The credit repositories do not make changes to data. Only a creditor or reporting subscriber can change the data recorded among the repositories. Repositories are not very customer friendly. Credit Bureaus are service providers to the mortgage industry. They assemble data and present it in a "decoded" format merging data from multiple repositories. They will merge and decode 1, 2 or 3 repository reports into one "in-file" report that can give a wider review of an applicant’s history. In addition, they may verify employment and check accounts like landlords or mortgages that are listed but not reported. This "decoded" format is referred to as a "Standard Factual Data Credit Report.” This format allows huge flexibility for mortgage lenders because, regardless of what data the repositories report, the customer may refute that information. With compelling

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documentation a bureau can: 1. 2. 3. 4.

Confirm and eliminate duplicate accounts. Delete accounts that appear to belong to someone else. Verify that late accounts are misreported. Update balances on accounts that have been paid.

Remember the old adage regarding first impressions? It is particularly true in this respect. An underwriter may be jaundiced in the loan review process if a borrower's credit history appears immediately negative. To present an applicant's credit history in the best possible light the credit bureau can present all of the accounts that were paid timely on the first page. Then, at the end of the report, show negative accounts. Types of Credit Reports Data Name Collected

In-File

Tri-Merge

RMCR

Description

Usually used to "peek" at what the borrower's credit history is like. This preview allows the loan officer to see One how the overall credit is without expending substantial repository cost and affecting the borrower's credit scores with multiple inquiries three Data is sorted and merged eliminating duplicate, old and repositories paid accounts. May also include scores. three Residential Mortgage Credit Report is used to verify repositories additional data, such as employment, rental history and unverified debts. The RMCR allows the credit bureau to direct references provide third party verification.

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Cost $5 - $8 - can be converted to full trimerge at no cost. $15 - $25

$50 - $60


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Current balance on the account? Remember to check reported date before counting balance – may be closed acct.

Current balance past due is a bad sign. Reporting a past due payment or balance - again check reporting date

When was account opened? How many months are reported? Old report dates need updating.

Code U I J A S C B M T

Means Undesignated Individual Joint Authorized User Co-signor Co-maker Borrower Maker Terminated

Payment history shows the number of times past due and last past due Code R I 0 M C

Means Revolving Installment Open, 30 Day Mortgage Line of Credit

Code 0

Creditor name and account number - verify it belongs to the borrower – remember many banks have merged

Reported date is the last time the repositories received information. Old dates indicate no long active account

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High credit is the maximum loan amount. Terms indicate repayment terms, such as monthly payment. Check that payments on statements are lower or

1 2 3 4 5 6 7 8 9 U

Means Too new to rate Current 30 days late 60 days late 90 days late 120 days late 150 days late Bankruptcy Repossession Charge Off Unrated


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It is important to remember that, no matter how much a borrower accomplishes with an individual credit bureau, the information in the repositories is not updated when a standard factual data report is modified. Only the creditor or subscriber can modify information with the repository directly. This can present a problem if significant modifications have been made and a loan is submitted to a reviewer who compares "in-file" data to the factual reports. Obtaining a Credit Report With automation being so prevalent, the ability of the loan officer to obtain a credit report has achieved a high degree of ease. The borrower must provide an authorization for this. A credit history is like an opinion - almost everyone has one. An immense amount of data is accumulated as you interact with creditors. You report employers and residence addresses when you apply for a loan; lenders report applications, balances, payment amounts and payment histories as you transact business; the courts report any legal actions against you. Credit data is stored among 3 major private companies referred to as "repositories": TRW, Trans Union (TU), and Equifax (CBI). Depending on geography - the South, or East or West of the Mississippi - all consumer credit providers, most mortgage lenders and even some major landlords will report to at least one and perhaps all three of these repositories. They assemble what amounts to a massive, interactive, and open database. This is "raw" credit data. The credit card application process is a "raw" credit experience. You are analyzed on the data that is contained in the repositories. Period. If you have missed a payment in the past due to extenuating circumstances, or if there are erroneous data in the system, you may be declined. Then your experience can become Orwellian. You don't generally get to talk to a human being and review a negative credit decision. Most consumer credit decisions are based on scoring systems. The scoring is based on the repository information. You are considered guilty if there is a problem and there is very little you can do to prove your innocence. One of the benefits of the mortgage process is that, as a borrower, you have the opportunity to address and correct items that arise during the process. A negative credit history is like an illness - people don't like to talk about it or admit an error. It is this pain or fear that causes an aversion to dealing with credit issues. Unlike credit card transactions a mortgage application, because of its human element, can be a healing experience. Like jumping into a swimming pool, once you're in the water it doesn't seem that cold. Understanding the process can allay the fear. Understanding the Ratings - What is "Bad" We expect that applicants should have "perfect" credit. Perfect credit means no negative ratings/incidents ever. Perfect credit is the basis for obtaining a loan to be sold into the secondary market and, at least theoretically, the most competitive rates offered. Anything less than perfect credit is considered adverse and is a basis for loan declination.

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Generally Acceptable Adverse Credit History Mortgage Payments NO Late Payments in last 12 months Credit Card/Consumer TWO (2) 30 day late payments in Loans last 12 months One (1) 60 day late last 2 years Legal Actions NO Open Liens, Judgments or Collection Actions Inquiries THREE (3) Inquiries in previous 36 months prior to application


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Beyond perfect is where the credit evaluation process becomes almost purely subjective. We have obtained a consensus definition of acceptable negative ratings to eliminate some subjectivity. A survey of underwriters for major lenders indicates that there can be some lenience in allowing less than 100% perfect credit. (Nobody readily commits to lenience in this regard. To achieve lenience no other negative factors may be present.) While the loan reviewer places most emphasis on the preceding 12-24 months, all negative instances must be clearly explained. Again, this is because the basis, or standard, for obtaining a marketable loan is "perfect" credit. No Credit is not perfect credit. Standard guidelines require 3 - 5 pieces of credit maintained for What is the Problem with Inquiries? at least 2 years to qualify as “established" credit. It’s not the inquiry itself - too many inquiries There are alternatives to having no commercial indicate: A borrower with latent credit problems that credit history. Payment records to landlords for cause him/her to repeatedly attempt, rent, utility companies, and installment purchas- unsuccessfully, to obtain new loans to es, merchandise redeemed from a pawnbroker all conceal delinquent accounts can be compiled to develop a repayment history. Someone who is trying to borrow for the payment Group I – rental housing payments (subject to down Someone who is trying to obtain multiple independent verification if the borrower is a rent- owner-occupied loans simultaneously er), utility company reference (if not included in Someone who cannot obtain credit or is the rental housing payment), including gas, elec- desperate for credit tricity, water, land-line home telephone service, cable TV. If the borrower is renting from a family member, request independent documents to prove regularity of payments, such as cancelled checks. Group II – insurance coverage, i.e., medical, auto, life, renter’s insurance (not payroll deducted); payment to child care providers – made to a business providing such services; school tuition; retail stores – department, furniture, appliance stores, specialty stores; rent to own – i.e., furniture, appliances; payment of that part of medical bills not covered by insurance; Internet/cell phone services; a documented 12 month history of saving by regular deposits (at least quarterly/nonpayroll deducted/no NSF checks reflected), resulting in an increasing balance to the account; automobile leases, or a personal loan from an individual with repayment terms in writing and supported by cancelled checks to document the payments. Credit Explanations As discussed, all adverse credit notations must be addressed in writing by the borrower. While it would be naive to think that a credit explanation could change a loan reviewer's opinion to approve or decline an application, there are scenarios that can be effective in addressing serious or recent adverse incidents which could compromise loan approval.  A logical explanation that compellingly indicates an applicant's efforts to properly handle an account.  Someone else's fault - documentation that the responsibility of an incident was out of the applicant's control.

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 

Extreme Contrition - an earnest admission of responsibility and recognition of how to avert future incidents. The Big Bang- The event or circumstance that caused the delinquency is no longer a factor.

From Bad to Worse Unfortunately many Americans fall prey to the lure of easy credit, becoming victims to a tempest of red ink. An understanding of credit status is important because in certain situations a borrower is not eligible for traditional financing any more. If an applicant falls out of the generally acceptable range, or displays any of the following characteristics, they need more help than what a traditional loan officer can offer. We will discuss this later. Credit Issue Late Mortgage

Description Over 30 days past due on rent or mortgage in last 12 months; currently past due

30 – 60 Days Past Due

If an account has been handled well historically, some creditors are loath to report minor late payments. Current 30- or 60-day late references are emblematic of a serious situation arising. Reported as an I-2, R-2, I-3 or R-3.

Over 60 Day Past Due Collection Action

This indicates a serious unwillingness on the part of the borrower to repay a debt: I-4, R-4 to I-6/R-6 Anyone who can report to credit repositories (collection agencies, doctor’s offices, parking enforcement, etc.) can file a collection action against you. All that is required is an unpaid invoice. Normally these are nuisance actions too small to go to the expense of obtaining a ruling via a judge. No action can result from a collection, but it will impede your ability to obtain credit. Means that the creditor gave up trying to get payment from you and wrote the account off as a loss. May become a judgment if charged off account is sold. A judgment is a collection action that has been reviewed for merit by a small claim, circuit or district court depending on the amount or size of the claim. A judgment is serious because the party to whom the ruling inures may seize your property, wages and assets to satisfy the obligation. Federal or state tax liens are more serious than judgments because the government is very good at seizing assets and collecting for money owed. Even though tax liens can come about as the result of legitimate disputes over tax practices, they are viewed primarily as a credit problem. A borrower enters into a credit repair agreement with a non-profit counseling agency. The account

Charge Off

Judgment

Tax Lien

Consumer Credit

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Resolution Get direct mortgage verification or canceled check to refute exact timing; 12 months time elapsed since incident Pay Off Account prior to application; pay account current; depending on circumstances may require 12-24 months time elapsed since incident. Pay Account Current/Pay Off; 12-24 mos. time elapsed Pay off collection.

Evidence of payment/dispute Must be paid

An attorney may appeal the judgment and, if successful, the ruling may be vacated, or thrown out.

Release of lien

Borrower may not have open CCCS accounts. Pay off and


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Credit Issue Counseling Bankruptcy Chapter 7 Liquidation

Bankruptcy Chapter 13 Adjustment of Debts by Wage Earner Bankruptcy Chapter 11 Reorganization

Description will show up on the credit report as “CCCS account.” The account will be CCCS until it is a “0” balance. A filing under any chapter of the bankruptcy code creates an estate. The Courts act as trustee over the estate. Under Chapter 7 all of a debtor's assets (with some exceptions) and liabilities are liquidated. Unless a creditor objects, all debts included in the bankruptcy are discharged within a few months of filing. This chapter allows debtors to pay back creditors in full or in part, based upon income, over a period of up to 5 years. The payments are made to a trustee who begins paying creditors as soon as the plan is approved. You must have less than $350,000 in secured debt and $100,000 in unsecured debt to file This plan is available to all individuals and entities, but is intended to allow an ongoing business to restructure its debt. The filing must be accepted by the court as well as creditors

Resolution close. Some lenders will never consider a borrower after bankruptcy is declared. FNMA/FHLMC allow financing 4 years after discharge Chapter 7 and 2 years after Chapter 13 with reestablished credit. Chapter 7 is the most negative form, philosophically, because the debtor has walked away from assets and liabilities and let the court force creditors to take less money than owed in what is known as a "CramDown." Because all debts are discharged this may disguise a previous pattern of debt mismanagement. “Dismissal” means that the court did not approve the filing.

Relief From the Tide of Red Ink Depending on the seriousness of the situation there are ways to avoid being subjected to intense pressure from creditors. Non-Standard Credit Mortgages - If a borrower is fortunate to have a large down payment or have built up equity in a home or in other improved property (not land), he or she may be eligible for a higher risk mortgage. These are referred to as “Sub-Prime,” "Credit-Rated Paper,” "B, C & D Paper” (as in, not "A"), “Hard Money” and "Equity Based" loans. They are offered under the same terms as the "junk bonds" of the 80's, giving investors a higher rate of return, or yield, than standard investments in exchange for accepting higher default risk. Theoretically, the interest rate premium, and the fact that a larger equity position is required, offsets the investor’s risk of default. A standard grading apparatus would show an increasing interest rate and equity requirement as the credit quality deteriorates.

Sub-Prime Lending In the post-crisis lending industry, Sub-Prime Lending no longer remains a solution for credit impaired borrowers to the scale it existed in the 90’s and 2000’s. Some private lenders will still make credit impaired loans, but the borrower must document his or her ability to repay. For information purposes we include a sample of credit rated lending options known as "Credit Graded,” "B, C & D,” “Choice” or” Non-Prime" mortgages. A generic grading system shows the illustrative increase in interest rates and equity requirement as the credit grade deteriorates.

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Generic Sub-Prime Grading Matrix Rating

Description/Allowable Derogatory

Ratios

A- FNMA Mortgage - Current; 2x30, 0x60; Consumer Credit - Generally EA1, 2, 3 excellent, no more than 20% of all other accounts report delinquencies; No bankruptcy; No judgments over $100 B

C

D

42/42

Mortgage - Current; 4x30, or 2x30 & 1x60; Consumer Credit 45/50 Reasonably good, no more than 40% of all other accounts report past delinquencies. No bankruptcy in 24-36 months; No judgments over $250 50/60 Mortgage - Slow; 6x30, 1x60, 1x90 - Can be currently past due; Consumer Credit - Significant past problems; Many accounts late; Open judgments; No bankruptcy within last 1224 months; Mortgage - Currently Past Due/Foreclosure; Consumer Credit - 60/60 Serious problems, collections, judgments, delinquencies; active Bankruptcy

Equity (LTV) 80-90

Rate Premium 0.00 2.50%

75-90

1.50 3.00%

70

2.00 6.00%

50-60

4.00 12.00%

The embrace of the huge profit potential of the ALT-A and non-prime loan business among mortgage companies has had unintended consequences which costs companies more than they realize in lost profits and time. The result, the further erosion of credit analysis and qualifying skills of loan officers, reduces the significance of the role of the originator. In addition, it contributes to the accidental application of predatory lending practices. High-Rate, High-Fee Loans (HOEPA/Section 32 Mortgages) The Home Ownership and Equity Protection Act of 1994 (HOEPA) addresses certain deceptive and unfair practices in home equity lending. It amends the Truth in Lending Act (TILA) and establishes requirements for certain loans with high rates and/or high fees.

Section 32 High Cost Loans A mortgage on a home where the annual percentage rate (APR) exceeds the rates on Treasury securities of comparable maturity by 1st mortgages – 8% or more 2nd mortgages – 10% percent Section 35 “Higher-Cost” Loans A Mortgage where the interest rate exceeds Freddie Mac’s “Prime Rate Mortgage Survey” by 1st Mortgages – 1.5% 2nd Mortgages – 3.5%

The rules primarily affect refinancing and home equity installment loans that also meet the definition of a high-rate or high-fee loan. The rules do not cover loans to buy or build your home, reverse mortgages or home equity lines of credit (similar to revolving credit accounts). The following features are banned from Section 32 high-rate, high-fee loans:    

All balloon payments for loans with less than five-year terms. Negative amortization. Default interest rates higher than pre-default rates. A repayment schedule that consolidates more than two periodic payments that will be paid in advance from the proceeds of the loan.

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  

Most prepayment penalties, including refunds of unearned interest calculated by any method less favorable than the actuarial method. A due-on-demand clause Creditors may not make loans based on the collateral value of property without regard to ability to repay the loan.

Ways to Improve Credit Problem No Credit

Credit Problems (Minor)

Credit Problems (Major)

Tactic Obtain secured credit card or work with loan officer to obtain credit cards/loans. Utilize multiple correspondence addressing each incident and follow up systems to test creditors responsiveness. Creditors only have 30 days to respond to written request in writing. If they do not, they must remove the notation under ECOA. New Social Security Number or Tax I.D. number.

Result Positive Outcome - establish credit. Could have been achieved without credit doctor. Positive Outcome - there is a chance that the creditor will not be able to respond to some or all of the requests in a timely manner and will have to remove negative references. On the other hand, there is no guarantee - you might do this yourself. Negative - this is highly illegal.

Credit Counselors/Agencies There are Consumer Credit Counseling Services (CCCS) - agencies which can help borrowers who have over-extended themselves work out repayment plans with creditors, re-arrange financial plans, and arrange consolidation loans. For a local agency, call the National Foundation for Consumer Credit (301) 589-5600, a non-profit organization. As seductive as it may sound, there is no bona-fide way of obtaining a new, completely repaired credit history without dancing around ethical barriers and breaking laws. If a company offers to repair credit and charges a large up-front fee, you are dealing with a "credit doctor.” See – Strategies for Improving Credit History for ways to work that may or may not improve the ability to obtain credit. Credit Counseling is perceived as a negative. This is counter-intuitive to many borrowers’ instincts. His or her thought is “I’m getting my credit cleaned up!” Our perception is that the borrower gave up on doing it themselves – couldn’t handle it – so why is he or she trying to borrow money again? There is one positive thing to be said about adverse credit history - it eventually does go away. The statute of limitations for delinquent credit reporting is 7 years. Judgments and liens are removed after 10 years. Often a lender who reported negative ratings will delete them if the account has been reestablished in a positive way. For instance delinquent student loans may have their negative ratings removed once paid. Even though lenders have an obligation to report delinquencies, guaranteed student loans were made available to help the students, not destroy financial futures.

Understanding Credit Scoring

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The development of credit scoring has been touted by the banking industry as a panacea to the problem of maintaining consistency in underwriting and assuring quality loans. Credit scoring is the process of numerically grading the overall profile of a borrower to ascertain how the profile has historically performed and making a credit decision on that basis. The Fair-Isaacs Company (FICO) developed a predictive model for Experian/TRW that has become the basis for many credit models that now exist. In fact these models have taken on a life of their own. They can be adjusted or enhanced by the ordering party to reflect their particular underwriting preferences.

Credit Scoring Models CBI/Equifax – Beacon – Most Conservative Model TransUnion- Empirica TRW – Experian – Most Active in Consumer and Business Reporting Credit Score Reason Code/Description Amount owed on accounts is too high Delinquency on accounts Too few bank revolving accounts Too many bank or national revolving accounts Too many accounts with balances Consumer finance accounts Account payment history too new to rate Too many recent inquiries last 12 months Too many accounts opened in last 12 months Proportion of balances to credit limit is too high on revolving accts Amount owed on revolving accounts is too high Length of revolving credit history is too short Time since delinquency too recent or unknown Length of credit history is too short Lack of recent bank revolving information Lack of recent revolving account information No recent non-mortgage balance information Number of accounts with delinquency Too few accounts currently paid as agreed Time since derogatory public record or collection Amount past due on accounts Serious delinquency, derogatory public record or collection filed Too many bank or national revolving accounts with balances No recent revolving balances Proportion of loan balances to loan amounts is too high Lack of recent installment loan information Date of last inquiry too recent Time since most recent account opening too short Number of revolving accounts Number of bank revolving or other revolving accoun Number of established accounts No recent bankcard balances Too few accounts with recent payment information

The scores are designed to predict, based upon past experience, how a customer will repay the loan. These scores, combined with specific risk grading criteria, are how banks have traditionally approved credit cards, auto loans, home equity loans and other minor consumer loans for the past 10 years. "Risk-based" underwriters like PMI companies have utilized the methodology for years. It is the contribution of mainstream commercial banking to the evolution of mortgage banking evolution. However, it is a negative for the mortgage business because in this industry lenders have traditionally given borrowers a closer look. In the interests of speed, many borrowers may fall between the cracks. The risk score is not supposed to make the decision to approve a loan. But one can't help but think that an adverse credit score is sure to impede the approval, while a positive score is a confirmation.

CBI 1 2 3 4 5 6 7 8 9

TU 1 2 n/a n/a 5 6 7 8 9

TRW 1 2 3 4 5 6 7 8 9

10

10

10

11 12 13 14 15 16 17 18 19 20 21

11 12 13 14 15 16 17 18 19 20 21

11 12 13 14 15 16 17 18 19 20 21

22

22

22

23

n/a

n/a

24

24

24

33

3

33

32 n/a 30 26 n/a 28 n/a 31

4 19 30 n/a 26 28 29 n/a

32 n/a 30 26 n/a 28 n/a 31

The basic theory of risk scoring is that there are historical factors that impact a borrower’s ability - or willingness - to meet obligations. The factors are, not surprisingly, credit history, source of income, down payment, debt to income ratios, and loan type. FICO Model     

35% overall payment histories 30% amount of debt 15% length of credit file 10% recent history 10% mix of credit

Chapter 4 - Ratios and Credit History – Page 86

How Good Is My Score? 720 & Above 680 - 720 660 - 680 620 - 660 below 620

Excellent Very Good Generally Acceptable Marginal Caution


The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014

Risk Grading There are numerous risk scoring devices. As the consumer credit business seeks ways to automate and streamline credit approval we add new tools constantly. In mortgage lending, none of these are designed to be exclusive; they are used in tandem with each other. Unfortunately, most of these tools currently take the form of what we refer to as automated underwriting protocols. These “proprietary underwriting models” include FHLMC and FNMA models as well as privately developed models. There are 3 possible outcomes from Automated Underwriting: Approve, Deny or Refer. Loans which fall into the “deny” and “refer” categories offer an opportunity for loan officers to use their knowledge to assist borrowers. Obviously, mortgage companies don’t need loan officers if a machine can approve a loan; so knowing the ins and outs of the guidelines is how the lender adds value. The developers of these programs – not surprisingly - don’t give much insight as to how to work within the models. These organizations are purposely secretive about the specific guidelines they set for rendering Automated Underwriting Decisions. If they told us the guidelines and how they worked we could simply tailor every application to meet the system’s requirement, making it relatively easy to manipulate the model’s outcome. To imbue to automated underwriting process with some transparency, FHLMC used to publish a manual risk-scoring worksheet – “The Gold Measure Worksheet.” Automated Underwriting employs a similar risk scoring mechanism where the machine finds enough positive criteria present to eliminate the need for a subjective (or human) review. The FHLMC Gold Measure illustrates a possible scoring system, and provides clarity on the “Loan Prospector” Automated Underwriting model. Although simple, it remains a statistically proven accurate indicator of credit performance. Represented by a self-explanatory one-page worksheet, the user can see which borrower profile elements receive the most weight in the scoring model. Each attribute receives a positive or a negative weighting. The system assigns weight reflecting the relative impact of the attribute in the overall creditworthiness measurement. Scoring Positives Perfect credit file with 11 or more open accounts Revolving balances below $500 Percent of all trade lines with derogatory rankings; 0-10% 2 years on job Good - 30% down payment Best - down payment of 40% or more Previous housing expense that is <120% of the proposed payment Loan term < 25 years

Scoring Negatives Percent of all trade lines with derogatory rankings; 16-40% >60% Worst delinquency ever is >30 days Judgments or collections More than 3 delinquent public records Bad - 2-3 inquiries Worse - more than 5 inquiries Less than 2 years work history Self-employed/commissioned borrowers Less than 2 months reserves Over 40% total debt ARMs Bad - Condominiums and 2 units Worse - 3-4 unit properties

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Consider the Impact It doesn't take long to realize that, utilizing risk scoring, the following transactions won't be easy to approve: 1.) 2.) 3.) 4.) 5.) 6.)

Borrowers with marginal credit Self-employed borrowers who have creative income approaches Borrowers with high ratios and little down payment funds Borrowers who do not have established credit Any condominium or 2-4 unit property with marginal attributes Anybody with a total debt ratio of over 42%

Income Fraud Alerts/Red Flags When dealing with borrower’s credit reports, care should be taken to look for issues that might indicate a borrower is misrepresenting or concealing information. These “Red Flags” can cause problems in the loan process. CREDIT / CREDIT REPORTS No credit (possible use of alias) High income borrower with little or no cash (undisclosed liabilities) Variance in employment or residence data from other sources Recent inquiries from other mortgage lenders Invalid social security number AKA or DBA indicated Round dollar amounts (especially on interest-bearing accounts) Borrower cannot be reached at place of business High income borrower with no "prestige" credit cards

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Chapter 4 - Ratios and Credit History – Page 90


Chapter 5 â&#x20AC;&#x201C; QUALIFYING: Income & Other Restrictions Understanding Income The most frequent complaint in qualifying borrowers is that "the ratios are too high.â&#x20AC;? The ratios themselves, though, are simply measurements. Actually, what needs to be analyzed is the information against which the ratios are being applied. In this case qualifying ratios really are only as useful as the information applied to them. Often, then, as lenders we are put in the position of saying "how much income does this person need in order to qualify?" and working from there. Most people know how much they can afford to spend based on their experience. These people may have income situations that make it hard for them to qualify for the amount they believe they can afford. The loan officer must have a fundamental understanding of the way all different people in all vocations are paid. If everyone were paid a base salary or an hourly wage for a standard workweek, a discussion of income wouldn't be necessary. The objective in addressing income as to qualifying is how much income the lender can count on to be stable and continuing. "Stable" Income

With individuals who work for a company that get paid a regular salary, there is no ambiguity over the amount of income available for debt service. However, the temptation to utilize a higher level of income exists for borrowers who have variable income or who are self-employed. It is for these borrowers that we must address income. Each category of income has different attributes that affect the manner of treatment. Within each category there are different ways to calculate income in a manner most advantageous for borrower qualification. To determine the manner of treatment we must ask the same basic question again; "How much income is needed for qualification?" Underwriters use conservative, less conservative and aggressive approaches

Chapter 5 - Income Qualifying- Page 91


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for calculation, dependent on borrower circumstances. Base Income with Enhancements If the income needed for qualification is higher than what is available from the base alone, the treatment of additional sources becomes important. The biggest question from a qualifying perspective is at what point does the borrower stop being a salaried employee and become technically self-employed. The standard definition is that where 25% or more of the income required for qualifying is of a variable nature, the borrower is considered self-employed and is subject to some of the rigors of self-employment qualification including income averaging and an examination of all applicable income documents.

25%

The reason for this is the underwriting concern that a borrower may offset some of the variable income earned with tax deductible expenses reducing the actual income. If the variable income does not result in deductions by the borrower, then there is no problem. However, if the borrower does have significant deductions which adversely affect qualifying every effort should be made to limit the amount of variable income attributed to the borrower for qualifying purposes to less than 25% of the overall qualifying income. One can even include a co-borrower's income to increase the proportion of variable income that can be utilized before invoking the 25% rule.

Getting the most of Overtime, Bonus, & Commissions Overtime, bonuses and commissions are three areas in which a salaried or base income employee can enhance their qualifying income. The most important aspect of utilizing these is past history of receiving the type of income, the current level, and the probability of its continuance. The circumstances surrounding each are different so its treatment and maximization are different. Overtime

Example - Calculating Overtime for Hourly Workers Year

Pay/Hr.

Hrs. Wk.

Base

Overtime

Weekly

Annual

Overtime may be paid out at 2008 $ 6.50 46 Hrs $ 260.00 $ 58.50 $ 318.50 $ 16,552.00 46 Hrs $ 273.20 $ 61.47 $ 334.67 $ 17,402.00 a multiple of base earnings 2009 $ 6.83 2010 $ 7.18 46 Hrs $ 287.20 $ 64.62 $ 351.82 $ 11,258.00 (time and a half, for example). The trick in maximiz- (8 Months in 2010) Total $ 45,212.00 ing overtime income is to extract the amount of hours of overtime worked for averaging, as opposed to averaging the dollar amount. Average the hours - not the dollar amount! The reason for this is that averaging the dollar amount reflects past earnings, whereas averaging the hours allows you to take advantage of the current rate of pay and utilize income going forward. This takes into account increases in the base or hourly rate as cost of living and other raises are applied. The most fundamental issue for overtime maximization is establishing the average number of hours worked per week. Obviously, the greater the number of hours worked, the larger the income for qualifying. If; 1.) There is nothing that prevents an employee from working more hours, such as a second job, school, or a demonstrated need to care for a family, and 2.) The em-

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ployer states that the employee is eligible to work more hours and states an average number of hours of overtime worked per week, and then it is possible that there could be additional income available for qualifying. Two Approaches to Overtime Income Calculation Approach

Conservative - Average Earnings

Maximized - Average Hours Worked

Example

Total Income Divided By Number of Months = Qualifying Income

Current Overtime Rate (7.18 x 1.5) Multiply by Average Hours of O.T. Qualifying Weekly Overtime Plus Base Weekly Income Total X 52 = 18,294/ yr divided by 12 =

45,212 32 1,412.87/mo.

$10.77/hr x 6 hours $ 64.62 $287.20 $351.82 $1,524/mo

Bonus, Tips and Commission With overtime you can establish qualifying income with some certainty; the number of hours and the rate of pay, in addition to a historical performance, can all be demonstrated. The only thing that can be reasonably quantified about Bonus, Tips and Commission income is that it will continue. In these cases a historical average is the accepted method of determining qualifying income. There are some circumstances in which a larger amount of income might be acceptable, depending on whether the situation is compelling and compensating factors are in place. Unfortunately, even under the most lenient guidelines, credence will never be given for income that has not yet been received - referred to as prospective income. Other Arguments for Using a Shorter Average When a borrower needs to utilize a higher level of income to qualify, and using the methods shown above does not provide enough income for the case, another strategy is to show the progression of a borrower's income. A case can be made that the current income (from the previous year's tax return and year-to-date income statement) can be used in the example of a borrower that has income which has increased regularly for 5 years and can provide substantiation that it will continue at least at the same level at a minimum. In the previous example, we assume that the borrower doesn't qualify for the loan requested based on 2001, 2002 and year-to-date income averaged over 30 months ($47,000 + $58,000 + $37,000  30 = $4733/mo.). By showing that the income has increased consistently, we can optimize the income by averaging the last 2 years Income Type Commissions

Bonuses

Tips

Conservative Treatment Average 2 Years Tax Returns

Optimal Treatment

Maximized Treatment

Utilize 24 months exactly. Example: 8 months Year to Date, 12 months past year and 4 months previous year

If there is a trend of increasing commissions, utilize a shorter average. For instance previous full year and year to date. Must show previous earnings were irrelevant/not comparable. (See self-employment.)

Average past 2 Use previous bonus alone with years letter from employer that future bonus will be higher Average Past Average previous 24 months 2 Years exactly, if beneficial for qualifying

Use guaranteed bonus if it can be shown that similar employees received similar bonus.

Chapter 5 – Income Qualifying - Page 93

Utilize bank statements to show deposits of tips above base. Utilize previous year and year to date.


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

(24 months) exactly, increasing qualifying income by $204. A maximized scenario shows the borrower is increasing income every year, and a shorter average is utilized to show just the most recent 18 months be able to utilize the past year and year to date income ($58,000 + $37,000  18 = $5277/mo.), increasing the qualifying income by $544/month.

Using History of Income Increase to Support a Shorter Average Year 2003 2004 2005 2006 2007 2008 2009 (6 Mos.) Total Divided By Months Qualifying Income

Optimal Approach

Maximized Approach

Conservative Approach Income (%Increase) $ 20,000 N/A $ 25,000 25% $ 31,000 24% $ 38,000 23% $ 47,000 24% $ 58,000 23% $ 37,000 28% $ 142,000

$ $ $ $

23,500 6 months 58,000 12 months 37,000 6 months 118,500 24 months

$ $ $

30 $ 4,733.33

$

24 4,937.50

18 $ 5,277.78

58,000 12 months 37,000 6 months 95,000 18 months

Another scenario for using a shorter average might actually be where the lender needs to omit a recent year. If there was a personal tragedy, or the borrower was working on something unrelated, which caused the income to drop it might be unfair to hold the decrease against the borrower. In this case, the same strategy is utilized, except the year that was unfavorable is minimized or omitted. If 2001 was the documented bad year, the traditional approach would yield income of only ($18,000 + $58,000 + $45,000  30 = $4033.33/mo.) while going back further and averaging ($50,000 + $58,000 + $45,000  30 = $6433.33/mo.) for a borrower whose income decrease was really an anomaly.

Eliminate a Bad Year By Using a Longer Time Frame Year 2003 2004 2005 2006 2007 2008 2009 (6 mos) Total Divided by Months/Years Qualifying Income

$ $ $ $ $ $ $ $ $

Income 45,000 47,000 40,000 50,000 18,000.00 58,000.00 45,000.00 121,000.00 30 4,033.33

(%Increase) N/A 4% -15% 25% -64% 222% 55% 228% 6.5 35%

$ $ $ $ $ $

40,000 12 months 50,000.00 12 months Eliminated 58,000.00 12 months 45,000.00 6 months 193,000.00 30 6,433.33

Omitting the income from a bad year, and including year-to-date income, can enhance the average, or stable, monthly qualifying income. Future Raises Something scheduled to happen in the future is never certain. Things change, as we all know, and we consider this one of the fundamental truths in underwriting. Anything that is “proposed”

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– that hasn’t occurred - is prospective and is automatically discounted or eliminated entirely. Since prospective income can never really be included for qualifying income, don't refer to it as proposed. Call it something different, like pro-forma income. It means the same thing, but doesn't have the negative connotations. An argument can be made for counting future raises if there is a history of past raises and the new pay will start reasonably soon (within 6 months) of closing. A future bonus may fall under the same category. Normally we only count a raise for qualifying when the borrower can present a paystub or other evidence of having received the increase. There are specific instances where a future raise can definitely be used. Government workers, armed forces servicemen, or employees of institutions which have regularly scheduled cost of living increases which are a matter of record can compellingly prove that their raise will be effective. In this case a future raise can be used as a matter of course. If an employee obtains a copy of a performance review which indicates a promotion, or a grade increase, then it is possible to utilize the higher figure. Again, it is a matter of how compelling the information is.

Dividends & Interest One frequent income qualification error is the use of assets that are income bearing but will be liquidated as part of the transaction. Just as prospective income cannot be used, income from an asset that no longer exists cannot be used. If a portion of the assets yielding income is to be liquidated, it may benefit the borrower to determine the percentage of assets remaining and then take a percentage of the previous income.

Self-Employment There exists a quandary for the self-employed borrower. It is based upon the premise of risk and reward. Small business drives economic growth and the entrepreneurial spirit has created many wealthy people. But there are some stunning and sobering statistics:  

Calculating Dividend/Interest Income Mutual Fund Account Portion Liquidated Percentage Income - 2008 Income - 2009 Total Divided by 24 Months Multiply by 50%

$ $ $ $ $ $ $

100,000 50,000 50% 8,125 13,150 21,275 886 443

Self-employed borrowers are more than 200% as likely to default on their obligations. In Southern California self-employed borrowers are 400% as likely to default. 90% of all start-up businesses fail within the first two years.

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These are daunting odds and present a special challenge in qualifying, processing and approving self-employed borrowers. The case will be reviewed far more thoroughly than that of the average borrower for a number of reasons:  

The borrower's income stream, even if it appears stable, is based upon the company's performance, which may vary. There are two levels of income to review. Self-employment income is taxable on a "net of expenses" basis. Since paying taxes decreases income, one of the benefits of self-employment is deducting expenses from gross income to reduce a tax bill. In this situation the most substantive form of income documentation - the tax return - suddenly becomes the enemy because every conceivable legitimate deduction is utilized to reduce the tax burden. In a closely held company where do you draw the line between where the company ends and the self-employed borrower begins? Is a company car really the company's? What expenses are really just personal expenses that are taken into consideration by general underwriting guidelines for the populace?

2 Years!! Because of the high number of failures of start-up businesses someone who is considered selfemployed must have been in business for at least 2 years to even be eligible for a mortgage. A case can be made for considering a borrower who has been self-employed for less than two years if there is sufficient documentation to show that the income going forward has a reasonable probability of continuing. Obviously, if the borrower has been in business for 22 or 23 months, and shows signs of success, it is probably close enough. You could ultimately achieve approval by simply delaying closing a month or two until the 24 month threshold was achieved. If a borrower could go back to a salaried position, such as a lawyer, doctor or other professional, the risk is mitigated particularly if the income being used for qualifying is lower than the salary being earned before and the business and clients are the same. One could also make the argument that an existing businesses previous cash flow could be attributed towards the borrower who recently acquired it - if it were a franchise or other established business. Who is Self-Employed? An individual who owns 25% or more of a business would be defined as self-employed. In addition to income averaging at this level you must now analyze the business as well as the borrower. The first level of understanding is what kind of a business it is, because this determines what documentation is required and how the income is averaged.

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Analyzing Self-Employment Income and Required Documentation One of the primary benefits of self-employment is that expenses (allowable write-offs, deductions, and deferments) can reduce taxable income. The fewer taxes you pay, the more money you keep - simple! Taxable income is net income. Often there is confusion when a self-employed borrower reports gross income, as opposed to net income – the lender will use income net of expenses for qualifying. In addition, companies themselves are vehicles for storing money or assets necessary for operation of the business. This money does not get taken out until it is needed or the business is liquidated. Self-Employment and Documentation Types Type Sole Proprietor

Description A 100% individually owned business with no separate legal entity or identity. There is no separation between the individual and the business. The only way to separate the person and the business accounts is if separate bank accounts are maintained. The benefit of this business form is its simplicity.

Document Schedule C Personal tax return

Partnership

A partnership is created with a legal contract that binds at least two people. There are stratification, or levels, of partnership participation. A general partner makes decisions concerning the operation of the business, and is liable for the business's debts. The general partner may deduct certain items for tax purposes but is limited to the amount of capital that he or she has contributed and the amount that he or she has "at risk.” A limited partner does not participate in the operation of business and is liable only to the extent that his or her investment in the partnership is at risk. K-1 will detail ownership interest, general or limited partner, capital contributions.

Partnership return is Federal 1065. Personal income on K-1 and Sche-dule E of 1040's

"C" A corporation is a legal entity created within a specific state for which shares Cor-poration of stock are issued. The stock may be sold to the public or privately to get money for the business operation. Owner(s) of stock are entitled to participate in the profit of the company. A board of directors controls decisions over the operation of the business. Owners of stock are liable only for their initial investment, not for business debts. The corporation may retain or disburse income at its discretion. In addition, there may be a fiscal year different than a calendar year, which may make year to year analysis difficult.

Corporation tax return is Form 1120. Personal income is W-2-.

"S" "S" Corporations are a hybrid combination of partnerships and corporations. 1120S Federal tax Corpo-ration Business income must be claimed within a cal-endar year (like a partnership) return, K-1 from and cannot be carried forward. However, shares of stock are issued and 1040 owners are limited in liability to their initial investment. LLC & LLP

Trader Investor

"Limited Liability Corporations" and "Limited Liability Partnerships" are recent innovations. From a tax perspective, they will mirror the business form of corporation and partnership. The benefit of this form is that officers and partners will have less personal liability. An individual who buys and sells on his or her own account, such as a stock investor or real estate speculator. An individual who owns and rents real estate or other income produc-ing assets.

1120S or 1065, depending on type

Schedule D 1040 Schedule E 1040

This is legitimate tax avoidance - not tax evasion. There are many wealthy self-employed people who pay far less in taxes than their employed counterparts. By its very nature self-employment income verification is in direct contradiction to the goals of the loan officer. The borrower wants to show the best possible picture to the lender, but the worst picture to the IRS. The problem Chapter 5 – Income Qualifying - Page 97


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here is that both the IRS and the lender have to use the same source of information - the Federal Tax Forms. Because each self-employed borrower is unique, many lending personnel have a phobia of analyzing this income. Every lending manual prescribing varying methods of how to do it exacerbates this phobia. The underwriters at FNMA probably thought that they were helping when they designed 3 different self-employed income analysis forms for lenders to use in assisting evaluating tax returns. In fact the forms themselves raise other quandaries: should I use the “Adjusted Gross Income Method” or the “Schedule Analysis Method?” Why do you need a “Comparative Income Analysis” - can't you just see whether the income is increasing or decreasing? The problem with these forms is that they try and provide the same treatment for all forms of self-employment. To be comprehensive the worksheet had is very long and daunting. In addition, they give the impression that there are some types of income that must be excluded. The truth is that every self-employed borrower is different. You can't use a pre-printed form and fairly maximize the income. The only method that works is to actually read the entire tax return!! The depth of the analysis goes back to the first question asked in this chapter - How much income does the borrower need to show to qualify for the loan they want? If they qualify based on a 2-year average of the adjusted gross income from the first page of the tax returns, you don't need to perform a further analysis. If they are challenged at that level, though, get out a pencil and be prepared to read and write. The philosophy of self-employed income analysis is to find all of the deferred income, deductions, non-cash losses, and duplicative expenses deducted by the business and held against the borrower and add them on back to, or on top of, taxable income. The result should be tallied in column form, by year, and averaged for the period analyzed (generally two years) to result in qualifying income. Income Analysis - Start With the Personal Returns Simple Self-Employed Income Analysis 2008 Gross Inome Depreciation Casualty Loss SEP IRA Total

$ $

198,103.00 18,123.00

$ $

13,867.21 230,093.21

Grand Total Divided by # of Months Stable Monthly Income

2009 $ $ $ $ $

177,654.00 19,175.00 25,076.00 12,435.78 236,349.78

2010 $ $

204,003.00 20,220.00

$ $

14,280.21 238,503.21

$

704,946.20 36 19,581.84

$

The most frequent complaint we encounter in analyzing self-employed borrowers is the complexity. Like many things, the way to tackle a complex task is to break it down into its components and work from there. Break apart the personal returns from the business as a beginning and begin analyzing where the income comes from. The federal 1040 will be the basis of the income analysis, so always start the analysis here, even though additional information and/or returns may be needed to complete the review. Take a blank piece of paper, or a spreadsheet, make the first column the most recent year, write down the source of each piece of income from

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the first page. As you note the income from the 1040, see what deductions have been taken that can be added back. Income Sources & "Add-backs" The general theory of adding deductions back to the taxable income is based on the fact that many of these deductions may not actually affect the bottom line of the business. They are allowable, non-cash flow deductions. You can almost always add back depreciation. A gray area is the concept of "non-recurring expenses.” If, for instance, there is a large deduction for attorney's fees, and the applicant's position is that a law suit was settled and won't occur again, how do you know that it won't?

Source W-2, 1099, Tips Schedule B, Interest/Dividends

Description & “Add-back” Rationale Salary & Other Income - Compare to company return for consistency Asset be verified and remain after closing. NonTaxable income can be added back in and "grossedup,” if necessary. Notes receivable must continue for 3

Schedule C - Sole Proprietor

Since the borrower and the entity are one and the same, look for duplicative expenses. Car expenses - is a car loan paid by the business? If yes deduct it from the debts. Add back “Business use of the home,” and “Depreciation.” "Optional" expenses like contributions; and pension/profit sharing can be added back. If there will be a home office and rent will be eliminated, add the rent back.

Schedule D

Capital gains can only be counted as income if there is a history of assets purchased and sold, and if the assets remain. Deductions from gain, exclusions and non-cash losses can be added back.

Schedule E - Rent Two Methods: 1.) Ignore tax returns, take rental and Royalty income supported by leases, deduct 25% and subtract Income Debt Service. 2.) Analyze Schedule E for add backs depreciation, anomalies such as tenant evictions, and eliminate properties sold. Newly added properties must utilize 1st method.

In isolated cases the borrower may have income which is paid to him - a Partnership and S Corporation income is also reported schedule E Property (it may even be a here, but add backs come from the K-1 or business vehicle he leases back to himself) returns. which he pays the rent on. It may Schedule F - Farm An active farm may not be eligible for financing. Depreciation, interest payments accounted for in the make sense to look for an add-back Income ratios can be added back. here, but this must be done in the context of which works better for qualifying. If it is added back as a non-cash loss, then there may be a mortgage to be added to debts. Partnership and S Corporation Tax Returns and Income Analysis

If the borrower's income is from a partnership or S Corporation the K-1 Form will determine the ownership interest. If the interest is more than 25%, the entity's returns must be analyzed. Unlike C Corporations, Partnerships and S Corporations must operate on a calendar year and their specific purpose is as a vehicle to disburse all income to the owners to avoid duplicate taxation. The K-1 Form itself will give the partners' share of deductible expenses which can be added back - depreciation, charitable contributions, and tax credits. An analysis of the tax returns can reveal other add-backs, non-cash deductions, and non-recurring expenses. A partner would generally not receive a salary from the partnership. If it is referred to as salary, it is more likely that it is a guaranteed draw or distribution. Conversely, an S Corporation can pay its officers a salary. In addition it may not be clear that there is an ownership interest if the borrower does not have a corporate title. Caution must be taken to identify that, if the borrower is an officer, the K-1 statement be requested to determine if there is ownership interest. If there is ownership interest, the borrower is not considered salaried and must submit to income averaging.

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Limited partnerships may be treated differently if the purpose of the entity is to provide a tax shelter. These are investments, generally, and do not represent the individual's primary source of income. “Limited partnership losses may be added back and should be explored further if the borrower is the limited partner.” In other words, the loss doesn't represent a negative going forward; it is an expression of the deteriorating value of the initial investment. General partners are liable for everything and must be investigated further. Analyzing the US Corporation Income Tax Return One of the unique advantages of the Corporation ("C Corporation" as opposed to "Subchapter S Corporation") is the ability to operate on a fiscal year that is different from the calendar year. This is referred to as "Straddling.” Because C Corporations have the highest income tax rate of any form, this straddling allows the company to declare income over two years, or offset a loss in one year against income in another to reduce the impact of taxation. The benefit for the corporation, however, becomes a challenge for the underwriter. This is because the fiscal year has to be reconciled with the calendar year of the individual returns. The borrower's income will appear under officer's compensation. This is the W-2 income accounted for on the personal tax returns. The corporation's net income is also income to the borrower. To determine how much income from the corporation can be attributed to the borrower, take taxable income and start adding back non-cash losses, depreciation, depletion, duplicative expenses, discretionary or voluntary expenses, and contributions to profit sharing plans. The result is the corporation income that the borrower can utilize for qualifying. This amount is multiplied by the ownership percentage of the borrower. Retained earnings are monies earned in a previous period and not paid out in the form of dividends. The combination of initial cash invested as capital plus retained earnings is what makes up net worth of the corporation. As a result it is possible to count this as income that is scheduled to be paid, if it can be shown that it has not been paid out or otherwise utilized in the income computation. In other words, if you were analyzing 2007 and 2008 returns and there were retained earnings in 2007, and not in 2008, that income has already been accounted for in the average. However, if retained earnings are carried forward to 2008, a case can be made to utilize that portion because it hasn't been counted anywhere else. The balance sheet is a part of the corporation return. It shows positives such as retained earnings. But it may also show negatives such as a deterioration of cash position from the beginning to the end of the year. Also, loans that come due within 12 months must be deducted from corporate income. Borrowers who do not take income from the corporation but loan themselves money are avoiding tax consequences. The loans may show as assets for the company. This cannot be counted as income. However, if the borrower decides to repay the corporation and it can be documented with copies of the promissory notes, checks payable to the borrower, and a letter from the accountant, it is possible to increase the corporation’s income, which would then be attributable to the borrower.

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The Profit and Loss Statement An income statement, profit and loss, or other Levels of Profit and Loss (P&L) Statement bookkeeping record is required to cover the period Preparation between the ends of the most recent tax period and Level Description document the business performance up to the current time - within 90 days. It is a concern as to SelfThe borrower, or internal whether an accountant must prepare the statement. Prepared accounting mechanism ,may prepare the document. It must be The extent of preparation of this document is consigned and accompanied by a tingent upon how much weight the underwriter perjury statement. needs to give the income from this period. If the reliance on the income statement is just to show Compilati An accountant takes the that the business is on track, it can be self- on borrower's information, and presents it in proper format, prepared. If the income is needed for qualificaaddressing apparent issues. tion, either because of a short business experience or to document an increasing income stream, an Audit An accountant reviews all inflows accountant prepared statement is necessary. The and outgoes independently and same treatment for the profit and loss should be presents a thorough view of the operation's financial condition. taken, as with the tax returns - non-cash losses, Because of the time and expense duplicative expenses, and tax treatment deductions involved, an audit is not such as depreciation, depletion and amortization, mandatory. as well as any discretionary contributions should be added back to the year-to-date income, for qualifying. The Balance Sheet As part of the financial statement of the borrower's company, there is a section dealing with the assets and liabilities of a company. This is the balance sheet. Balance sheets are also included on corporate tax returns and may be compared year over year. If the company is owned by an individual it is possible to add liquid net worth to the individual’s net worth. On the other hand, notes and loans payable within one year are counted against the company's income in underwriting review. Self-Employed Business Credit Reports/Dun & Bradstreet The use of business credit reports for self-employed borrowers on residential loans has diminished as FHLMC and FNMA eliminated the requirement. The idea was that the underwriter could find out if the business had borrowed money to give to the borrower to meet the down payment requirement. However, the reason they were eliminated was that they were being routinely required for the most prevalent form of self-employment - the Schedule C Sole Proprietor. There is no entity for a sole proprietor to shield debts or borrow money on behalf of. A credit report ordered through a standard credit repository or bureau does not yield that much information anyway and is a compilation of the information provided by the business. However, there are occasions when an underwriter requires them. This could be triggered by signs of business troubles encroaching on the personal financial situation of the borrower, such as business-related judgments or legal actions. For commercial loans it is more prevalent to check a Dun & Brad-

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street (800-666-6994) where they specialize in background, licensing and credit checks for businesses. Verification of Authenticity (4506 & 4506T) With extensive fraud occurrences among self-employed borrowers where either the lender or the borrower have submitted tax returns that exaggerate income, the industry has moved over the past 4 years to protect itself. The 4506 is the IRS form which allows the beneficiary to receive a copy of the complete return as filed from the IRS. It costs $6.00 per year requested. On October 1, 2007, the IRS begins offering The Income Verification Express Service (IVES) which provides two-business day processing and delivery of return transcripts. It is no longer too cumbersome for a timely check of the borrower’s tax return authenticity. The 4506T is the IRS form which allows the beneficiary to retrieve a transcript of the tax form which was filed. This allows the lender to quickly check and assure that the numbers reflected on the return that the borrower submitted match those filed with the IRS. All self-employed borrowers should sign this form, as a cautionary note. Go to IRS.gov to request the service. No Income Verification Loans No income verification loans are often touted as tools for self-employed borrowers who are too busy to meet the documentation requirements of a fully documented loan. The truth is no income verification loans allow loan officers to avoid the challenges involved in qualifying selfemployed borrowers. While the documentation burden may often be lifted, there is usually a price to be paid. Normally, borrower who must utilize reduced documentation programs are subjected to higher interest rates, reduced program selection (being limited to 15- or 30-year fixed loans), and larger down payment requirements. In some cases, the self-employed borrower’s income documentation is SO convoluted that a reduced documentation loan is the only solution. If there is a significant down payment and the borrower is willing to pay a slightly higher rate, there are many programs that allow the borrower to utilize stated income for qualifying and not require proof of income. However, the borrower must have 1.) Excellent reserves - at least 6 months' PITI; 2.) Perfect credit; and 3.) The asset verifications, such as bank statements, shouldn't call the income into question. There are also no income verification loans available for borrowers who do not have perfect credit. However, this involves the "Credit-Rated Paper" financing discussed in Chapter 4, which means the program variety is restricted and the rates are significantly higher than similar programs. Documentation Types and Their Meanings Type

Description

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Type Full Documentation

Alternative “Timesaver” Documentation Reduced/Stated Documentation “SISA” (Stated Income, Stated Assets)

Description Full refers to the process of directly contacting (by mail) the verification source, such as a bank or employer, in addition to the borrower provided bank statements, employment documentation and other materials. Loan officers may NOT hand carry this documentation, so an unfolded Verification form is VERY suspicious. VOE – Verification of Employment VOD – Verification of Deposit VOM – Verification of Mortgage VOR – Verification of Rent VOL – Verification of Liability An alternative to full documentation simply means that the borrower may provide the bank statements, W-2’s, pay stubs and other documentation, in lieu of direct written verification. A loan officer can “mix and match” alternative and full documentation items when there is difficulty verifying a specific item with alternative documentation. Stated, or reduced documentation loans may become a thing of the past. “Stated” income or asset verification indicates that the borrower will not provide documentation to support the income or asset figures provided on the application. However, the borrower’s application will be underwritten relying on the information, so ratio calculations and cash sufficiency are still required to meet guidelines. Most loan fraud surrounds the exaggeration of income or assets by loan officers or borrowers to assist in qualifying. If the loan officer isn’t certain that the stated information is accurate, the borrower should be encouraged to apply for a non-qualifying loan, even though the rate and down payment requirements may be higher.

What is a Compensating Factor? If “no income verification” is not an option, there is the school of thought that there may be sufficient compensating factors to allow an underwriter to approve a loan even though the ratios do not meet guidelines. Relying on compensating factors as a manner in which to obtain a loan approval is referred to as "throwing it against the wall and seeing if it sticks." There are various levels of compensating factors that provide various levels of assurance that insufficient income will not cause the loan to be denied. These are not the only conceivable compensating factors that can be addressed in presenting the case. Query the borrowers as to why they think they can afford the loan if the ratios are high. Have them draft out a monthly income and expense analysis showing how they are planning on affording the payment. This is perhaps the strongest mechanism for approving a loan with higher ratios. If the borrower is mature and has experience in homeownership, there is a good chance that they know what they are doing, so have them explain it. Co-borrowers Often, when a borrower cannot afford a proposed home purchase, a co-signer will be added. Cosigning is a bank term and does not really impact the perception of the case from a home lender’s point of view. From a mortgage lender's point of view, a co-borrower is required. The distinction between a co-signer and a co-borrower is that a coborrower’s application is reviewed as thoroughly

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Qualifying Tip – Co-Borrowers When considering adding a co-borrower, to achieve the fullest benefit that co-borrower should at least propose to co-occupy the property. This will only work if it makes sense. A second borrower moving into a one-bedroom condo doesn't make sense, but Grandma could move into the basement unit of a townhouse.


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as the borrower’s, with the same supporting documentation. If a co-borrower will be living in the property, then it is fairly reasonable to include them on the loan and allow the entire regular lending guidelines to apply cumulatively. However, if the co-borrower will not be occupying the property (non-occupant co-borrower - NOOCB) separate guidelines apply. Generally speaking, the NOOCB must be a relative or have a family-type relationship. In addition the occupant borrower must qualify on his or her own and have his or her own minimum cash investment. In these cases the NOOCB acts more as a compensating factor, and does not really add to the strength of the case. In addition, NOOCBs shouldn't be seen as a solution to a qualifying problem until all of their income, liabilities and credit have been examined, because they could, in fact, deteriorate the quality of the case. They should also be willing to answer all questions the lender may pose, because their application will be scrutinized as closely as the borrower's. Unemployment Insurance Obviously, it is really important for borrowers to have jobs and stable income. There are times when it is impossible to avoid unemployment. Unemployment can be used in an averaging scenario, when the income is variable. In some cases an argument can be made that the unemployment period is temporary and that employment income along former lines can be anticipated. Further substantiation of this can be when a borrower has obtained an offer of employment but has not yet commenced working. Income “Red Flags” In some situations a borrower’s documentation simply raises questions that have to be addressed. In others, discrepancies may be an indication of a borrower trying to conceal facts or perpetrate fraud. Being aware of these warning signs can eliminate problems later in the loan process. EMPLOYMENT / EMPLOYMENT VERIFICATION Employee is paid monthly No prior year earnings on VOE Gross earnings per VOE for commission-only employees should not be used (see IRS Form 1040 Schedule C) Borrower is a business professional (may be self-employed) Answering machine or service at place of business (may be self-employed) Prior employer "out of business" Seller has same address as employer Employer signs VOE prior to date it was mailed by the lender Borrower uses employer’s letterhead for letters of explanation Employment verified by someone other than personnel department Pay stubs are not preprinted for a large employer Pay stubs are handwritten for a large employer Current and prior employment overlap Date of hire is weekend or holiday Income is primarily commissions or consulting fees (Self-employment) Employer uses mail drop or post office box for conducting business Change in profession from previous to current employer Borrower is a professional employee not registered/licensed (doctor, lawyer, architect, real estate broker, etc) Illegible employer signature with no further identification Inappropriate verification source (secretary, relative, etc.)

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Document is not folded (never mailed) Evidence of ink eradicator (whiteout) or other alterations Verification "returned to sender" for any reason Inappropriate salary with respect to amount of loan SELF EMPLOYED (Some “red flags” are indicators that someone may be self employed, these are important if a borrower has not revealed themselves to be self employed) Business entity not registered or in good standing with the applicable regulatory agencies. Address and/or profession does not agree with other information submitted on the loan application Tax computation does not agree with tax tables No estimated tax payments made by self-employed borrower (Schedule SE required) No FICA taxes paid by self-employed borrower (Schedule SE required) Self employment income shown as wages and salaries Income or deductions in even dollar amounts High bracket taxpayer with few or no deductions or tax shelters High bracket taxpayer does not use a professional tax preparer. Paid preparer signs taxpayer’s copy Paid preparer hand-writes tax return TAX RETURNS Schedule A – Real estate taxes paid but no property owned Schedule A – No interest expense paid when borrower shows ownership of property (or vice versa) Schedule A – Employee who deducts business expenses (check against Form 2106) Schedule B – Amount or source of income doesn’t agree with information submitted on loan application Schedule B – No dividends earned on stock owned (may be closely held) Schedule B – Borrower with substantial cash in bank shows little or no related interest income Schedule C – Gross income does not agree with total income per Form 1099 Schedule C – Borrower shows interest expense but no related loan (business loans with personal liability) Schedule C – Borrower takes a depreciation deduction for real estate no disclosed (or vice versa) Schedule C – No IRA or Keogh deduction Schedule C – No salaries paid on non-service companies Schedule C – No "cost of goods sole" on retail or similar operations Schedule C – No schedule SE filed (computation of self-employed tax) Schedule E – Net income from rents plus depreciation does not equal cash flow as submitted by borrower. Schedule E – Additional properties listed by not on loan application Schedule E – Borrower shows partnership income (may be liable as a general partner for partnership’s debts) Form W-2 – Invalid employer identification number Form W2 – FICA and local taxes withheld (where applicable) exceed ceilings Form W2 – Copy submitted is not "Employee’s Copy" (Copy C) Form W2 – Large employer has handwritten or typed W-2

Eligible Borrowers In order to get a loan on a home, the borrower must be a person, not a corporation. But beyond this, there are many distinctions as to what kind of a person you are. A natural citizen of the United States does not have problems in this regard. This is because there is no way - even if convicted of a crime - which they could be asked to leave the country and, consequently, the property they own. However, because of the dynamic nature of the world and because of massive immigration, more and more foreigners are purchasing homes requiring financing in the U.S. When we say "natural person" we mean that the borrower may not take out a loan in the name of a corporation, partnership, foreign country, or other entity. They must own the property as individuals.

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Resident Aliens Resident Aliens are de-facto citizens of the United States. They may not vote, but are entitled to live here and enjoy all the protections of the constitutions and benefits of a wealthy society. Permanent resident aliens are eligible for loans just like citizens. There are distinctions between permanent and non-permanent resident aliens. A non-permanent resident alien is a person who is in the some stage of the process of becoming either a citizen or a permanent resident alien. Following are the criteria for determining the difference between a permanent resident alien and a non-permanent resident alien. Permanent resident aliens should have a "green card" which is issued by the Department of State and shows that they are lawfully residing in the country. If permanent residence has been applied for, the borrower's passport should be examined for the interim Visa that shows this. The document may be stamped in the passport, or a separate form, referred to as an I-551. Non-Immigrant Visas Recently, FNMA changed its guidelines on non-immigrant borrowers. Previously borrowers were required to be permanent resident aliens – to possess a green card - in order to qualify for FNMA/FHLMC financing. Now, most non-permanent visas will qualify the borrower for financing. The borrower still must meet the other requirements of the program and specifically must have 2 years of employment and banking/credit history. FHA and non-conforming sources are other sources for non-resident alien financing. While some non-resident aliens are eligible for financing, some cannot obtain financing at all. Specifically, borrowers who have diplomatic visas - Class A, are ineligible because they may be immune from civil prosecution. This would preclude a lender from foreclosing on a defaulted loan. In general, borrowers who have not resided in this country also present a special challenge because it is difficult to gauge their real earnings and assets. The guideline is that if they have not resided in this country for at least 2 years, and have not established U.S. credit histories and banking relationships, they are ineligible. This is because it is difficult to prove they have not defaulted on overseas obligations; they may have properties overseas that are liabilities that are concealed; or they may have borrowed money from an overseas source. All of these are issues which U.S. lenders would have no way of discovering, which means there is a high potential for latent adverse contingencies from borrower non-disclosure. There are strategies for assisting borrowers like this. You can perform an in-depth review of overseas accounts, contact their banks and analyze cash flows, and even contract a State Department sanctioned interpreter to translate documents. Even with the extra verification there is little likelihood that an exception to the guideline will be made if there are unexplained facets of the case. A non-permanent alien may hold one of the Visa categories outlined in the table below.

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Visa Symbol A

B C D E F G

H I J K L NATO

Description 1.) Ambassador, career diplomat, consular officer, 2.) Other foreign government official or 3.) employee, or attendant, servant or personal employee of someone classified A Temporary visitor for business or pleasure 1.) Alien in transit, 2.) in transit to United Nations, 3.) Foreign government official, family, servant, attendant or personal employee Seaman or Airman 1.) Treaty Trader or 2.) Investor 1.) Student or 2.) Spouse or child of student 1.) Principal representative of recognized government, 2.) Other representative of recognized government, 3.) Representative of non-recognized or non-member government, or 4.) Officer or employee of INTERNATIONAL ORGANIZATION 1.) Temporary worker of distinguished merit, 2.) Temporary worker performing services unavailable in the United States, 3.) Trainee Members of foreign information media Exchange visitor Fiancée of U.S. Citizen Intra-company transferee Member of North Atlantic Treaty Organization

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Chapter 6 â&#x20AC;&#x201C; QUALIFYING: Assets, Down-Payment and Closing Costs Understanding Asset Qualifying Assets, down payment and closing costs are inextricably linked. Accurately assessing the sufficiency of assets to consummate a transaction requires an understanding of the components. This process is called qualifying for assets. Understanding what the costs are made up of allows you to quickly estimate and manipulate the numbers, tailoring the transaction for its requirements. It should be stated that one of the strongest factors in the loan approval process is the level of assets. Often, having a large amount of residual cash can make up for a shortfall in income. With this thought in mind you should approach the issue of assets and cash sufficiency from two fronts: 1.) How to increase the amount of available assets; and 2.) How to reduce the amount of the cash required. So, like income qualifying, start with the idea of how much cash the borrower needs for closing. But to gauge the amount required, we do not have to perform a written Good Faith Estimate of Closing Costs. The costs can be estimated quickly and refined later with a lenderâ&#x20AC;&#x2122;s Good Faith Estimate of Closing Costs.

Understanding Closing Costs Throw away the pre-conceived notion that closing costs range from 4-7% of the sales price. This is not because they may not be. This is because it is misleading as to the actual numbers. Closing costs can be controlled, mitigated, and adjusted - customized for the transaction. That is not to say that it feels that way at closing. Settlement is actually the money pit - all of the funds are rolled in together and disbursed out by the settlement agent, title/escrow company, or closing attorney. Helping the customer to understand these charges helps the customer understand that settlement fees are not all just loan charges but are all of the costs associated with the closing of the transaction. There are relatively few loan fee components compared to all of the services. The Components of a Buyer's Closing Costs There are four categories of closing costs: 1.) Loan fees or points; 2.) "Hard" closing costs which are fixed transaction fees charged by the service providers to the transaction; 3.) Municipal and governmental charges which are the taxes and fees required by the jurisdiction in which the property is located; and 4.) prepaid items. Within certain categories, charges may be adjusted.

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1.) Loan Fees and “Points” There are many considera- Determining Optimum Cash Utilization tions with respect to paying Sales Price $ 150,000 points, some of which have Loan Amount $ 142,500 LTV: 95% been reviewed in earlier Option 2 Option 3 Option 1 chapters. When cash is at a Down Payment $ 7,500 $ 7,500 $ 7,500 premium and seller contri- Closing Costs $ 1,500 $ 1,500 $ 1,500 $ 4,275 $ 4,275 $ butions are limited by pro- Points Transfer Tax $ 1,650 $ 1,650 $ 1,650 gram guidelines, seller paid 1,500 $ 1,500 $ 1,500 $ points may not be an alter- Prepaids $ 16,425 $ 16,425 $ 12,150 native. By eliminating the Total Cash Required Seller Pays (%) 0 3% 3% loan fee/point component $ 4,500 $ 4,500 $ of closing costs a borrower Seller Pays ($) Net Cash Required $ 16,425 $ 11,925 $ 7,650 can increase his or her leverage. As housing costs increase, purchasers may find that they have the income for a large mortgage, but not the cash for a large down payment and closing costs. A home buyer may find that a "zero point" option can help minimize closing costs, which might allow a larger down payment, or money for other expenses related to a new home purchase, such as furniture, repairs or sundries. 2.) "Hard" Closing Costs There are many, many neces- The Fixed Nature of "Hard Costs" sary services performed in Sales Price $ 100,000 $ 300,000 conjunction with the settle- Closing/Attorney's Fee $ 400 $ 400 $ 125 $ 125 ment of a real estate transac- Title Search Survey $ 175 $ 175 tion. A fee at closing acTermite Report $ 45 $ 45 companies each of these serAppraisal $ 350 $ 350 vices. The fees for these serCredit Report $ 20 $ 20 vices are fairly standard Document Prep/Underwriting $ 450 $ 450 within a range and so will Courier $ 45 $ 45 stay roughly the same for Tax Service $ 80 $ 80 each transaction regardless Flood Certification $ 12 $ 12 of size. This is why you can- Inspections $ 150 $ 150 not estimate the cost based Sub Total $ 1,852 $ 1,852 750 $2.50 $ 250 $ upon the transaction size. As Lender's Title Insurance a real estate or finance pro- Total with Title $ 2,102 $ 2,602 fessional you should consult and become familiar with the HUD Booklet "A Guide to Settlement Costs" for a detailed explanation of what these services and charges represent. While the term “sales price” is used in this chapter, the costs would also apply to refinance transactions.

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Title Insurance Title insurance is designed to indemnify you against your legal fees and expenses should someone else file a legal claim to your property. In the event of a total loss, referred to as a forfeiture or reversion, the policy insures your equity and, theoretically at least, would reimburse you for your loss. There are two types of Title Insurance: Lender's and Owner's. The lender's policy will always be required if there is a loan involved in the purchase - the lender requires it and the borrower pays for it. The owner's policy, however, is a discretionary purchase for the buyer. To understand whether it is an advisable purchase there are some mechanics of the title insurance business that need to be understood. 

Between 70% and 90% of the premium for owner’s title insurance is commission that goes back to the title company. This is because the borrower is insuring “equity”, not the sales price or value of the property. This is why title companies press so hard for borrowers to purchase owner’s title insurance. Understanding this, you may now realize that a very small portion of the premium is allocated towards any sort of fiduciary fund to pay claims. So either the incidence of claims is very, very low, or there is very little risk involved in writing this kind of insurance. In fact, both are true. Very few title claims are paid out, although environmental claims do present a risk in some areas. In addition, the risk of a claim is statistically non-existent relative to some of the other risks of loss in real estate ownership. This is because:  There is a title search and survey performed which would reveal any unacceptable defects in the title. These would have to be corrected at the owner’s expense before the title insurer would issue a policy.  Unless there is a problem with the title, properties are conveyed with a “General Warranty Deed.” This means that the seller is saying that the property he is selling has a marketable title. If there is a problem with the title, that seller is liable. (It may be difficult to collect from a seller, a benefit of owner’s insurance.)  In most newly developed projects (PUDs, Condos) there are underlying policies of title insurance. If this is the case, then there are many other parties who will be defending a claim along with the buyer, so this is somewhat of an additional indemnity.

States set maximum premiums and fees and establish the laws governing the insurance business. As a result, even though there are many different title insurance companies, the fees do not vary much. Title insurance is also the subject of many debates when purchasers finally start to study closing costs. If cash is at a premium, owner's title insurance is an added expense. At the very least, a negotiation and disclosure should be made over the full amount of commission to be paid. 3.) Government/Municipal Title Related Charges The Government wants to get its piece of each transaction, whether city, township, county and/or state. Depending on the jurisdiction, these charges may be called transfer tax, recordation tax,

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tax stamps, sales tax, etc. Some states or jurisdictions may offer homeownership incentives under which the buyer’s portions of these charges are waived, such as homestead exemptions. The charges may be levied against the buyer, the seller or both. Some jurisdictions may simply not levy these charges. Whatever the case, the charges are triggered by the act that makes our entire system of legal property ownership possible - the recording of a deed of sale. Recording a deed indicates a transfer of ownership or title to a property. The transfer indicates the amount of consideration, or sales price, upon which a levy is based. In addition, there may be a tax levied for recording a mortgage or deed of trust that would be based on the amount of the loan. These fees/taxes are variable depending on the sales price and loan amount. Knowing these charges is important not only for evaluation of the buyer’s requirements, but also for computing the costs of selling a home in another jurisdiction when a new purchase is contingent on a sale. Your local settlement company is a good source for this information. 4.) Prepaid Items As the term implies, a prepaid item is something paid for at closing which will come due in the future. Pro-rated real estate taxes, homeowner's and flood insurance, PMI, and interim interest are among the most common prepaid items. These are also the most confusing component of closing costs because they are not fixed or immutable and can change depending on the closing date and the jurisdiction. The key concept to understanding prepaid items is that interest on a mortgage is usually paid in arrears - after interest has had a chance to accrue on the balance. This is why the first payment Interest is due in advance at closing date on the mortgage is usually at least one month after the closing date. People who are accustomed to paying rent think they are getting a "free month" because the first day of the next month after closing arrives and their payment isn't due for another month.

st

The 1 payment is due at the beginning of the next month

In this example, the borrower closes on March 16th. Interest is due at closing from the 16th of the month until the end of the month. The First Mortgage Payment is due May 1 – after the interest has accrued on the balance.

Interim Interest Also referred to as per diem, or per day, this is an adjustment of the interest from the closing date until regular principal and interest payments start accruing under the term of the loan. This is the easiest place to see the interest in arrears concept, because at closing the settlement agent collects interest from the date of settlement until the end of the month. This is where the common misconception of "closing at the end of the month" being a money saving function comes from. If

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you close at the beginning of the month, you would pay 30 days of interest. The cost is just a mortgage payment in advance - and this is the only time one would pay interest in advance. Just like staying in a hotel, you pay interest on the loan for the days that you have it. It doesn't mean you are paying more at closing because, more than likely, you are not paying to stay in a hotel, your old home or a rental anymore. If the cost of the per diem interest is too much to bear it is possible to arrange for an interest credit at closing for a closing early in the month. This means that the lender does not collect any per diem interest at closing, but simply moves the first payment date to the first day of the month following closing. The first payment would be the regular principal and interest payment less interest for the number of days that into the month that the closing occurred. It is important to note that, no matter what the closing date; FHA requires that at least 15 days of interest be included in the closing cost calculation for qualifying purposes. Insurance Escrow

Next Year, the Insurance Premium is due this day

One of the most frequent complaints about escrows for homeowner's, flood and private mortgage insurance is "why do I have to pay money into escrow when I have already paid the insurance premium for a year?" The key to understanding this is to understand that all insurance requires that the premium be paid in advance - regardless of whether it is Beginning in May, we collect 10 payfinanced or not. Again, the reguments until March, lar monthly payment for principal and interest, taxes and insurance In the same example – at closing the borrower pays for one year of insurance. The renewal (PITI) doesn’t come due for at insurance premium is still due on the anniversary of the closing. At closing we collect March and least one month because the April’s premium for next year, leaving May through March to be collected over the year. payment is due in arrears. This has to be reconciled with the fact that the insurance anniversary date is the closing date. Usually there are 10 monthly PITI payments that the lender receives prior to the insurance anniversary or premium due date. The insurer will expect to receive the annual premium that is 12 times the monthly insurance portion of the payment. To make up for the 2 month shortfall, the lender places 2 months insurance into the escrow account so that there will be enough money to pay the premium when it comes due. When there is private mortgage insurance (PMI), it is the same issue. When utilizing PMI under the traditional plan, there is an initial premium paid at closing. The 1 year renewal premium will come due after the borrower has only made 10 regular PITI payments. So to offset the expected shortfall, the lender collects 2 times 1/12th of the renewal premium at closing. If the PMI is a monthly plan, there is no initial premium, but the premiums must start being re-

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mitted from the date of closing. In this case the lender will collect two months of the premium again, to make up for the fact that the first regular PITI payment is not expected for 30-60 days. Real Estate Tax Escrows This can be the most confusing prepaid because, on top of the fact that real estate taxes may come due at different times within neighboring jurisdictions, sometimes the real estate taxes are paid in advance, or partially in advance. When this is the case, the lender has to make sure that it collects enough in escrow with the expected PITI payments to pay the taxes when due. The loan officer has to make sure that the borrower understands that they must repay the seller for any Understanding Escrows Illustrated Tax Bill Due September 15, Semi Annually, In advance Settlement June 15 First Payment Due August 1

3.) The seller has paid for taxes for the time he used the property. The buyer owes the seller a refund for the period of time beginning at closing, through the tax period.

1.) At closing the borrower has to place enough in escrow to pay the next tax bill when it comes due. How much should he place in escrow? – see # 2.)

2.) The borrower’s 1st Payment is due August 1, but he will only make one payment before the tax bill is due. The taxes bill is for 6 months. 6 month bill – 1 payment = 5 month escrow.

amounts that the seller has paid in advance. For instance, if the seller has paid 1/2 year in advance and the tax bill is based upon an annual assessment, the borrower could pay as many as 14 months real estate taxes at closing; 6 months to pay back the seller, 6 months to the jurisdiction and 2 months into escrow. Calculating: “How Many Months’ Taxes are Due?”

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When and for how many months are taxes due? When is the first payment due? Count the number of months from the 1st payment until the month when taxes are due. Subtract the number of payments the borrower will make from the number of months in the tax period. The shortfall is how many months of taxes to collect at closing. As in qualifying ratios, it is important to investigate whether borrowers are entitled to any government reduction in tax assessments, such as owner occupancy homestead deductions, senior citizens deductions or deferments. With new construction, there may be an additional closing cost to take into consideration. Until the property was sold, it was assessed as "unimproved.” There may be an improvement levy/tax that the jurisdiction assesses to make up for the fact that they were unable to tax the property until the occupancy permit/certificate of completion was issued. It is important for the loan officer to measure and fine-tune the impact of the closing costs and prepaid items. Without this a borrower may not have enough funds for closing. Conversely, the need for seller contributions could be overstated which could leave seller contributions underutilized.

Estimating Closing Costs – Qualifying for Cash Loan officers should practice preparing closing cost estimates. The Federally required Good Faith Estimate (GFE) form that must be given the borrowers at initial inquiry is changing beginning January 1, 2009. The GFE form is designed to correlate with the order of appearance of items on the HUD-1 Settlement Statement. The HUD-1 Settlement statement is the final accounting of charges related to closing. With the change in disclosure requirements, comparing the GFE to the Settlement Statement is part of the settlement transaction. Certain charges may not change from the time of origination until the time of closing. Please see Chapter 12 – RESPA for detailed information on the new GFE form. One drawback of the new GFE is that is does not provide a total of the amount of cash the borrower needs to qualify for the loan. Because of this the legacy GFE may still be used as a qualifying tool. In addition, the 2010 GFE aggregates multiple charges into individual headings for simplicity in comparing initial to final costs. This doesn’t illustrate the various individual cost components and the legacy GFE may still be used for this purpose as well. The GFE prepared for compliance purposes will be generated by loan origination/processing systems in order to reduce the risk of non-compliance. The loan originator should still understand the line-by-line method so that he or she can explain to the borrower what the detailed costs are and what services they represent. What These Costs Represent Understanding what the actual costs represent and who they are paid to can also help to explain the Good Faith Estimate and Settlement Statement.

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Line Paid to Paid By - Description 700. Real Estate Seller - This is the total dollar amount of the real estate broker’s Sales/Broker's Broker sales commission, which is usually paid by the seller. This Commission commission is typically a percentage of the selling price of the home 800 Section - Items Payable in Connection with Loan. These are the fees that lenders charge to process, approve and make the mortgage loan. 801. Loan Lender or Buyer - This fee is usually known as a loan origination fee but Origination Broker sometimes is called a “point” or “points.” It covers the lender's administrative costs in processing the loan and the costs of commissioned sales people. Often expressed as a percentage of the loan, the fee will vary among lenders. Generally, the buyer pays the fee, unless otherwise negotiated. 802. Loan Lender Buyer/Seller - Also often called "points" or “discount points,” a loan Discount discount is a one-time charge imposed by the lender or broker to lower the rate at which the lender or broker would otherwise offer the loan to you. Each "point" is equal to one percent of the mortgage amount. 803. Appraisal Fee Appraiser Buyer - This charge pays for an appraisal report made by an appraiser 804. Credit Report Credit Buyer - This fee covers the cost of a credit report, which shows your Fee Bureau credit history. The lender uses the information in a credit report to help decide whether or not to approve your loan. 805. Lender's Lender Buyer - This charge covers inspections, often of newly constructed Inspection Fee housing, made by employees of your lender or by an outside inspector. 807. Assumption Lender This is a fee which is charged when a buyer “assumes” or takes Fee over the duty to pay the seller’s existing mortgage loan. 808. Mortgage Mortgage Buyer/Borrower, Seller, Lender - Often, lenders will not allow Broker Fee Broker brokers to charge an origination fee and will insert the fee as a mortgage broker fee. In some cases, the fee paid to the broker is a yield spread premium and does not come out of the borrower’s funds at all. If this is the case, the fee may show up as P.O.C. – (Paid Outside Closing) 809. Tax Service Tax Service Buyer/Borrower – The Tax Service Contract runs for the life of the Fee Company loan and reports to the lender when real estate taxes go past due. This is important because delinquent taxes allow the government to force the sale of the property without the lender’s consent to satisfy back taxes. Tax liens are first liens. 810. Flood Flood Buyer/Borrower – Also known as a “Flood Zone Determination” a Certification Service flood certification is an independent confirmation as to whether a Company property is in a flood hazard area. If it is, the lender will require Federal Flood Insurance. 811. Other Lender or Fees such as Document Preparation, Underwriting, Processing, Broker Document Review, Wire Fees and Application Fees may also appear here, even though they are not pre-printed on the form. These are referred to collectively as “lender or broker fees.” Often they are called “junk fees.” Section 900. Prepaid Items Required by Lender to Be Paid in Advance: You may be required to prepay certain items at the time of settlement, such as accrued interest, mortgage insurance premiums and hazard insurance premiums. 901. Interest Lender Borrower – Also known as per diem interest, this is the pro-rated amount of interest from the date of closing until regular principal and interest payments begin to accrue under the terms of the note.

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Line 902. Mortgage Insurance Premium

Paid to Lender Mortgage Insurer

Paid By - Description Borrower – Lenders require that the first year’s private mortgage insurance premium or FHA Mortgage Insurance Premium, be paid in advance. Even if the premium will be financed, it will still appear as a charge here – the increased loan proceeds cover the cost. Buyer/Borrower - Hazard insurance protects against loss due to fire, Hazard 903. Hazard windstorm, and natural hazards. Lenders often require the borrower Insurance Insurance to bring a paid-up first year’s policy to the settlement or to pay for Company Premium the first year's premium at settlement. 904. Flood FEMA Buyer – If the flood certification indicates a flood hazard, the lender Insurance will require flood insurance. 1000. Section - RESERVES DEPOSITED WITH LENDER 1001. Hazard Insurer or Buyer – Lines 1000 – 1008 are Escrow Account Deposits. These Insurance Municipality lines identify the payment of taxes and/or insurance and other items 1002. Mortgage Collected by that must be made at settlement to set up an escrow account. The insurance Lender lender is not allowed to exceed a cushion of 2 months. 1003. City property taxes 1004. County property taxes Section 1100. Title Charges: Title charges may cover a variety of services performed by title companies and others to conduct the closing. These costs for these services/items may vary widely from provider to provider. 1101. Settlement Title, This fee is paid to the settlement agent or escrow company. or Closing Fee Escrow Responsibility for payment of this fee should be negotiated between Company or the seller and the buyer. Attorney 1102-1104 Title, The charges on these lines cover the costs of the title search and Abstract of Title Escrow examination, so that the closing agent can perfect the clear title for Search, Title Company or the property. The title company, attorney or underwriter examines Examination, Title Attorney and issues a temporary “binder”, binding coverage and stating limits Insurance Binder and terms that will appear on final policy. 1105. Document Title, This is a separate fee to cover the costs of preparation of final legal Preparation Escrow papers, such as a settlement statement, mortgage, deed of trust, Company or note, transfer or deed Attorney 1106. Notary Fee Title, A Notary Public takes oaths and, in the case of the real estate Escrow closing, attests to the fact that the persons named in the documents Company or did, in fact, sign them. Attorney 1107. Attorney's Title, An attorney is traditionally required to review any drafting of legal Fees Escrow documents. Since most loan documents are pre-printed forms, an Company or attorney may not be required for the closing. Attorney’s fees are, Attorney however, compensable settlement services. Occasionally, a vendor may place their Closing or Escrow fee here. 1108. Title Title, Lender’s Title Insurance covering the loan amount, is a normal Insurance Escrow requirement of a lender. Owner’s title insurance, which insures the Company or owner’s equity based on the sales price less the loan amount, is Attorney not. The charge is variable based on the size of the policy. Section 1200. Government Recording and Transfer Charges 1201. Recording Jurisdiction Buyer/Borrower- The fees for accepting for record the new deed Fee Courthouse and mortgage/trust. Normally a per page charge.

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Line 1202 and 1203. Transfer Taxes, Tax Stamps

Paid to State/Local Government

Paid By - Description Buyer/Seller/Borrower - Transfer taxes may be collected whenever property changes hands or a mortgage loan is made. These are taxes on the transaction and are set by state and/or local governments. These may be referred to as tax stamps, recording stamps, recording taxes or other names. Section 1300. Additional Settlement Charges: 1301. Survey Surveyor Buyer/Borrower – Utilized in conjunction with the title examination and underwriting, a survey examines whether any property line or easement violations exist impacting the title. 1302. Pest and Inspection Termite or Wood Destroying Pest Inspections assure there is no Other Inspections Company active infestation or damage. Well/Septic for non public water/sewer property. Final Completion for new construction or repairs.

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Seller Contributions Depending on the loan program, a seller may assist by paying for closing costs on behalf of a buyer. This is called a contribution because it is a standard practice and pays for actual costs normally incurred by a buyer. This is acceptable because the lender still assures that the borrower is making an equity contribution in the form of a down payment.

Contributions Help Buyer Pay for Costs

Sales Price Down Payment Loan Amount Closing Costs Seller Paid Costs Cash Requirement

No Seller Paid Help $ 200,000.00 5% $ 190,000.00 6000 0 $ 16,000.00

3% Seller Paid Help $ 206,000.00 5% $ 195,700.00 6000 6000 $ 10,300.00

There are limitations as to what the Concessions Erode Buyer Equity seller can pay for. The reason for this Sales Price $ 200,000.00 is that excessive seller contributions Maximum LTV 95% may artificially inflate the sales price. Loan Amount before Concessions $ 190,000.00 Excessive contributions are called Repair Allowance $ 6,000.00 concessions. For instance, a seller try- Effective Sales Price after Concession $ 194,000.00 $ 4,000.00 ing to sell a house without a swim- Effective Borrower Equity $ 184,300.00 ming pool to a buyer who wants a New Maximum Loan Amount $ 15,700.00 swimming pool agrees to give the New Borrower Down Payment Required buyer $10,000 to pay for a swimming pool to be installed. The reality is that the house price is being inflated to pay for a swimming pool that does not yet exist. The danger in an inflated sales price is that the financing is based upon a certain amount of equity contribution - or down payment - from the buyer as a personal investment. The seller's concession may erode the buyer's equity contribution to the point where the loan balance is greater than the value of the house. As a result concessions may be allowed, but the underwriter/lender should make a downward adjustment to the loan amount to compensate for a lower equity contribution. It may seem a contradictory technicality that a seller contribution of 3% of the sales price towards closing costs is acceptable, but a 3% decorator's allowance is not. To a certain extent it is because everyone accepts the fact that seller assistance is based upon a certain amount of price inflation. From the seller's perspective it is all the same. A sales price of $100,000 in a transaction with no contribution as opposed to a $103,000 sales price with a 3% contribution nets the seller approximately the same amount of money. The distinction is one of valuation. If the contribution is traditional in the marketplace, and the inflated selling price is supported by other comparable sales, then the lender has some certainty that the borrower's equity contribution/down payment is bona fide. Avoiding Problems with Seller Contributions  

Watch for concessions, especially on transactions where a reduced sales price could have an impact on the loan approval. An 80% LTV loan with a concession could push the loan into a PMI requirement. Decorator/repair allowances are concessions. Don't specify what can and cannot be paid with the seller contribution. Specify a flat dollar amount. This allows the buyer the maximum flexibility in structuring financing.

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 

In addition, this will avoid disputes at closing regarding who is responsible for paying certain fees. Avoid over-leveraging. A seller contribution is tantamount to financing of certain costs. Even in situations where contributions are limitless - like the VA Guaranty Program - the contribution at closing will be carried for the entire ownership of the home. Avoid exceeding the listing price of the house to finance a seller contribution. Even if the sales price is justified, it would be hard for an appraiser to justify a valuation that was higher than the seller's.

Structuring Seller Paid Closing Costs Structing Closing Costs to Reduce Cash Required

When making assisting a buyer in qualifying, "Typical" "Structured" prior to the working on an offer with a real Points $ 2,850.00 $ Attorney's Closing Fees $ 940.00 $ 940.00 estate agent, combining closing cost tailoring $ 810.00 $ 810.00 and allowable seller contributions are the most Lender's Fees $ 1,100.00 $ 1,133.00 effective ways of reducing the cash require- Government Charges $ 1,028.00 $ 118.00 ment. First, throw away the pre-conceived no- Prepaid PMI Hazard & Real Estate $ 574.00 $ 574.00 tion that closing costs range from 4-7% of the Total Costs $ 7,302.00 $ 3,542.00 sales price. Not because they don't, but beSeller Contribution $ $ 3,090.00 cause this statement can automatically turn a Down payment $ 5,000.00 $ 2,060.00 buyer off from investigating the actual num- 2 Mos Reserves $ 1,734.00 $ bers. The closing costs can be controlled, mit- Cash Required $ 14,036.00 $ 2,512.00 igated, and adjusted - customized for the transaction. They must be analyzed number by number to assure potential buyers that they can do it! In this example we are able to take a typical $100,000 standard transaction and reduce the cash required from $14,000 to less than $3,000. Don't pay points Use Monthly PMI Get the Seller's Help Community Homebuyer Program

If cash is an issue, a difference in $50 per month is far less dramatic than $3000 at closing. The traditional plan can add at least 1 point up front. Monthly PMI takes this away. Increase the sales price enough to cover at least a 3% blanket contribution to closing costs. It's all the same to them if they are netting the same amount of money. The borrower can obtain 3% of their down payment in the form of a loan from a credit union or the lender! Also the reserve requirement is waived.

Sources of Assets for Down Payment, Closing Costs and Reserves The borrower may have saved cash over time, or may be selling a current home and reinvesting the proceeds. In fact, the borrower may have waited until he or she has a surplus of cash beyond what is needed to close and if this is the case, a discussion of assets isn't really necessary. It is when the borrower doesn't have the appropriate sufficient funds that a loan officer earns the commission. Here is a listing of some possible alternative sources of down payment funds.

Source

Description/Treatment

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Source

Gift

Sale of Asset

Borrowing

Side Jobs

Rental/ Deposits Repayment of Personal Loans Gambling Earnings

Description/Treatment Gifts from family are an acceptable source of funds. With FNMA/FHLMC financing, the borrowers must document that they have 5% of the sales price of their own funds invested into the transaction. If the down payment is 20% or more, the 5% limitation does not apply. FNMA/FHLMC requires that the source, transfer, and receipt of the gift be verified. “No income verification” loans do not generally allow the use of gift funds. FHA/VA does not limit the amount of the gift and does not care who the source is, provided there is no business relationship. SEE GIFT TIPS! If a borrower has any property that could be sold, such as coin or stamp collection, jewelry, used cars, artwork, rugs, or anything of durable value, this can be used as a source of funds for closing. A sales receipt is required, along with a copy of the payment to authenticate the sale. The asset may also be used to meet post closing reserve requirements, if a reputable dealer ascertains the item's value and what the dealer would pay for it - to demonstrate its liquidity. An insurance policy stating the value of an asset is also substantiation of value. Borrowing against an asset is an acceptable source of down payment funds. Loans include 401(k), life insurance policy or other retirement savings plan loans that provide for partial liquidation in emergency or home purchase. Pawnshops are excellent sources of secured loans, lending on everything from musical instruments, technical equipment, jewelry, cars, silverware, or anything of durable value, and you get a receipt. Many stock accounts have margin options, which is a loan secured by stock. A credit union may lend you money on an unsecured basis and take something of value as security for the purposes of a home loan. With the exception of VA, loans for down payment and closing costs must be secured. FHA/VA - Borrowing is not an acceptable way of making up the difference between the sales price and appraised value. YOU MUST ALWAYS QUALIFY CARRYING THE LOAN PAYMENT! If a borrower needs to make up a small cash shortfall to meet the requirement to provide 5% of the funds, consider performing some personal services, such as house sitting, painting, dog walking, lawn mowing, catering, etc. Because these are not subject to withholding taxes, and because they are paid immediately and usually by personal check, these funds can quickly absorb cash shortfalls. These cannot be counted as income, but are acceptable sources of cash if documented properly. Handicraft sales can achieve the same goal. Often the rental security deposit is overlooked as a source of cash reserves. A letter from the landlord stating that a security deposit refund is due can substantiate the amount of money underwriting may use as a reserve. You lent someone money 5 years ago, but have been letting it go because you are friends. They didn't sign a note, but you wrote them a check. Get them to pay you back, at least partially. A letter from the borrower, a copy of the original check and copy of the repayment are required. When you gamble and win a large amount of money, a casino may write you a check in lieu of cash. Again, while this is not a source of income, it can be acceptable documentation of funds.

Borrower’s Own Funds The guideline that the borrower must have 5% of his or her own funds is a reflection of the fact that as lenders we want to show that the borrower has some attachment to the property. If they are leveraging a purchase to the point that they do not have any real investment of money and are receiving all gift funds, then there is little inclination for the borrower to sacrifice and make the payment of the mortgage a priority. Some Community Homebuyer programs allow as little as Chapter 6 – Asset Qualifying - Page 121


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0%, 2% or 3% of the borrower’s own funds to be invested into a transaction. The portfolio performance of borrowers having less than 5% of their own funds invested into the property is roughly 300% worse than traditional 95% LTV programs. Expect that this is an issue that is heavily scrutinized when the borrower’s funds situation is very close. Reserves One of the last trip wires you may encounter in qualifying is that there are insufficient funds in reserve. Reserves are moneys lenders require to offset any unseen cash shortfalls and to show that, after the transaction, the borrower isn't broke. The standard guideline is to have 2 months' PITI remaining after all down payment, closing costs and prepaid items are met. This is because there are costs outside of the transaction (moving expenses, necessary sundries like shower curtains and garbage cans, inspections, etc.) that will absorb some cash flow ordinarily devoted to making the payment. Any of the sources mentioned above would suffice for reserves and wouldn't have to be liquidated. FHA requires only 15 days of interest in reserve. VA doesn't care and some Community Homebuyer programs waive the reserve requirements if the case is strong. Lender Credits for "Above Par" Pricing Towards Using Yield Spread to Contribute to Closing Costs Closing Costs You can use the “above par,” rebate, or yield spread towards some of the purchaser’s closing costs, prepaid items, or other fees. In certain cases, the amount of the premium is limited to the amount of the seller contribution allowed under the specific loan plan. Tips for Using Gifts

Sales Price Loan Amount Down Payment Closing Costs Total Cash Required

$ $ $ $ $

100,000 95,000 5,000 1,500 6,500

Price on Loan Sale ("above par") Cash from "Yield Spread" Less Lender Cost of Loan Cash Available to Borrower

$ $ $

103.50% 3,325 1,425 1,900

The gift letter form is designed to state the intention that funds received are a "bona fide" gift, and that there is no explicit, or implicit, requirement for repayment. To substantiate that there is no implicit repayment required and to confirm that the funds received are, in fact, gift funds and not funds from another source, we require that the following documentation be provided in addition to the actual gift letter: Donor's Ability to Give

This shows that the person giving the gift actually has the funds to give. This can be accomplished two ways. The donor can provide a complete bank statement showing that the funds are available in their depository institution, or The donor can take the gift letter form, when Section A is complete, and have the depository institution complete Section B.

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Proof of Transfer

Verification of New Balance

The "paper trail" of funds must be established to document that the funds received are actually from the donor and not an undisclosed or borrowed source. To do this the following must be provided: Proof of withdrawal of funds from donor. This can be accomplished by providing A copy of the cancelled check from the donor, A copy of the withdrawal slip from the donor's account, Copies of the wire transfer advice. If a broker or 3rd party is liquidating funds on behalf of the donor, copies of this transaction must be made (i.e., debit memo, inter account transfer, etc.). Proof of receipt of gift funds. This can be provided in the form of A copy of the recipient's deposit slip, A copy of the wire transfer advice or A copy of the credit memorandum from the bank Once the gift funds have been received, we need to prove that the funds, now received, are sufficient to complete the transaction. To accomplish this, when the gift is deposited, please have your bank provide a letter with the following verbiage: PLEASE BE ADVISED THAT $____________ (gift sum) HAS BEEN DEPOSITED INTO THE ACCOUNT OF ____________ (recipient's name) ACCOUNT NUMBER ____________ (recipient's account). THIS DEPOSIT IS IN ADDITION TO THE CURRENT BALANCE OF $ ___________ (recipient' s current account balance). THIS WILL RESULT IN A NEW BALANCE OF $_______________ (gift deposit combined with current balance) Signature of Depository, Date

Shared Equity The concept of shared equity is a partnership between an individual who has cash and an individual who is able to make the mortgage payments. The intention of shared equity is to allow an individual who has no cash, but is able to afford the monthly payments to buy a home with the help of a partner. The buyer would get the tax write off for the mortgage interest and, when the home appreciates, a portion of the equity. The equity partner would receive the appreciation, or the equity. There are numerous problems with this approach. First, there is a legal ownership agreement that divides the ownership interest of the property. The lender does not care if there is a joint agreement, but revealing that there is an agreement could jaundice the approval process. More problematic is the fact that shared equity partners must sign all the closing documents and be obligated on the transaction. They are de facto nonoccupant co-borrowers and then the transaction is subject to those limitations. While the occupant borrower may qualify for the loan, there may be problems such as the number of properties financed for the shared equity partner. “Red Flags” for Assets and Deposits Review the asset portion of the borrower’s application closely for inconsistencies. Asset documentation is one of the most difficult to track areas in the mortgage process. These warning signs can help you avoid pitfalls in the loan process.

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VERIFICATION OF ASSETS /DEPOSIT / BANK STATEMENT Regular deposits (payroll) significantly at odds with reported income Earnest Money Deposit not debited to checking account NSF items require explanation. Large withdrawals may indicate undisclosed financial obligations or investments Lower income borrower with recent large accumulation of cash Bank account is not in borrower’s name (business entity, trust funds, etc.) Evidence of ink eradicator (whiteout) or other alterations Verification "returned to sender" for any reason High income borrower with little or no cash (undisclosed liabilities) IRA is shown as a liquid asset or a source of down payment Non-depository "depository" (escrow trust account, title company, etc.) Credit union for small employer Borrower’s funds are security for a loan Illegible bank employee signature with no further identification Source of funds consist of (unverified) note, equity exchange or sale of residence Cash in bank not sufficient to close escrow New bank account Gift letters must be carefully reviewed (canceled checks, bank statements) Borrower has no bank accounts (doesn’t believe in banks) Document is not folded (never mailed) Young borrower with large accumulation of unsubstantiated assets Young borrowers with substantial cash in bank

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Chapter 7 - The Home Financing Process It has been said that there is no substitute for experience as a teaching tool. There was one instructor who had an unorthodox but effective method to initiate new recruits - he staged public "mock" loan application appointments assigning seasoned loan officers to role play as borrowers and real estate sales professionals. The new loan officer would walk in completely cold and, in front of a full complement of branch personnel and peers endure the contrived "worst case" customers that the experienced pros created. The result was the overt, general humiliation of the new recruit. This was the instructorâ&#x20AC;&#x2122;s intention - very few of his loan officers went into their next "real" loan application without being sure they were prepared. He knew that the key to a successful loan process was at the beginning - a great loan application. In the vernacular of the business, "taking a loan application" is the loan application interview. The interview can be conducted in person, via mail, fax, or over the telephone and the purpose is to collect all of the information and documentation that will be required to obtain a loan approval. Note that a mortgage related application does not begin for disclosure timing purposes until there is a property. Then there are the forms -- lots of them and many different varieties from lender to lender. None, however, are as important for the processing of the loan as the application form itself.

Understanding the Home Buying Process A recent survey sponsored by the National Association of Realtors revealed that over 80% of all loan applicants were referred to their lender by their real estate sales professional. This gives you a sense of how much influence the real estate agent has in the transaction. Among other things, real estate sales professionals will recommend a number of lenders with whom they have worked successfully. The real estate sales community has a huge amount of leverage over lenders in the performance of their commitments, since lenders rely on them for repeat business. The real estate sales professional is counting on the lender not to jeopardize his income on the transaction. Where a lender who has no ties to the community may be unresponsive, a lender the real estate professional recommends is certain to be responsive to the transaction. Select Real Estate Sales Professional: The real estate sales professional helps the buyer to determine their needs, select an area, and understand the buying process.

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Aside from ingratiating themselves to real estate sales professionals, a loan officer can perform a useful service in the early stages of the home selection process by pre-qualifying or preapproving a borrower before a property is selected. A "Pre-Qualification" is based upon the borrower representations of their financial situation. The lender then states, based upon the information provided what type of financing the borrower can qualify for. A "Pre-Approval" is a review, by an underwriter, of the supporting documentation, including a credit history that verifies the stated information. Because this is an actual approval it holds more weight than a “PreQualification.” With a “Pre-Approval,” the borrower can proceed directly to closing with a satisfactory appraisal. In some cases a pre-approval can offer interest rate protection as well. Making an Offer: The offer specifies the price and contingencies such as financing and home inspection. It also specifies the down payment, settlement time, and costs the seller is to pay.

Once pre-qualified or pre-approved the borrower can proceed with identifying a home and negotiating a price. Again, the real estate sales professional is critical in acting as an intermediary and in providing information regarding recent home sales that will help establish a fair price. The offer sets forth the sales price, how much the down payment will be, what the terms of the financing are and whether the seller will assist with closing costs.

The down payment will be determined, in part, by the kind of financing selected. Generally there is a deposit of a portion of the down payment with the contract or offer. This is referred to as an "Earnest Money Deposit" and represents the buyer’s good faith in presenting an offer. The Loan Application Process

Offer Acceptance: Once accepted the offer becomes a contract. The buyer orders a home inspection and selects a settlement agent. If the loan was pre-approved, now we can order the appraisal.

A pre-application checklist, kit or other format for collecting the loan documents necessary to obtain approval should be provided to the buyer or borrower at the earliest possible convenience. This Pre-Application Kit will help speed the loan application interview and the loan. It cannot be overstated how important it is to collect all of the information required on the application checklist prior to the application interview with the loan officer.

Why You Should Use a Pre-Application Kit Getting the information required for the loan in advance of the application can save your life, especially when you are new to the business. It allows data to be reviewed at leisure, in the context of overall qualification, and if you have questions about the borrower there is time to get them answered. When you use a pre-application kit you can   

Screen unverifiable information that would be detrimental to loan approval Identify missing or contradictory information or documentation prior to application Allow the borrower the opportunity to volunteer additional information not requested supportive of additional assets or income

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  

Preview credit information, by obtaining a credit authorization Spend time in the application interview discussing loan programs or solutions to problems instead of filling out forms or collecting documents Put the responsibility of providing all application documentation on the borrower.

In the event that the borrower is unwilling or unable to provide the pre-application kit, and the supporting information, the loan officer can still brief him or her to bring the basic documentation to the application interview. The same information is required on every loan application and is as easy to remember as 1-2-3. REMEMBER THE BASICS – EASY AS 1-2-3 If salaried - most recent pay stubs covering 30 day period 1 If self employed - year to date income and expense statement (profit & loss) and Month of balance sheet Pay stubs If salaried – all W-2 forms for previous 2 years 2 If self-employed - Federal Tax Form 1040 (with all Schedules attached) for previous 2 Years of years (Please note: If you are a commissioned sales person, have any bonus income, Income Documenta rental income, or income from other sources, these forms are required even if you do not consider yourself self-employed) tion If owner or partner in business federal corporate tax returns Form 1120 or 1120S or partnership returns Form 1065 (with all Schedules attached) for previous 2 years, or applicable 2 year fiscal years. 3 most recent months bank statements - all pages. Please include savings, checking, 3 Months investment, stock, mutual fund, 401(k), IRA and Keogh Accounts. Assets

With this information and a copy of the sales contract or other property information, the loan officer has enough information to begin the process. This information does not necessarily constitute a complete application.

The Application Interview- Completing the Application Form Each individual loan officer develops a unique way of interacting with customers - explaining, questioning, developing an accurate profile of the borrower. This initial interview is critical, because during the first meeting customers tend to be more compliant and receptive to requests for additional information or explanations. The loan officer is in control and can manage the customer's expectations. One of the most frequent complaints customers have with lenders is that they receive frequent requests for additional information. The application interview is the loan officer’s last opportunity to ask for information without the customer providing resistance, so it is important to be thorough.

Separate the Sale from the Application Process - Focus on Information Gathering If this is a true application interview, the terms of the mortgage have already been arranged. After a review of the Good Faith Estimate, commence the information collection process immediately by setting out the application form to be completed (or the lap top) alongside an "additional items needed" checklist. The application form actually works like a tickler, SO FILL IN ALL THE BLANKS! If something can't be filled in, you are missing information!

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Sections 1 & 2 of Application

If you are sitting with the customer, share any concerns with them as they come up. This is the reason a face-to-face interview can be so critical. Rather than recording incorrect information or data that will confuse or detract from the loan approval, clarify it now. Property issues frequently are revealed here: Is the property a condominium? Can you offer this type of loan on a condominium? Is the down payment appropriate? This can be a good segue into the asset part of the application. Read the sales contract now. How much is the earnest money deposit? Record this information not only on Section 6 Assets, but also in section 11, Details of Transaction. Did they bring the copy of the earnest money deposit check? Ask for it now! Every time something is missing, put it on the checklist!

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Section 3 – Personal Information Here we analyze whether the borrower has any potential areas of discrepancy. If they have moved a lot, there may be numerous landlords or mortgages to verify. If you are collecting their

previous address, GET THEIR rental data – write down the name, address and phone number of the landlord so that you can have the credit bureau verify it later. Section 4 – Employment Data

Section V - Income & Housing Expense  Examine Pay stub  Salary evident from pay stub?  Yr. to Date Higher/Lower than base salary? - Document/Explain  Deductions - Any Loans? Shown on Credit Report? if not request rating  Retirement? - Get Statement  Bonus/Overtime/Commissions 25%  Rent amount? - Get Landlord Name & Number  Mortgage Amount - Shown on Credit Report? - if no, need 12 months checks

While collecting employment data verify the income documentation. Check the names, addresses and social security numbers against the documents provided for information that doesn’t make sense such as:  A W-2 from an employer that is not listed.  A missing W-2 for a listed employer.

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 If there is a job that has been going on all year with a very small year-to-date income number.  A 1099 instead of a W-2 – indicating self-employment.

Section III & IV - Borrower Information & Employment  Borrower's Complete Name, Jr., Sr. ID Variance?  Social Security Number Match  30 Days' Pay stubs  2 Years W-2's  Self-Employed at least 2 years?  Two Years 1040's/1120/1065  Non-Schedule C business credit report necessary?  Any Job Gaps/Different Employers? get letter

Incongruent information caught early can save trouble down the line. These are all substantial examples of items that can be caught at the time of application. Section V - Income & Housing Expense In the employment section we check dates. Here, we need to check the numbers. The borrower may state a certain income, but may intend to tell you the net income after taxes as opposed to the gross. Review the documentation to verify. On Reduced documentation loans make sure the income is reasonable. They may offer additional income such as benefits, which cannot be counted. Again, there is space for all types of income to be noted, SO NOTE THEM.

As to the housing expense, if they are currently renting, ask for the name, address and phone number of their landlord. Is the mortgage on the credit report? If not, get 12 months checks!  

NO Income/NO Ratio Verification Loans. Do not state income here or anywhere else on the application. Rental Property – Put primary housing expense where PITI goes

Section VI - Assets & Liabilities

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List IRA’s, Savings Bonds, 401(k)’s Everything

STOP! Compute real estate schedule information now

Collecting asset and liability infor- Section VI - Assets & Liabilities mation is critical for the success of  Copy of Earnest Money Check - Agrees with Contract? Review Bank Statements the application. If there are liabili-   Funds for Closing Evident? - When received & What ties listed here which are not veri-  Any large withdrawals, deposits? - Explain & Document Net Worth Business? Self-employed P&L fied on the credit report, verifying   Cars owned free & clear? Titles? them may become a chore later.  Other assets? Anything? Anything? Liabilities Reported not reported or verified? Anything listed or disclosed on the   Credit explanations needed? application must be verified, so list-  Proof of Payoff? Real Estate Schedule - Rental Property on Tax Returns? ing inconsequential accounts can   Leases for Rentals lead to wasted time tracking verification. This is why we always want to take a credit report with us prior to the application inter-

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view. In addition, this is your only real opportunity to really question large deposits or other transactions on the deposit verifications – bank statements. It is tedious, but before you write anything down check to make sure you review all pages of any document BEFORE you commit it to the application. The “Schedule of Real Estate Owned” is a continuation of Section VI – Assets and Liabilities. It presents an opportunity and a challenge. If the borrower has sold an existing property which is pending settlement the loan originator should complete a “net proceeds worksheet” to accurately document how much cash the borrower will get. In addition, if a property is being marketed for sale, and may be rented to allow the customer to qualify for a new mortgage, the borrower should be advised now that the amount of the rent will be reduced by a vacancy/expense factor of 25%. To offset the vacancy factor the borrower must rent the property for a higher amount at least 125% of the mortgage payment is required to negate the effect of not having sold the property. Section VII - Cash Requirements and the First Disclosure - The Good Faith Estimate Sufficiency of assets for closing is a critical concern. The borrower will receive many differing accounts of how much cash they need to bring to closing. At this point you can set them greatly at ease by accurately completing the “Good Faith Estimate of Closing Costs.” From the Good Faith Estimate

Essentially, you are adding all of the costs and coming up with the total transaction costs. Then you subtract all of the items that will be paid for by the seller, the funds from the loan transaction and items, like the deposit that the borrower has already paid. This results in the borrower’s net cash requirement for closing. Hopefully the borrower has sufficient funds for closing. In a refinancing transaction and closing costs are being financed, you will go through this process to determine what the appropriate loan amount should be.

Loan File Set Up Once the application is complete, it helps to place the file in order and use a two-hole fastener to place the documents in a legal folder. Using a "Standard File Order" helps to re-review the file to assure that nothing was missed.

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While putting the file in order, make notes on a conversation log of some sort regarding the unusual circumstance revealed through the application process. A checklist of items needed to complete the application, which resembles the initial application checklist is given to the customer to inform them of anything remaining to be provided for processing. There is nothing operations personnel hate more than having to spend significant extra time piecing together a new loan file. It is especially important if you are a new loan officer to do everything you can to make the job of the operations staff easier. All of the comments, notes, qualification information, customer contacts, and special instructions should be included on a conversation log. In addition, having the file in order will allow the processor to more quickly analyze problem areas and prepare the file for submission to underwriting for approval. Standard Loan File Set Up Order – Two Hole Fastened Right Side From Top to Bottom Left Side From Top to Bottom Conversation Log Loan Registration Appraisal Request Customer Pre-qualification Calculations Copy of Application Deposit/Appraisal Fee Pre-Application Kit Contact information for case (Upside Down) Customer Supplied Documents not needed for loan approval

Original Application Application Supplements, Green Cards, Reason for Refinance Credit Report Credit Related Information, Explanations, Payment Histories Income & Employment Information Asset Information Divorce Decrees Leases Sales Contract for Purchase, Deed Refinance, Construction Contract or Costs for Construction Permanent Disclosures

At the outset of the process the case is “opened” or “set-up,” generally performing the data entry and preparing disclosures required before the file is given to a processor to submit. Due to changes in the disclosure requirements of Truth-in-Lending and RESPA (Ch 12 & 13), disclosures are now sent much earlier in the process. This is because these disclosures are required to be received by the borrower before collecting any fees and ordering any documents beyond the appraisal. Red Flags in the Application Process The application process reveals more information about the borrower than any other common experience in our culture. It is therefore quite understandable that individuals seek to conceal certain facts. It can also be amusing to see borrowers attempt to conceal information, because as lenders, our job is to reveal all aspects of a borrower’s creditworthiness. In addition to each item that was recommended to be checked, these issues may cause problems in the application process.

APPLICATION

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Invalid social Security number Significant or contradictory changes from handwritten to typed loan application PURCHASES New housing expense exceeds 150% of current housing expense Escrow closing check drawn on different depository from VOD Escrow receipt used as verification (may be a personal check or NSF) Fund paid outside of escrow (pre-existing trust relationship) Borrower lives with parents or relatives Borrower pays no rent at current residence Is the source of the down payment consistent with assets available? All recent increases in the bank accounts, as verified on a bank statement or VOD, must be explained. Sources of closings funds such as gifts, sale of assets, and stock liquidation must be verified with a "paper trail". The source of the funds (gift letter and copy of check) and the receipt of funds (copy of deposit slip and verified new balance) must be documented.

Understanding Truth-in-Lending Loan officers receive more calls with regard to the Truth-in-Lending Disclosure than any other form. The Federal Reserve Regulation Z was authorized by the "Truth-in-Lending" Act of 1969. The intent of the law was to create a uniform method of calculating the cost of credit by developing an APR - Annual Percentage Rate. The APR weighs the monthly payments against the noninterest finance charges (loan costs) on a loan. It also gives borrowers the right to cancel a transaction that results in a lien against their primary residence - a Right of Rescission. One impetus of the law was to provide for "early disclosure" of the APR. This means the disclosure must be delivered to the applicant within 3 business days. The purpose of early disclosure of the APR was to allow a consumer to comparison shop and avoid "hidden" finance charges. If this is the reason for the disclosure, it seems contradictory that it would be delivered after a borrower has submitted an application. Every borrower receives the form, though, so it is important to alert them ahead of time. Without the warning the loan officer can expect an angry or panicked call from a customer within the first week of the application process demanding an explanation for what they perceive are changes in the terms of the loan. The confusion stems from words. Annual Percentage Rate and interest rate mean the same thing to a borrower - but they refer to two different concepts. When the APR appears on a form and is higher than the interest rate discussed during the application there is understandable concern. From the consumer's perspective the APR is the interest rate, because most consumer loans, credit cards and car loans carry a simple rate with no fees and APR here refers to the rate. Likewise, the phrase "Amount Financed" sounds like lender jargon for the loan amount, but is invariably lower than the amount applied for. "Why was my loan reduced?" is the question. There are 4 boxes on the form: The “APR,” “Finance Charge,” “Amount Financed,” and “Total of Payments.” Then there is a “Payment Schedule,” followed by a number of other disclosures describing the loan terms. To understand the Truth-in-Lending disclosure (TIL), start with the concept that it is note the note rate, but a measure of the cost of credit designed to include loan fees in addition to the interest rate. For example: If you borrow $100, but there is a $1 charge for the loan, then you really have only received $99 in usable cash. The $1 in this example is a finance charge. However, the

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borrower will still make payments on the loan based upon the $100 principal balance. This APR computation measures what the rate on the loan would be if the interest rate took into consideration the fee that was charged to make the loan. The APR Formula Keystrokes to Compute the APR for a Fixed Rate Loan Enter Loan Amount Enter Interest Rate Enter Term Compute Payment Compute Prepaid Finance Charge Subtract from Loan Enter Result as PV Compute Interest Multiply by 12 for APR

100000 7.75% 360 CPT 1836 100000 98164 CPT 0.662%

PV "I%"/12 N PMT 1836 PV "I%" x 12

100000 0.646% 360 $716.41 98164 0.662% 7.943%

Being able to prepare a TIL for a customer would illustrate the calculation, but this is rarely practical. As in the $100 illustration, the first step in determining APR is to subtract the prepaid finance charges from the loan amount. The result is the “Amount Financed.” Then the full principal and interest payment (including PMI) is applied against the “Amount Financed” as if it were the loan amount. The resulting interest rate is the APR. There are some nuances. Determining the Amount Financed - What are Finance Charges? Everything that one must pay for in exchange for obtaining a loan (charges you wouldn’t incur if you were paying cash for the property) is considered a prepaid finance charge. This includes loan fees such as discount points, origination fees, private mortgage insurance; miscellaneous fees such as tax service, underwriting, document preparation, and lender review fees. In addition, prepaid items such as per diem interest and escrows for PMI or prepaid PMI, FHA upfront MIP, and the VA funding fee are considered finance charges. Interestingly, appraisal fees, credit reports, termite reports and other inspections such as completion inspections (except for construction loan draw inspections), well and septic inspections that are required by lenders are not considered finance charges. Neither are fees for recording a deed of trust. These are excluded from the amount-financed calculation because a buyer or borrower would incur them regardless of whether a loan was involved. Appraisal and credit report fees are "passed through" to service providers. There is a catch. Any item that the borrower does not pay for is not included in the calculation. This would be the case when a property seller is contractually obligated to pay the fees, or in a lender funded closing cost situation.

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APR (Annual Percentage Rate) The cost of your credit as a yearly rate.

FINANCE CHARGE The dollar amount the credit will cost you.

AMOUNT FINANCED The amount of credit provided to you on your behalf.

TOTAL OF PAYMENTS The amount you will have paid after you have made all payments as scheduled. 

% $ $ $ 1.) Compute total of payments by multiplying payment schedule, including PMI by amount of payments 2.) Amount Financed is the loan amount, less points, prepaid interest, PMI, and lender fees. 3.) Finance Charge is the Total of Payments less the Amount Financed 4.) Compute the APR by dividing the Total of Payments by the number of payments and apply that against the Amount Financed, as if it were the loan amount. (See Keystrokes to Compute APR)

Payment Schedule The payment schedule is the second half of the APR equation. If you borrow $100 and you have $99 to use, how are you repaying the $100? On a fixed rate loan, the payment schedule is quite simple - the monthly payment is the same through the life of the loan. Variable payments are also a factor when there are changing payments on the loan as in an ARM, Buydown, GEM, or GPM. The payment schedule varies in these situations. To determine the payment amount to apply against the amount financed divide the total of payments by the number of payments and utilize this average payment. PMI is considered a finance charge. The initial PMI premium, MIP or Funding Fee must be considered in the amount financed. If there is money placed in escrow for PMI or MIP, this is considered in the amount financed as well. When the PMI premium changes monthly – it is acceptable to use a range (varies from – to). The APR on ARMs can change, based on future interest rate changes. Buydowns, GPMs and GEMs have fixed payment schedules, so the APR on these loans will not change. Finance Charge The APR, amount financed and total of payments have been calculated as explained above. What is the total finance charge? The difference between the total of payments and the amount financed represents the cumulative total of all interest and prepaid finance charges accrued on the loan. Subtracting the amount financed from the total of payments reveals this number. Program Disclosures - work in tandem with the Truth-in-Lending statement and should be given in conjunction with the TIL. They explain more fully the historical performance of the ARM, when the consumer has applied for one. All programs should have disclosure describing fully how the payment schedule works, whether there is any prepayment penalty, late charges, tax and

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insurance escrow treatments, due on sale clauses and any other nuances of the program. The "Refund of the Prepaid Finance Charge" - Again terminology can cause confusion between the intended meaning of a phrase and how the consumer interprets it. In the context of the TIL, this applies to prepayment and mortgage insurance. In the event that there is prepaid mortgage insurance, such as the “Up Front FHA MIP”, monthly FHA MIP or traditional prepaid or financed PMI, if the loan is paid off early the consumer may receive the cancellation value of that insurance. Consumers sometimes equate the “Finance Charge” box from the TIL with this statement and assume they will still be obligated for the interest under the loan, even though the loan is paid off. Recording Fees/Security Interest - Even though they are not included in the finance charge, fees to record a deed of trust in the jurisdiction are shown. All mortgages loans are secured by a property, the address of which should be shown. Late Charge - Stating what the late payment percentage is, when the payment is considered late, and that it is based on the principal and interest portion of the payment only. Assumption - States whether the loan is assumable. While there are no new unconditionally assumable loans being made institutionally, some loans are assumable with the new borrower's approval by the existing lender. However, even if assumption is allowed, many lenders will change the terms to reflect the current market or disallow the assumption. Insurance – If insurance is required as a pre-condition of the loan approval, the lender must give the terms of the insurance.

How to Process a Loan There may be occasions in your career when Basic Steps in Emergency Processing you are called upon to process your own loans. Your pipeline is just starting to swell when your Order appraisal processor is involved in a serious car accident. Order credit report - if not already done You feel sorry for your processor – but your Review file for completeness Type application and submit to underwriter troubles haven’t even started yet. If the loan application is perfect, processing is where the home loan sequence begins to reveal its nightmarish realities. Under normal circumstances, it is the processor’s duty to complete the verification process, assure regulatory compliance and prepare the case for presentation to the underwriter, loan committee or other decision-maker. It seems simple enough, but here is where the effect known as "I am not sure if this is completely clear" kicks in. You may have to know how to process to a small degree, to help fill in during an emergency. This isn’t a lesson how to process. It is a lesson in what to do in an emergency – first understand the process. What seemed apparent to the loan officer isn't so apparent to the processor. If it isn't apparent to the processor, it isn't going to be apparent to the underwriter either. In an ideal situation, the processor and loan officer work together to identify "critical" items that could cause the loan to be denied and ascertain whether they can be fixed. Working together and with the borrower it is unlikely that any adverse information can't be refuted. Then there are non-critical items - things that the loan can be approved "subject to" or as a condition of the approval - "nickel & dime" conditions.

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The problem comes when a processor doesn't segregate the level of importance of various documents and mails a simple list of outstanding documents to a borrower. Suddenly an inconsequential bank statement or other innocuous pieces of information are as important to the borrower as a critical document, such as proof that a delinquent account is incorrectly attributed, or the current year’s tax return. The borrower receives the list and puts everything together, except for the critical document, then sends it in. The mail gets reviewed a week later and suddenly - nearly 1 month into the loan process - there is a huge problem. Welcome to mortgage banking. This is why a complete application is so important! The loan officer is a "field underwriter,” and should not allow the processor to dictate what information is needed prior to submitting a loan to an underwriter. Conversely, the loan officer should not burden the processor with the duty of trying to qualify a borrower. The Approval Process - Who is the Underwriter? It is ironic that approval timing and contingencies are still the biggest problem in the mortgage business. The approval process is a relatively short period of time. If a human underwriter is reviewing the loan, the documentation review and credit decision usually take place in the space of an hour. The average underwriter can review between 5 and 12 cases a day. The remainder of the underwriter’s time is spent clarifying conditions of approval, mitigating problems with approvals, answering challenges to the initial decision, and determining that subsequently submitted documentation meets the requirements of the initial approval. In the case of Automated Underwriting via Desktop Underwriter or Loan Prospector, the decision engine normally responds within 5-15 minutes, but the exhibits of the loan package – the income, asset and credit documentation – are subject to review and interpretation by a human underwriter. For this reason, a loan which is credit approved through Automated Underwriting in 5 minutes may still be held in underwriting or processing for much longer while the documentation is reviewed. Depending on whether an investor on a whole loan basis is purchasing the loan, or being sold off into a security by a mortgage banker, the underwriter may be an employee of the company or an employee of another company. There may be more or less leniency as a result of this. It may impact the amount of time it takes to obtain an approval. In addition, depending on the loan size, there may be a loan committee or a pool insurance underwriter. Most underwriting today is what is called compliance underwriting - assuring that the loan meets guidelines. The approval process isn't very subjective if the loan meets guidelines - it meets the guidelines, it's approved. If the loan doesn't meet guidelines then there comes the process of determining whether there are sufficient compensating factors to approve the loan. It is the loan officer's job to intervene in a situation where there is difficulty and act as the borrower’s advocate. If there is mortgage insurance, the PMI Company will also have to approve the loan. PMI underwriters generally underwrite on a risk basis. They look both subjectively at whether they have a good feeling about the case and whether the case meets risk profiles established in their risk scoring systems.

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Government Agencies (FHA/VA and state bond programs) do approve loans directly, and in some cases must, approve loans directly. FHA allows approved underwriters to approve loans through the Direct Endorsement program. VA offers the same thing called the "Automatic" underwriting program. State agencies have their own underwriting, or may accept a FHA Direct or VA Automatic approval. A new trend in underwriting is the "contract" underwriter. This may be a PMI underwriter who is authorized to approve loans for various lenders, saving the lenders the expense of maintaining

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a large staff of underwriters. The bottom line is the same. The underwriter is a person who is subject to the pressure of balancing the need to make loans and the need to make loans that will not default or be ineligible for purchase in the secondary market. Even one default or one non-saleable loan can be a huge problem for a small or mid-sized lender.

Desktop Underwriter and Loan Prospector Many people projected that the era of the traditional loan officer would be over when the mortgage process evolved into a fully automated system. Those people did not understand the business, as it exists on a practical basis. Automation only eliminates the underwriter. The loan still needs to be structured correctly. The customer also needs an advocate in process. Most importantly, automated underwriting only provides acceptable initial results in about 25% of all applications because: 

 

The supporting documentation varies from what was entered into the system initially. Automated Underwriting relies on the information that humans enter into the model. If that information does not conform to the documentation requirements, the loan is denied and must be manually underwritten or re-submitted to Automated Underwriting The program specifications require manual underwriting. The loan does not meet eligibility criteria for other reasons, such as credit, loan parameters, or other factors.

If you have access to automated underwriting it can simplify the process tremendously. Even though Automated Underwriting protocols sometimes reduce the documentation required for approval, this does not mean that you should not collect as much application documentation as possible. If simply to give a borrower the opportunity for a better rate through another source, or to cover tracks in case a further review of information is required, there is no excuse for not collecting as much information as possible from the borrower. Remember that once the borrowers sign applications, they think they are done. Don’t put yourself in the position of chasing conditions simply because it was easier to get the application in the door. Ultimately, the complete application remains the “Holy Grail” of the mortgage business. Strive for complete applications. Remember that the originator and borrower are both are signing an application certification. Incomplete or misleading information is fraud. Conducting Pipeline Review We “prove” excellent customer service by providing the results of conducting a weekly pipeline review. The written reports resulting from the review show the customer that the loan officer is in control of the pipeline. Referral sources receiving weekly reports do not badger support staff for status on their transactions. Delivering weekly reports is also an excellent opportunity for the loan officer to generate additional business. Finally, a weekly status review is a time management tool for the loan officer and processor alike. A loan officer, who conducts status weekly, instead of every time a customer asks what the status is, controls the number of interrupting tele-

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phone calls received by himself and his processor. Pipeline review is an amazing time management tool for production and production support personnel. Management has even more critical reasons to insist on loan officers performing a weekly review. By insisting on pipeline review as part of the corporate culture the company shares responsibility for the smooth outcome of a transaction with the loan officer. In addition, the company can assure that the employee is reviewing each case appropriately by requiring a copy of the weekly pipeline review. When a problem arises on a case, the company’s first question should be “has the loan officer properly managed this case?” by reviewing status logs. The temptation is to allow customers to access loan status via the internet. This is particularly true when there has been a significant technology investment on the part of the company. The availability of status reports through an internet portal does not preclude the need for the loan officer to conduct a weekly status review.

Conducting Weekly Status Reviews Responsible Party Loan Officer Processor

Loan Officer/Processor Loan Officer

Processor

Processor

Loan Officer/Processor Loan Officer

Description Schedules meeting with each processor handling cases. Time allotted for meeting should be 2-5 Minutes for each case in process Assembles all of the loan officer’s files regardless of status, in the order defined by the processor. The file should not be “prepared” for status. The loan officer should witness the actual condition of the loan file. Meet at the scheduled time to review all cases in process. Either processor or Loan Officer is charged with the responsibility of completing the status log. Assumes responsibility for external related documentation on case Customer contacts for additional information Referral source calls for items required on the transaction Any qualification issues must be resolved by the loan officer Loan Program or lock-in issues are the loan officer’s responsibility. Assumes responsibility for internal related documentation on the case Closing Department or closing agent related documentation Underwriting Department flow related issues, condition/stipulation satisfaction Vendor issues Credit Report ordering/correction Appraisal ordering/correction PMI Flood Certification Insurance Policy During the week, incoming loan documentation is fastened on top of the file. During the loan status meeting, loose (received) documents are reviewed together with the Loan Officer and marked on the status report to determine whether document is sufficient or if 2nd request is necessary. Take completed Status Log and make one copy for loan officer, processor and branch manager. Take copies of each individual loan’s updated status report and deliver to all referral sources the following day.

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Sample Status Log Status Log Loan Officer Processor Date Completed Borrower

Processor to Handle

Loan Officer to Handle

Borrower

Processor to Handle

Loan Officer to Handle

Borrower

Processor to Handle

Loan Officer to Handle

Borrower

Processor to Handle

Loan Officer to Handle

Borrower

Processor to Handle

Loan Officer to Handle

Checklist Appraisal Ordered Credit O.K. Lock Expiration VOE O.K. VOA O.K. Complete Application Docs In? Checklist Appraisal Ordered Credit O.K. Lock Expiration VOE O.K. VOA O.K. Complete Application Docs In? Checklist Appraisal Ordered Credit O.K. Lock Expiration VOE O.K. VOA O.K. Complete Application Docs In? Checklist Appraisal Ordered Credit O.K. Lock Expiration VOE O.K. VOA O.K. Complete Application Docs In? Checklist Appraisal Ordered Credit O.K. Lock Expiration VOE O.K. VOA O K

Status Logs, Status Reports and Detailed Status Process is available in the “Loan Officer’s Practical Guide to Marketing at www.lendertraining.com

"Congratulations! Your loan is approved" This is the best part of the process. If it was a difficult case, it may proceed quite rapidly to closing. Understanding the mechanics of closing will allow you to "grease the runway" for a case that has been languishing in underwriting. Settlement requirements are quite simple. These are the items that must be obtained in order to assure the borrower’s and lender’s interests in the property being purchased.

The Closing and Requirements As you prepare your borrower for an approaching settlement, it is useful to remind them of the information that will be required for closing. Every case requires the same information and documentation for closing. The “Final Four” items allow the case to proceed to closing.

Settlement Preparations: Mortgage Approval means "begin to prepare for settlement.” Get the homeowner's insurance policy, termite report, title binder, survey and final inspections.

The “Final Four” Title Binder Survey Hazard/Flood Insurance Termite/Inspections Four items you can always count on having to get.

Settlement Agent A settlement agent is also known as a closing attorney, title company or escrow company. The settlement agent is responsible for scheduling settlement and provides; 1.) a title binder – the

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commitment to issue title insurance, 2.) a survey, showing the house location on the lot and 3.) The “Insured Closing Protection Letter” that indicates the lender is indemnified for a specific closing agent. 1. Title Insurance At settlement, buyers are offered the opportunity to purchase OPTIONAL Owner's Title Insurance to protect the equity in the home being financed. This policy is in addition to the mandatory lender's policy. This "Owner's Policy" is not required by the lender. If the transaction is a refinance and there is a Title Insurance Policy in force, the owner should provide the settlement agent with a copy as soon as possible. There is a possibility of savings by reissuing an existing policy. In addition, with the old Title Policy, a full title search may not be necessary - a present owner “bring down” simply researches the title from the date of the last title search. 2. Survey: A house location survey shows the location of the property improvements relative to the lot lines. It may not be necessary to obtain a new survey if 1.) The title is insurable without a new survey, and 2.) No changes have been made to the exterior of a house (the borrower must sign an affidavit stating this). If these requirements can't be met an existing survey may be re-certified as a cost savings. Surveys are not required for condominiums 3. Homeowner's Insurance Policy: The basic standards for Homeowner’s (Hazard/Fire Insurance) are that the company should be Bests Rated A- or better and meet the following:       

Dwelling Coverage in the amount of the Loan or Replacement Cost Dated within the same month, but prior to the date of settlement Paid receipt for the first year's premium Correct property address Names shown as they are shown on the loan application or property title Mortgagee/Loss Payee Clause Investment Properties must carry rent loss coverage equal to 6 months rent.

4. Condominiums: The management company provides a certificate of insurance showing the borrower’s names, the condominium unit number and Loss/Payee clause. The settlement agent may procure this. If the borrower is purchasing a property, the agent is responsible for this. If it is a refinancing, the borrower is responsible. 5. Planned Unit Developments: If there is a Homeowner's Association collecting fees for maintenance of Common Elements, such as roads, recreational facilities, or other amenities, your property is in a Planned Unit Development (PUD). We require evidence that the association maintains the common elements. A letter from the association or Management Company is sufficient. In addition, they must provide evidence that the association carries liability insurance in an amount of at least $1,000,000 per occurrence. If the borrowers are purchasing, the agent is responsible for providing this. If they are refinancing, this is the borrower’s responsibility. The title company will determine that subject unit’s dues are current. 6. Flood Insurance: If a flood certification firm determines the property to be in a Flood Zone “A”, flood insurance must be obtained. If the flood certification cannot make a determination of the flood zone location of the property, a risk assessment must be obtained through FEMA. Sometimes, a house location survey will identify the 100-year flood plain on the property, and if the improvements are located outside of this zone, the Flood Insurance requirement may be waived.

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Flood Zone Determinations Requiring Flood Insurance Zone Description Designation BA Areas of 100-year flood, base flood elevations, and flood hazard factors not determined AO Flood depths of one to three feet (usually sheet flow on sloping terrain) average depths determined, area of alluvial fan flooding, velocities determined AH Flood depths of one to three feet (usually areas of ponding), base flood elevations determined AE,Al-A30 Areas of 100-year flood, base flood elevations, flood hazard factors determined A99 To be protected from 100-year flood by federal flood protection system under construction, no base flood elevations determined IV Areas of 100 year coastal flood with velocity (wave action), base flood elevations, flood hazard factors not determined VE, Vl,V30 Areas of 100 year coastal flood with velocity (wave action), base flood elevations, flood hazard factors determined

7. Termite Report: A termite report, showing no damage or infestation, is required. Refinances MAY be exempt from this requirement. The original form dated within 45 days of settlement must be provided. Condominiums MAY be exempt from this requirement, if the association shows a line item in the budget for pest control. New Construction requires a soil treatment certificate. 8. Well/Septic Certification: If your property is serviced by a well and/or septic system a certification from the local health authority as whether the water is potable is required. If a Termite Soil Treatment is performed, water quality must not be affected and a certification to this effect is required. Refinances MAY be exempt from this. If there is a community well, rights of use must be documented. 9. New Construction: A Residential Use Permit (RUP), Certificate of Occupancy or Completion is required from the code compliance authority in the jurisdiction is required. When the property is complete we must be notified so that we may order the final inspection from the appraiser. 10. Floating Rate: Floating rates must generally be locked 5 days prior to closing. A Word on Titling When you buy a house, you get a title to the property. This may be referred to as a Deed of Bargain and Sale, General or Special Warranty Deed, Fee Simple Deed, or a Title. This is the original document that is recorded among the local land records in the jurisdiction where the property is located. You notice that on the first page of the application there is a section that requests "Manner in which title will be held.” There are 4 common forms of ownership. In addition, the type of deed that you receive may affect the owner's interest. A General Warranty Deed conveys the property with the seller's guarantee that the title is good. A Special or Limited Warranty Deed is basically a statement from the seller of the property that as far as he knows, the title is good. A Quit-Claim Deed sets forth some probability of a problem with the title - the seller only warrants that he or she is selling the property and will not pursue a claim against it. The Brooklyn Bridge would be conveyed by Quit Claim Deed. If ever enforced, there is a possibility you

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lose your title. Thus, by accepting a Quitclaim, you are releasing a seller of any liability in the event of forfeiture. When encountering property rights, it is important to know what kind of community property laws your region has. Common Law States give spouses rights of Dower & Curtsey that may have to be addressed at closing.

Common Forms of Titling Joint Tenants with Right of Survivorship means that when one owner dies, the survivors automatically become the owner of the property. Tenants by Entirety is a form of ownership reserved for married couples. The property reverts to the survivor but shields the owner from claims of individual creditors Tenants in Common allows the owners to assign percentage of ownership to each owner. When one owner dies, it creates an estate that will be distributed under the terms of the owner's will Sole & Separate means there is no other titleholder

Lender Sends Loan Instructions to Settlement Agent The lender will not normally go to settlement, but sends closing instructions to the settlement agent who will prepare a settlement statement. This is an exact summary of the costs of the transaction. Once prepared, the settlement statement will show exactly what you will be required to pay at closing. Borrowers should bring a certified check for the remainder of the down payment (if any) and closing costs. Loan officers are encouraged to read all of their company's closing documents as well as attend a number of settlements to become familiar with the mechanics of real estate transactions. Some people recommend that loan officers attend settlement as a customer service and sales opportunity. Closing “Red Flags” Incidences of fraud or misrepresentation are often discovered at closing. While not every instance represents intentional fraud, knowing about these problems will allow the loan officer to correct them before settlement and prevent possible delays. TITLE REPORT Income tax or similar liens against borrower on refinances Delinquent property taxes Notice of default recorded Seller not on title (double escrow) Modification agreement on existing loan (s) Seller owned property for a short time with cash-out on the sale Buyer has preexisting financial interest in property ESCROW INSTRUCTIONS Cash paid outside of escrow to seller Down payment paid into escrow upon opening Reference to another (double) escrow. Related parties involved in the transaction Unusual credits with no economic substance (see HUD-1 settlement statement) Right of assignment (who is the actual borrower?) Power of attorney used (why can’t borrower execute document?)

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Business entity acting as the seller may be controlled or related to borrower Change of sales price to "fit" the appraisal No amendments to escrow "Fill in the blank" escrow instructions Purchase not subject to inspection Unusual amendments to the original transaction Demands paid off to undisclosed third parties (potential obligation) No real estate commission (possibly related parties) Actual settlement charges exceed "Good Faith Estimate" by 10%

The HUD-1 – Settlement Statement It is at the closing that questions may be raised Closing Cost Anomalies about the disparity of fees disclosed on the Pro-rated Condo Fees Good Faith Estimate and the total charges on New Construction Assessments/Partial Levy the settlement statement. Of course no one is Termite Treatment concerned when the fees are lower. When they Reimbursement of Seller Paid Real Estate Taxes More Days of Per Diem Interest are higher, however, there is usually a panicked Optional Owner's Title Insurance Purchased call to the loan officer to explain. Obviously Refinance - Most recent payment not accounted the good faith estimate is just that - an esti- for in Payoff mate. Look at all the numbers. Isolating the lender's charges from the overall closing costs can often defuse a situation where a borrower is attributing the higher number to variances in the closing costs. For a detailed description of the HUD-1 and changes in closing costs from application to closing, please see Chapter 12 – RESPA.

Closing Documents In addition to the HUD-1 Settlement statement, the borrower signs a multitude of documents at closing. Promissory Note There is only one loan document that the borrower MUST sign. A Note is simply evidence of a debt. The mortgage note sets forth the terms of the loan and evidences the borrower’s promise to repay the loan. The promise itself is not enough to secure the lender’s interest. Mortgage notes are secured by collateral agreements which dictate that the lender may reclaim ownership of the property should the borrower fail to repay. The Mortgage or Deed of Trust A mortgage is a document that secures the borrower’s promise to repay. There are fifteen states which use both mortgages and deeds of trust. With a deed of trust the property is titled in the borrower’s name and places property in trust for benefit of lender in the event the borrower de-

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faults. The trustee is charged with taking certain actions, including the sale of the property, for the benefit of the lender. A mortgage has no trustee, so the transaction has only two parties. The borrower is giving a mortgage – the mortgagor The lender is receiving a mortgage – the mortgagee Final Truth-in-Lending Disclosure, which states the annual percentage rate, the loan terms, and the number of payments Initial Escrow Statement, which includes estimated taxes, insurance premiums, and other charges which the borrower will pay from the escrow fund during the first twelve months of the loan. When the closing is completed, the lender will record the lien (for mortgages) or the deed (for deeds of trust) in the public records. Wet and Dry Settlements The "Wet Settlement" Act requires that actual cash or "good funds" be at the closing table. This is designed to assure that all the accounting be based on actual receipts and disbursements so that the settlement agent may accurately disburse all funds at the closing. The settlement agent acts as a conduit for all of the funds accounted for at the transaction. So the settlement statement is a bucket where all the money goes and comes out of. When all the parties meet at the closing table, this is referred to as a round table closing. In certain parts of the country, closings are conducted in escrow. In an escrow closing the settlement agent conducts the closing in multiple parts and does not release funds until all requirements of settlement are met. The Right of Rescission - Refinances Although this information is not an early disclosure requirement, it affects any extension of additional credit on a borrower’s primary residence. This is part of the Truth-in-Lending Regulation and it provides a 3 full-day "right to cancel" the transaction. Because of this, on refinance and home equity loans, documents are signed but funds do not disburse until after the period expires. Other Disclosures  

Good Faith Estimate (HUD) This must be accompanied by the HUD “Settlement Costs Booklet” that describes the charges associated with closing and defines them specifically. It also illustrates how the settlement statement works. Good Faith Estimate Addendum Required Service Providers (HUD) – As a lender you must provide a listing of providers that the borrower must use for certain services if they do not have any choice in the matter. Credit Bureaus, Appraisers and Title or Settlement Companies are usual candidates. ARM Disclosure (Federal Reserve) – The “Charm Booklet,” also known as the “Consumer Handbook on ARMs” accompanies the Truth-in-Lending and ARM disclosures on

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  

an ARM Product. Equal Credit Opportunity Act (Federal Trade Commission) – Advises consumers of their rights under the regulations including: 1.) They may not be discriminated against on any basis; 2.) That they have recourse and who to call. Transfer of Servicing (HUD) – Most lenders sell their loans. The transfer of servicing disclosure tells borrowers how the loan may be sold, and what their rights are under these laws Borrower's Certification and Authorization (FNMA) – The form acknowledges the borrowers’ receipt of a perjury statement. It also says that the lender has the right to change the documentation requirements for the application. The form also serves as a credit authorization and signature release.

Loan Officer and Processor Time Management Techniques The loan process is a very detailed progression and assembly of paperwork. Sloppy or incomplete documentation is the single largest cause of problems in the process. To avoid issues with loan processing, every loan officer should have systems in place to manage a caseload. These systems insure that the loan officer spends time generating business, not following up on individual loans. Systems also reduce interruptions for processing. Interruptions are a processor’s largest time management challenge. System 1 - The Complete Application System for Loan Officers Despite the advances in automation, missing documentation is the biggest problem loan officers’ face. The problem begins when a loan officer accepts an application that is missing information. This puts the responsibility of obtaining the documentation on the loan officer, instead of the borrower. The loan officer, who is now in a defensive position, begins the process of mostly undocumented follow-up. Even though a borrower may be aware of additional documentation requirements, once the application is submitted, there is pushback for providing more. The borrower says, “I thought I sent you that.” Then, when the loan officer receives the missing documentation, it raises other questions - such as a pay stub that shows variable income, a bank statement with unexplained deposits or other problems. When this happens there is a question as to whether the loan can be granted. A negative feedback loop begins as the referral source may become involved, and documentation requests are followed by more documentation requests. The customer becomes frustrated or angry. This situation is caused by the incomplete application The solution is obvious – don’t accept incomplete applications. Loan Officers must have a complete application system. A Pre-Application Kit, or other open ended information collection device, such as the one on the following page, can meet this need. When utilizing this system, the loan officer can arrest the application process until he or she is satisfied that there is enough documentation to proceed. With this in hand, the loan officer can turn in a complete application and not have to revisit the loan until it closes. This frees the loan officer to originate loans and make more money, not chase documentation.

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Pipeline Review Weekly pipeline review may seem redundant in an era of automated approvals and fast decisions. You can simply forward an e-mail that the loan is approved or the appraisal is in. What else is there to check? As this book shows, there are many things that can and do go wrong in the process. As loan officers, we are responsible for the loan process. When a customer or referral source calls and asks what the loan status is, the loan officer will typically call or e-mail the processor. The processor has to stop what he or she was doing and investigate the status. This interruption can cost the processor 15 minutes of productive time. In addition, because the loan officer doesn’t know what the status is, the customer or referral source isn’t convinced of the loan officer’s professionalism. It also creates a time management issue for the loan officer, because returning phone calls takes 15 minutes of productive time. In this case, one phone call costs 75 minutes of time for the loan officer and processor.

Loan Status Calls Waste Time Action Customer Call to Loan Officer Call to Processor Investigation Call back to Loan Officer Call back to Customer Total Time Per Call

Minutes Spent 15 15 15 15 15 75

vs Loan Status Minutes Per Loan Status Meeting with Client Total Time Per Loan

Instead of reacting to customer requests, move pro-actively to deliver loan status reports to interested parties. This is a sales opportunity for the loan officer. The pipeline review meeting saves the processor’s time by avoiding interruptions. The loan officer saves time by staying out of the return phone call loop.

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To obtain your own "Pre-Application Kit" to customize and use with your own process, visit www.quick-start.net and buy “The Loan Officer’s Practical Guide to Marketing.” Chapter 7 – The Application Process - Page 150


Chapter 8 â&#x20AC;&#x201C; Property Types When I first started as a loan officer I took every loan I could. I immediately learned that none of the other loan officers I worked with wanted to take condominium loans. They were small transactions and many questions had to be answered - on top of whether or not the borrower was qualified - before the loan could be taken. Needless to say, I ended up with many condo loans. If I was to survive these loans I needed to understand all of the guidelines associated with condominiums. I did, and it was not long before underwriters were calling me to discuss project approval questions. Each market has its own unique concentration of property type. The professional loan officer has to become an expert on those properties to succeed.

Understanding Property Types We have learned that different types of borrowers present special risks. The loan program, down payment or other characteristics may be reasons a loan may not meet guidelines. One major facet of risk is the type of property being given as security or collateral. Primarily, there are two sources of risk that drive property underwriting: 1.) What kind of risk is the lender taking if they have to re-sell the property after a foreclosure? 2.) What kind of risk is the borrower accepting by living in a certain property type? Usually, property risk begins when the density of units increases. When someone buys a singlefamily house, with public streets and no common areas, there is limited risk as to outside forces impacting the borrower. However, risk increases when the property is part of a Homeowner's Association that is responsible for maintaining common areas such as roads, pools, tennis courts, landscape, etc. In a situation like this, for instance, someone might slip and fall on a community road, and sue the homeowner's association. If the association lost the suit and there wasn't sufficient insurance, they might go bankrupt which would adversely impact property values. There are numerous forms of property ownership, each impacting the risk of the individual loan. In addition, within each type of property ownership, there may be sub-types of property, which impact the risk, such as a mobile home project, a log cabin or historic home, or a condominium with a commercial/retail influence.

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Property Types by Ownership Form Property Type

Description

PUD (Planned Unit Development)

This refers to a property comprised of Single Family Homes, Town Houses. The individual homes and land are privately owned, but common elements such as roads, open areas and recreational facilities are owned and maintained by a mandatory Homeowner's Association. Individual owners in PUDs are required to be members in and pay for the Homeowners Association. A Condominium is created out of vertical air space. Instead of owning a parcel of land, you purchase a subdivided piece of space contained within a condominium regime, which might be an apartment or a townhouse. The walls, common elements and all improvements are owned and maintained by the condominium. A cooperative is a corporation that owns real estate. To purchase a cooperative unit the owner actually purchases a pro rata share of the corporation stock. The corporation is responsible for paying real estate taxes, underlying mortgages, and maintenance of all common elements. A leasehold estate is a long-term ground lease. Renting land out for unencumbered use instead of selling creates a ground lease. At the end of the lease term the land is returned, in its improved state, to the landlord. Also referred to as SFD (single family detached) property, this means that the land is unencumbered by any covenant requiring ownership in an association. An attached home can be Fee Simple as well.

Condominium

Cooperative

Leasehold

Fee Simple

Why Condos are Hard to Finance Like many forms of property ownership, the development of condominium ownership and the lending guidelines surrounding it have evolved to reflect the industry's experience. Condominium ownership creates a high density of individually owned units. The risks and guidelines are based on common sense. Unlike a Planned Unit Development, where the owner maintains each individual house, the owner’s association maintains a condominium building. Unlike a cooperative, where the board of directors of the corporation can be selective about who can live there, condominiums cannot have restrictive covenants. They cannot exclude people who might default on the maintenance obligations (a condominium unit that is owned by an investor who rents out the unit would have less of a vested interest in project maintenance) such as absentee owners. Because project maintenance relies on owner’s contributions, a project's soundness is impacted by the overall ability of the unit owners to pay for the operation of the condominium. Conforming Guidelines Keep in mind that, just like in underwriting a loan, a project underwriter may decide that a project has superior factors and merits an exception. As a result, particularly with new projects, the agencies may make exceptions to their standard guidelines. FNMA and FHLMC both have guidelines for condominium projects. The classifications address the level of risk and approval. Effective 5/1/05 FNMA eliminated the approval classifications known as A, B, and C. It has replaced these approval criteria with new processes. The announcement was met with much elation, but a closer examination showed that the guidelines were only moderated somewhat. Most importantly was a slightly lower pre-sale and investor concentration requirement. A major modification was the release of FNMA’s Condo Project Manager (CPM) program which automated

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the approval process and allowed lenders to save time in managing condominium project lists and documents. Condominium Classifications by Agency FNMA New Type R (attached) or P (Limited Project 0r Detached only) or T (Full FNMA Existing Approval) - Direct FNMA approval Project required. Not Fully via CPM. 1028 Form issued by FNMA Sold Out indicates project phase has been underwritten and approved by FNMA. Form 1027 is conditional project approval. Requirements for approval: 1.) 50 % of units within a phase must be sold or under contract to settle. Unit appraisals must address market absorption and sales plan (Addendum A) and budget adequacy (Addendum B). 2.) Attorney's opinion letter addressing condominium documents. 3.) Conversions require engineering structural survey. CPM approval is valid for 6 months Required for Approval: Attorney's opinion letter; Addendum B. 2-4 Unit Projects have additional requirements Existing Type S (Full Review) - Project is 1.) Project 100% completed, no additional phasing, 2.) Owner's association is in control for one year, 3.) 90% sold/50% owner occupied, 4.) No entity owns 10% or more Type Q Limited Project Review - For down payments of 25% (20% for DU) or more - Project is 1.) 100% Complete 2.) No other restrictions FHA Type U - Project is 1.) On FHA Approved Approved Condo List 2.) 51% Owner Occupied 3.) No entity owns 10% or more 4.) Project is not otherwise ineligible

FHLMC Code 1 - Direct FHLMC approval required. Requirements for approval: 1.) 70% of units within a phase must be sold or under contract to settle. Of those 70% must be sold to owner-occupants. Unit appraisals must address market absorption and sales plan (Addendum A) and budget adequacy (Addendum B). 2.) Attorney's opinion letter addressing condominium documents. 3.) Conversions require engineering structural survey. You can use the documented approval by FNMA or FHA to document project approval.

Code 2- Project is 1.) 100% completed, no additional phasing, 2.) Owner's association has been in control for two years, 3.) 90% sold, 4.) 90% individual unit owners multiple sales to one owner counted toward % of individual owners. 60% owner occupied. “Streamlined Review” process eligible for LTVs below 90 (LP Accept) or 80% Code 3

As this table demonstrates, as a project becomes more established, the guidelines for approval become less rigorous. This is because the lender's risk is mitigated as the project proves that it is acceptable in the marketplace and people continue to buy units there. You will note that there is considerable influence placed on the percentage of owner occupants within a project. There are two reasons for this: 1.

Owners who live in a project tend to have a greater "pride in ownership,” and thereby theoretically - will take better care of the project. They will vote to spend money for items that may become necessary to maintain the project such as a special assessment. An absentee owner would only care that the rent charged covered the expenses.

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2.

If the economy turns down, investors would not necessarily make the sacrifices required to maintain mortgage payments, resulting in defaults and foreclosures that would adversely affect the market value of other units within the project.

For instance, if there were a project with 100 units and the monthly assessment fees were $100, and one individual owned 30 of these units, what would happen if that person went bankrupt? Monthly revenue for project operation would go from (100 x $100 = $10,000) to (70 x $100 = $7,000) for a $3,000 per month shortfall. In order to keep the project viable, the association would have to spread the $3,000 shortfall out over the remaining 70 units ($3,000 divided by 70 = $42.85/mo additional levy). This is an increase of nearly 50%! Such a dramatic increase could create a domino effect where other unit owners could no longer afford the maintenance obligation and collapse the entire project. Private Mortgage Insurance and Projects While the agencies have established guidelines for condominiums, so have the Private Mortgage Insurance companies (MIs). During the introduction of condominium ownership, many MI's did not evaluate condominiums any differently than individual home loans. As a result, some companies became over exposed insuring large percentages of units within individual projects. It was the MI's that were significantly hurt when the real estate market softened dramatically with the rise in interest rates in the early 1980's. As a result, many of the MI companies have developed guidelines that are even more restrictive than agency guidelines (as with all guidelines, exceptions can be made). To summarize there are a number of specific rules which may apply: 

 

Square footage limitations - Efficiency condominiums are cheaper to buy and require a smaller down payment investment than a house. In addition, the smaller the unit the more difficult it is to sell (a phenomenon which may be linked to the fact that the agents involved can only earn a small amount of commission). Finally, because the equity investment is so small, there is more chance of the lender taking a loss. As a result, the smaller the condominium, the more likely the owner is to walk away from the initial investment during bad economic times. Minimum square footage is considered to be approximately 600-square feet, or one bedroom. Owner occupancy - Because condominium apartment projects mirror the appeal of rental apartments, they hold investment potential. These tend to turn into largely investor-held buildings - and because many MI's hold to the belief that pride in ownership is a critical part of risk analysis - investor concentration in condominiums is a huge issue for MIs. Twenty to Thirty percent investor to owner occupant ratio is generally acceptable, with some higher concentrations allowed for established projects. Risk exposure - The MI's track exposure in projects and will only accept a certain number of units or a percentage. Always check ahead of time to assure a slot remains. In addition, the PMI Company may perform its own project review prior to insuring the first loan. There is currently a movement in underwriting away from traditional subjective underwriting guidelines toward the process of predictive credit scoring. In cases such as this project eligibility may not be an issue. Several of the insurers have stipulated that with scores of over 700, no other underwriting criterion needs to be met.

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Regardless of project status, the following information will always be required in conjunction with condominium financing: Documentation Required for Project Approval Legal Documents Insurance

Financial

___ Recorded Declarations, By-Laws, Amendments ___ Covenants, Easements and Restrictions ___ Horizontal Plat/Survey ___ Master Policy Declarations ___ If Professional Management firm handles Association funds Fidelity Bond equal to 6 Months HOA fees, naming Management Company as insured and HOA as payee ___ If HOA handles funds, Director's & Officer's Liability ___ If High Rise, Elevator Insurance ___ Certificate of Insurance for specific unit being given as collateral ___ Current and Past Years' Budget

Treatment of Condominium Fee for Qualifying Purposes When you are using income and debt ratios in trying to qualify someone to buy a house, do you add in the amount they would be paying for utilities such as electricity, water, gas, sewer, heat and air conditioning? These are not factors in normal underwriting, but they can be large components of the housing expense for a condominium. In fact you can "net out" the utility portion of the condominium fee from the amount used for qualifying. To do this, analyze the project's budget to determine the percentage of the total budget attributed towards utilities, and subtract that percentage from the total fee for qualifying. The appraiser may make your job easier by indicating the percentage of utilities included on the report on page two, project information. Agency “Approved Lists” FHA and VA do approve each individual condominium phase and unit. Project approval through FHA requires an attorney's opinion letter, budget, engineering report, environmental impact analysis and 51% owner occupancy. When a project or phase is FHA or VA approved, it appears on the "approved list.” When there is an existing project where it is unlikely that the association will go to the expense of complying with the FHA/VA requirements, it is possible that the individual units could qualify for "spot loan" financing. No more than 10% of the units (20% for projects with less than 30 units) are eligible for spot financing, and the project must still meet the 51% owner occupancy percentage. FNMA publishes a "list" of condominiums that it has issued 1028 and 1027 approvals for. Until recently, they required the lender to prove that a project, other than a newly approved project, was eligible. FNMA has released Condo Project Manager (CPM), a portal which allows lenders to investigate and request approvals on condominium projects. FHLMC issues a list of condominiums that it has purchased loans in and for projects that it has declined project loans. These lists, however, do not necessarily mean that financing is available. Having a loan in a

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When a project has a high investor concentration according to the Management Company, consider seeking alternative sources of information. Tax records, appraiser’s data sources, even direct mail campaigns within projects can be a good way to override management company statistics. Second homes are considered owner occupied.


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

project that is on a “list” indicates that there is a better chance that the project meets guidelines, but is more useful for locating projects in which a declination has been issued. On most loans in existing condominiums it is up to lenders to "warrant" or guarantee that the condominium meets the agency guidelines. Termite Reports - If the condominium budget shows a line item for pest control, often the requirement for a termite report can be waived. In addition, because termites need water to digest wood, units above the 3rd floor are normally considered exempt from this requirement. This is because the industry has determined that termites can only climb about 3 floors before they have to turn back to get a drink. However, if a specific unit has a fireplace or wood storage area, a termite report might be prudent to determine if any wood destroying Standard Condominium Questionnaire insects have been introduced by im1. How many units are in this condominium? ported firewood. Owner Occupancy Ratios/Individual Unit Owner Concentration Normally, the person who completes the pre-sale questionnaire has done so repeatedly and often. It is a mundane task. Often the individual may memorize certain responses or may not update pertinent information. This may be detrimental to the ability of a lender to obtain financing. Press the individual for the source of their information regarding this and how recently it was compiled. There are a number of additional questions to ask beyond the standard responses. 1.)

2.)

3.) 4.)

2. How many units are sold? 3. How many units are closed? 4. How many units are owner occupied? 5. How many units are second homes? 6. How many units are rented? 7. Are all units and common areas completed? 8. When was the control of the condominium turned over to the unit owner's association? 9. What percentage of the monthly association fees are more than onemonth delinquent? 10. Are there any special assessments now planned or have there been in the past year? 11. How many individual unit owners, other than the developer, exist in this project? In other words, how many different unit owners are there? (If there are 10 units, and one person owns 2 units, there would be 9 individual owners.) 12. Does any one individual own more than 10% of the units? 13. Is there any additional phasing or annexation for the project? 14. Is the project leasehold? 15. Is the project a party in any legal actions? 16. Is the project a conversion? If so, was the conversion in the last 3 years? 17. Are there short-term rentals, or rental desks within the project? 18. Are there cleaning services provided to the unit owners? 19. What percentage of the project is devoted to commercial space? 20. Is the project professionally managed or self-managed? If professionally managed, does the management contract have a 90-day right to cancel with no penalty?

Are any of the non-occupant units second homes or occupied by the unit owners for at least two weeks of the year? Consult the tax records - Are tax bills still being sent to the property? If so, there is a chance that current owners intend to return and a compelling argument for a lower investment owner ratio. Is the current unit a rental being purchased by an owner occupant? If there is a concentration of units owned by an individual or firm, are the units being actively marketed? Perhaps the underwriter can meet a pre-sale requirement instead of a owner occupancy requirement.

PUD/Classifications & Requirements There are fewer risks relative to Planned Unit Development Financing. Obviously if the project

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is complete, there is less risk. Concerns arise from the failure to complete a project, examples of which abound. The impact then is on the marketability of the units that are complete, when common elements aren’t finished or do not materialize. Again, FHLMC, FHA, VA and FNMA all have varying requirements. New Projects, Proposed or under Construction

Existing Projects

FNMA 50% pre-sold for attached housing. All common areas must be complete. No 2-4 family units. Project may not be a conversion. Fidelity and liability insurance required. Fee simple ownership, budget review. Project may not be otherwise ineligible. 1028 - Project approval is acceptable in lieu of meeting warranties. Control of HOA turned over to owners association. Not ineligible. Liability/fidelity Insurance.

FHLMC No pre-sale requirement May not be a conversion, contain commercial or multifamily or 2-4’s. Liability, flood and hazard insurance required. No fidelity. Need comparables outside project.

FHA Approved list

VA Approved list

Same as FNMA.

Fee simple - no requirements.

Approved list

New Construction Projects - Construction Permanent Financing Newly constructed homes present other considerations for the loan officer. Aside from the project approval issues, the financing process is very different when there is no developer present. Pre-built homes are called “spec” referring to the speculative nature of the builder’s investment. When a borrower contracts with a builder to construct a property – called “custom built” - the buyer or borrower becomes the developer. The loan officer is the construction lender and the permanent lender. Traditionally, mortgage lenders do not generally make construction loans because they are difficult to package and re-sell. They are inherently short-term loans - intended for the construction period (usually 3-9 months) and then retired. These are ideal loans for banks or savings and loans to make. The loan needs to be structured so that money from the loan is made available over a period of time as the construction proceeds. The loan amount is not fully disbursed at closing, like a permanent loan; rather the proceeds are disbursed in a series of draws based upon a pre-arranged construction schedule. Because of this they are almost always interest only transactions. The process begins with the raw land. Raw land is either purchased in cash or financed. This has a bearing on the transaction because land equity is considered a part of the down payment for the construction lender. In addition, when converting the construction loan into a permanent loan, the permanent lender may require that the valuation be based upon the acquisition cost, as opposed to the final value of the home. This acquisition cost formula may be a problem for the

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borrower with permanent financing because of loan-to-value restrictions and issues such as cash out to recapture the initial investment. Often, to escape this dilemma, borrowers elect to do one of two things with a permanent loan: 1.) Arrange the permanent financing (end-loan) at the time of the construction loan closing (referred to as a construction-permanent loan); or 2.) Wait until the property is seasoned to escape the loan to value restrictions imposed by the acquisition cost formula. The advantage of a construction permanent transaction is that the entire package is wrapped up into one closing, and the buyer/builder doesn’t have to worry about the end loan. The disadvantage is that, because the construction loan and permanent loan are tied together, the borrower’s end loan terms may not be the most favorable. However, construction lenders are able to force this type of arrangement because they can facilitate a “modification” which is the altering of the final construction loan documents. The modification proceeds like refinances in that new document are executed; however, because the funds transfer is internal, there are no closing costs or taxes. C o n s tru c tio n P e rm a n e n t F in a n c in g Land P ric e Cons truc tion Contrac t Total Cos ts

$ $ $

50,000.00 200,000.00 250,000.00

Down P ay m ent Dra w S che du le Clos ing 1s t Cons truc tion Draw 2nd Cons truc tionDraw 3rd Cons truc tion Draw 4th Cons truc tion Draw Final Draw

M ax im um Loan Cons truc tion Loan Rate

10% Fund s Ne e de d $ 50,000.00 $ 80,000.00 $ 30,000.00 $ 30,000.00 $ 30,000.00 $ 27,023.47

Ca sh In $ 25,000.00 $ $ $ $ $ 4,378.87

Loa n Ba la nce $ 25,000.00 $ 105,088.54 $ 135,832.92 $ 166,795.07 $ 197,976.53 $ 225,000.00

Total

$

247,023.47

$ 29,378.87

$

Final Interes t P ay m ent

$

1,593.75

(40% ) (15% ) (15% ) (15% )

$ 225,000.00

225,000.00

8.50%

Num be r of Da ys 15 30 30 30 30 30

Inte re st Ca rry $ 88.54 $ 744.38 $ 962.15 $ 1,181.47 $ 1,402.33 $ 1,593.75

165 $

4,378.87

The disadvantage of seeking permanent financing outside of the construction lender is there will have to be a refinance closing, unless an unlikely arrangement can be made with the construction lender to have the construction loan terms modified. The second disadvantage is that the loan to value limitations may impact the borrower, particularly when the borrower wishes to capitalize the very valuable property he has just built. This can be overcome by seasoning the loan - waiting until the property has been complete for one year - or by financing through a lender who doesn’t have a seasoning requirement. As discussed, the construction financing is arranged at a maximum amount, with scheduled disbursements, referred to as draws, as the stages are complete. It works like this.

Financing Investment Property When an area real estate market becomes dynamic property values fluctuate rapidly. The pur-

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chase of an investment property can provide for both income and equity growth. The major challenges in financing investment property are determining appropriate source of funds for down payment and, at the same time, assuring adequate cash flow. Initial Equity Source

Ste p 1 - Hom e Equity As a Source for Inve stm e nt Ca sh

If you are considering the purchase of an investment property, you more than likely already own a home. If the home was purchased over 2 years ago, this is the likeliest source of initial equity. Refinance or home equity lines are both easy ways to access these funds. The cost of this must be considered to determine that the transaction makes sense. This example shows the derivation of funds:

Market Value of Home LTV Less Existing Mortgage Lendable Equity Transaction Cost Available for Investment

Cost of Equity Calculation The above calculations provide us with the source of equity and the cost of carrying the new mortgage. One hidden benefit is that the new mortgage may be tax deductible. Cash flow is the next challenge. Cash Flow How much to pay and whether to buy is a feasibility question. Do market rents support the purchase? One indication of market rent is what the federal government will pay for rental assistance (HAP-Section 8). This equation determines what the market rent must be to break even: What Must the Rent Be?

$

250,000.00 80% 150,000.00 50,000.00 7,500.00 42,500.00

$ $ $ $

Ste p 2 - Ca lcula ting the Cost of Hom e Equity for Inve stm e nt

Rate Loan Size Payment Difference (Equity Cost)

Existing Mortgage 6.50% $ 150,000.00 $ 948.10

New Mortgage 5.75% $ 200,000.00 $1,167.15 $ 219.04

Ste p 3 - De te rm ining the De bt Se rvice /Ca rrying Costs Sales Price Transaction Costs Down Payment

$ $ $

150,000.00 4,890.00 30,000.00

Cash Required Mortgage Amount Principal & Interest at 9.75% Real Estate Taxes Insurance

$ $ $ $ $

34,890.00 120,000.00 700.29 200.00 50.00

Total Debt Service Expense Factor Income Required to Offset Vacancy

$

1,096.00 75% 1,461.33

$

20%

5.75%

Ste p 4 - De te rm ining the Ma x im um Mortga ge W he n Re nta l Am ount is Know n Market Rent Real Estate Taxes Insurance Available for Debt Service Mortgage Amount @ 9.75% Downpayment Amount Maximum Sales Price

$ $ $ $

900.00 (100.00) (30.00) 770.00 $89,623.00 $ (22,405.75) $ 112,028.76

9.75% 20%

Alternately, what should the sales price be if the market rent is known? The following calculation determines sales price based upon market rent. Because these formulas depend on rental income covering the debt service, the lower the interest rate, the better the cash flow.

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Investment Property Pre-Qualification Using the financial calIn v e s tm e n t P r o p e r ty P r e -Q u a lific a tio n culator, you can determine the maximum sales price an investor can afford. In this case, unlike the housing expense calculation, negative debt service is based upon another property’s rent and cash flow. If the property has a positive cash flow using a conservative vacancy factor (like 75%), anyone who qualifies for his or her current home can afford an investment property. It is when there is more than a slight negative cash flow that one needs to enhance the calculation. D e te r m in e s

S te p

1 :

th e

m a x im u m

D e te r m

in e

n e g a tiv e

M a x im

u m

c a s h

flo w

a n d

s a le s

p r ic e

B o r r o w e r 's I n c o m e M u lt ip ly b y T o t a l D e b t R a t io

$

4 ,0 0 0 .0 0 3 6 %

M a x im u m

$

1 ,4 4 0 .0 0

S te p

2 :

M o n t h ly

D e te r m

M a x im u m

P a y m e n ts

in e

M o n t h ly

M a x im

u m

N e g a tiv e

P a y m e n ts

$

C a s h

$ $

(9 2 5 .0 0 ) (2 7 5 .0 0 )

M a x im u m

$

2 4 0 .0 0

A L N P M

3 :

n t ic ip e s s O e t R e lu s M a x im

S te p

D e te r m

in e

M a x im

u m

P IT I fo r

a te d R e n ta l In c o m e p e r a t in g E x e n s e s n ta l In c o m e a x im u m R e n t a l N e g a t iv e u m R e n ta l P ro p e rty P IT I

4 :

S o lv e

M a x im u m S E E E C D M

R e n t a l N e g a t iv e

fo r

M a x im u m

R e n ta l P IT I

u b tra c t T a x & In s u ra n c e n te r a s P a y m e n t (P M T ) n te r C u rre n t R a te n te r N u m b e r o f M o n th s o m p u te L o a n A m o u n t iv id e b y L T V a x im u m S a le s P r ic e

S a le s

m o n th ly

o r a c tu a l A m o u n t

T h is is t h e m a x im u m a m o u n t th e b o rro w e r c a n a f fo r d fo r a ll o b lig a tio n s

F lo w

1 ,4 4 0 .0 0

L e s s H o u s in g E x p e n s e M o n th ly D e b ts ( c a r e tc .)

S te p

fo r in v e s tm e n t p r o p e r ty

D e b t R a tio

fro m

s te p

1

e n te r a m o u n t fo r c u rre n t P IT I (h o m e ) a ll o th e r d e b ts T h b o to s h

is is t h e m o s t th e rro w e r c a n a ffo rd to p a y o ffs e t r e n ta l in c o m e o r tfa ll

S u b je c t

$ $ $ $ $

1 ,1 0 (2 7 8 2 2 4 1 ,0 6

0 5 5 0 5

. . . . .

0 0 0 0 0

0 0 ) 0 0 0

U s e u s e

F ro m

a c tu a l a m o u n t

2 5 %

v a c a n c y /e x p e n s e

S te p

2

S te p

3

P r ic e $ $ $

1 ,0 6 5 .0 0

(2 1 3 .0 0 ) 8 5 2 .0 0 8 .2 5 % 3 6 0 $ 1 1 3 ,4 0 8 .4 8 8 0 % $ 1 4 1 ,7 6 0 .5 9

F ro m (u s e 2 0 %

a c tu a l a m o u n t o r u s e o f P IT I)

= P M T = I% = N = P V

L T V

First, figure out whether the borrower can handle any negative rental. Applying the total debt ratio against the borrower in step 1, and deducting any other obligations in Step 2, reveals the maximum rental negative. Imputing the anticipated rental income for a type of property and applying a vacancy factor gives a net rental income. Add to the net rental income the maximum rental negative a borrower can afford and you have the resultant PITI. Subtracting the taxes, insurance and other fees from this reveals the maximum P&I that can be entered into the calculator for determining the maximum loan amount and sales price. Rental Properties: Income properties often create problems for potential homebuyers. Aside from the difficulties of managing rental real estate, lenders may have a disparaging view of the impact rental real estate has on the prospective borrower. Restrictions on rental income include:  Exclusion of 25% of the gross rental income as a vacancy/loss factor. Although a property may carry a positive cash flow, lenders adjust this income significantly to take into account the potential for the property being vacant with no rental income for an extended period of time. This is known as a vacancy/expense factor. While most rental properties experience a 5 - 10% vacancy factor, an additional expense must generally be considered to determine the wear and tear on the property. The exception to this is FHA/VA loans, in which the borrower can demonstrate a lower vacancy factor, or previous experience as a landlord. Then the vacancy expense factor can be as low as 7%. If this is the case, then examine the actual cash flow of the property. Has it been rented for more than two years? If so, can you examine the borrower’s Schedule E, Rental and Royalty income, from his or her tax returns? Adding the actual income, less actual expenses (depreciation and depletion added in) may result in a

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  

more favorable net rental income than a 25% vacancy factor. In many lease situations, properties are rented on a month-to-month basis. If this is the case, the tenant must be contacted to provide a letter attesting to the fact that they intend to continue residing in the property. How many properties are financed? If a purchaser owns more than four 1-4 family properties that are financed, and the subject property is an investment property, they are generally ineligible for financing on conforming loans. Each property's mortgage must be verified. Also, the taxes and insurance must be obtained separately, either by proving that they are held in escrow, or by providing copies of the paid bills for the obligation.

Property Documentation Requirements for Investment Property Financing 

  

Leases: A current lease showing the monthly rental repayment, lease ending date, and names of landlord and tenant. If the lease is expired, a "tenant letter” will suffice along with the expired lease. The tenant letter is a statement by the tenant giving their occupancy terms and intent to continue occupancy. In certain situations, two years of tax returns may be substituted for leases. A two-year average will be utilized. Insurance: Rental dwelling coverage is required for all investment property. If the dwelling has more than one unit, rent loss coverage in an amount equal to 6 months PITI is required. Schedule of Rental Comparables is required to be completed by an appraiser. This is used to substantiate market rents. Operating Income Statement is required to be completed by an appraiser. This is a line-byline analysis of the property's expenses. The underwriter will use the net income from the operating income statement to determine income for qualification if the net income number is lower than the net rent shown on the property’s lease.

2 to 4 Unit Properties There exists an anomaly among financing terms when you deal with a hybrid between owner occupied property and 2-4-unit investment property which one owner occupies. In this case the borrower has the disadvantage of owner occupying, particularly if they need the rental income to qualify for the loan. Total debt ratios tend to be very high. Instead of using the rental income to offset the mortgage payment, the rental income is added to income under the Gross Income Method. The Cash Flow Method takes into consideration the fact that The Adva nta ge of Ca sh Flow Qua lifying for 2-4 Fa m ily Ow ne r Occupie d Prope rty the borrower has an effective lower monthly payment. Gross Income Cash Flow This is an anomaly that is always encountered when financing owner occupied 2-4 family properties. The fact is that the overall cash flow of the subject is what the borrower’s payment should be for qualifying purposes. What we have Chapter 8 – Property Types - Page 161

PITI Net Rental (After 75% ) Qualifying PITI Qualifying Gross Income Monthly Debts Ratios

$ $ $ $ $

Method 3,101.20 2,175.00 3,101.20 8,350.00 527.00 35/43

$ $ $ $ $

Method 3,101.20 2,175.00 926.20 6,175.00 527.00 13/24


The Loan Officer’s Practical Guide to Residential Finance- SAFE Act Version © 2014

shown here is that an owner occupant is treated more severely under these guidelines than an investment property. If we categorized this case as an investment property, this borrower would qualify under the cash flow method with ratios of 13/24. The additional irony of this treatment is that it is from underwriting guidelines that are supposed to be more stringent. The only argument against this is that conventional ratios (i.e., 33/38 or 28/36) are based upon gross income and tax consequences of that lease income as if it were straight salary or income taxed at the regular tax rate. The fact is that that income won’t be taxed because it will be offset against rental expenses on Schedule E.

Cooperatives FNMA Cooperative Classifications Type 1 An established cooperative project in which a lender is providing financing on a spot-loan basis. At least 70% of the total units in the project must have been conveyed to principal residence purchasers. The lender must determine the acceptability of a Type 1 project, unless the project is composed of single-width manufactured housing units.

Type 2 Any cooperative project that is submitted to Fannie Mae for review--either because it does not meet our eligibility criteria for a Type 1 project (or we have not agreed to waive the criteria it does not meet) or because the lender wants it to appear on our list of accepted projects. The project may be existing, proposed, or under construction. We determine the acceptability of a Type 2 project (including one that is composed of single-width manufactured housing units).

Cooperative ownership is not actual real estate ownership. It is ownership in shares of a corporation that owns real estate. The owner has a perpetual lease on a specific unit for as long as the shares are owned. FNMA purchases cooperative share loans, and certain banks will loan on the units, however the loans and projects normally have to meet FNMA guidelines. More recently, cooperatives have not been apartment buildings but communities that use the corporation business form to manage and control common elements. Since cooperatives are not real estate, closing costs are significantly reduced because there is no title to search and no real estate transfer tax.

Manufactured /Mobile, Modular and “Kit” Homes Construction methodology changes as builders seek means to create more affordable housing. Mobile homes are much more sophisticated now than in the past. The quality of interior and exterior finishes makes it difficult to discern a stick-built tract home from a mobile home - until you pull a trailer up, of course. That is the problem - if the house is security for a loan, and you can take the house away, what is going to keep the borrower from taking it away and selling it for cash and defaulting on the mortgage? Most financing restrictions with regard to mobile/manufactured homes have to do with this. For instance, most lenders will only lend on doublewide mobile homes - that is two that are attached - making it more difficult to move. A permanent foundation is another requirement. A modular home is partially built at the factory, in 2 or more pieces, and then assembled on the foundation at the site. The issues lenders have with these homes have to do with the quality of Chapter 8 – Property Types - Page 162


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construction, whether construction will be completed, and the operation of a newly constructed project. The only control that the lender can exercise over these products is builder approval. As long as reputable national builders assemble these, there should be no difference between a stick built home and a manufactured home. “Pre-fabricated” or “Kit” homes have increased in popularity. The builder assembles all of the pieces for the home in a package, like a toy model kit. The difficulty with a kit is that the kit manufacturer wants to be paid at the time of delivery. Under normal new construction guidelines, the kit wouldn’t be fully paid for until the end of assembly. Commercial Loan Guidelines In this context, commercial property lending guidelines are nearly non-existent. To a certain extent, this is the only area in which totally subjective common sense plays a role in loan approval. Entire books have been written on the subject of financing commercial properties. From a residential lender’s perspective, anything that is not a home or a 2-4 family residential property is a commercial property. However, there are areas in which the two intersect and it is helpful for the loan officer and his customer to understand some basic distinctions. Commercial Property Types and Basic Guidelines Type Multifamily

Hotel Strip Malls Storefront Buildings

Office Condos, Single Tenant (Owner Occupied) Industrial/ Warehouse

Description Any property containing more than 4 units is considered a multifamily property. While FNMA, and FHLMC, as well as FHA , purchase or insure loans in these projects, this is normally done through commercial channels. Basically the requirement is for LTV’s in the 75-85% range and debts service coverage or 115% (income exceeds debt service by 15%) There aren’t many institutional conduits for hotel loans. Generally, the hotel must be an affiliate of a national chain and exhibit occupancy rates of over 70% Stand Alone Malls without a major tenant are difficult to finance. Debt service of 125% and near 100% occupancy Units with Mixed Use commercial and owner occupied may be financed via FHA 203(k) as long as the commercial use does not exceed 49% of total space. SBA financing is available for properties which are 51% or more occupied by the owner at 85% LTV maximum SBA financing may be available for single tenant, owner occupied to 85% LTV. May include some build out and facilities acquisition under SBA. Conduit lending programs do offer some outlets for heavy industrial property. But the environmental due diligence is so intensive as to dissuade most lenders from participating

Warehouse properties, Gas Stations and Small Office Buildings are often SBA candidates. Office buildings, cooperatives, and larger apartments over 25,000 square feet or over $1,000,000 in financing normally find financing through a major life insurer or pension fund. More than anything you will need knowledge of processing of commercial loans to successfully place this type of transaction. The borrowers are sophisticated, knowledgeable and will place a loan at the best terms which may include rate.

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Appraisals With the advent of the Dodd-Frank Act (Appraiser Independence Rule – formerly HVCC), production staff may no longer be involved in the ordering, or discussing, of appraisals and technology with appraisers. As a consequence, not much time is spent discussing appraisals and appraisal technology in this course. The issues that arise from appraisals are most often value related from the perspective of the market – something the loan officer has no control over. In fact, the loan officer is legally prohibited from exerting any influence over the value conclusion of the appraiser. Appraisal Basics An appraisal of the real estate is requested to support the transaction. An appraisal is an estimated value – an opinion - of property by a trained professional to indicate whether the property is adequate to serve as security for a loan. Loan Officer Knowledge of appraisal technology and underwriting is given an inordinate amount of weight training resources and regulatory authorities. The problem with this is that there is very little, if anything, that a loan officer can do to anticipate or fix problems that arise in this area. Loan officers are expressly prohibited from influencing the value conclusion. Value Conclusion Methodology Approach Description – Weight in Valuation The Cost LEAST WEIGHT – used for confirmation purposes. The cost to replace or rebuild the Approach existing structure and site improvements based on construction industry estimates is the approach that is given the least emphasis. It is most useful when appraising a property to be built. The Income INDICATIVE WEIGHT – if an investment property. Used for income-producing (rental) Approach property. In addition to reviewing market rents, the appraiser capitalizes the property (determines if the rental income would recapture the cost of the property). The appraiser must consider future revenue and expenses. The Market MOST WEIGHT - A comparison of the subject property to similar recent sales using the Approach principle of substitution. Similar properties are called comparable sales or “comps”. The appraiser starts with the sales price of a comparable and reduces or increases the relative value of the comparable based upon aspects of the subject that are superior or inferior. In “adjusting” the value of the comparables, the appraiser arrives at a scientific conclusion of the indicated value of a property. This is the approach that is given the most weight in the value conclusion.

States license appraisers, but appraisers may also have designations from industry associations that advance their credentials, such as the SRA (Senior Residential Appraisal) or MAI (Member Appraisal Institute) issued by the Appraisal Institute of America. Simple Approaches to Resolving Valuation Problems Concern Circumstance – Possible error

Possible Solution Get the appraiser to go back out and re-evaluate the property? Do you have evidence that he or she overlooked something? Did he or she do most of the report at a desk and spend little time at the property? Was it a “rush” order?

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Concern Comparable Data New Data

Desk, Drive by or Limited Appraisal (Short Form Appraisals) Confirm the value independently FIRST Motivated buyer or seller

Excessive Seller contributions New Appraisal

Borrower Provided Appraisals

Possible Solution Check the comparable properties listed on the report. Is there someone, like an agent or builder who can provide additional comparables for the appraiser to consider? Are there pending or recent sales that might support a different conclusion? Ask an agent or builder in the area of the property if there is any “inside” or soon to be released information that could change the value conclusion. New comparables are very powerful tools, because they don’t indicate that the appraiser “missed” something – it’s new data. Short form appraisals can be useful if the value conclusion would be better if the basis for the value assessment was tax records – over assessed property. If there is significant equity in the property, or the purchaser is putting a lot of money down, is there even a need for a full appraisal? Did DU/LP require a full appraisal? Will the investor accept a short form appraisal? Check the property value independently. One web-site offering this service is domania.com, but there many valuation sites, including tax assessor’s offices. A value that appears unobtainable here will be even more difficult to obtain through a full appraisal. Even with a low value, the transaction can still work. The purchaser has to make a larger down payment. If the contract is contingent upon loan approval, the buyer may use this as leverage to extract a concession in sales price or costs from the seller. The buyer may cancel a contract that is contingent upon financing, if the financing approved does not meet the terms of the sales agreement. Excessive seller concessions, particularly those that drive the sales price over the list price, can cause value problems. Can the loan be restructured to eliminate these? If there were serious flaws in a prior appraisal, the borrower may be willing to pay for a new appraisal. The new appraiser may arrive at the same value conclusion, but you have satisfied the borrowers need for confirmation. It is very rare that a customer will be able to use an existing appraisal. Loan officers should be wary of a customer who wants to use an appraisal from a non-approved vendor. What if the borrower were to abandon the loan process or provide a faulty appraisal?

Fraud Alert Be conscious of strategies outside of normal influences as to valuation. These can be indicative of problems and can cause delays or problems in a transaction. APPRAISAL Ordered by a party to the transaction (seller, buyer, broker, etc.) Comps are not verified as recorded or submitted by potentially biased party (seller, real estate broker) Tenant shown to be contact on owner-occupied property Income approach not used on tenant-occupied SFR Appraiser uses FNMA number as sole credential (discontinued program) Market approach substantially exceeds replacement cost approach "For Sale" sign on the photos of the subject (in refinance loans) HUD-1 or grant deed on original purchase is less than two years old (for refinance loans)

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Chapter 9 - REFINANCING When you purchase a home you are caught up in the excitement of the moment - the house of your dreams - the mortgage of your nightmares. The reality is that many people do not approach purchasing considering the personal financial planning aspect of the transaction. Often the purchase is made and the consequences of a high mortgage payment or product selection only set in when it's time to make the first payment. However, even with an expensive mistake, there is always an opportunity to correct the circumstance to a more opportune one in the future. Thus, anytime in which it can save money or meet other objectives, it is a good time to change financing terms or "re-finance", that is, finance again. The refinance transaction is similar to the purchase transaction. The only difference is that no title changes hands. The same costs for settlement services exist. The most important concept in refinancing is to correctly calculate the difference in payments and terms and weight these against the costs of the transaction. This is measured against the time in the home to determine whether there is time to make the transaction feasible.

Where to Start - Determining “Value” An initial difficulty in refinancing is the determination of the value of the property. Unlike a purchase transaction, there is no sales contract that gives the market indication of what the value of the property is. A Uniform Residential Appraisal Report (URAR) must be performed. The entire scope of the transaction must be considered tentative until a valuation analysis is complete. Loan to value (LTV) limitations can then be accurately determined. For the initial consultation, use a moderate 1-3% rate of appreciation per year of ownership if the borrower does not know what the approximate value of the property is. “Seasoning” Another consideration in the value of a home is how long it has been owned. Theoretically, a property could have been purchased at a price well below market. The borrower, knowing this, might try to refinance the property immediately after the purchase in order to more fully leverage it. Even though the property may be appraised at the higher value, lenders will not usually accept this valuation unless the ownership has been “seasoned” – like firewood – for at least one year. Seasoning also applies in “No Cash Out” transactions. If a borrower is refinancing a 1st

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and 2nd mortgage – any extensions of credit in the last 12 months are considered “Cash Out.” Rate Reduction The most common reason for refi- Basic Rate/Payment Reduction Feasibility Analysis Current Mortgage Proposed nancing is to reduce a high fixed Balance $ 100,000.00 $ 100,000.00 rate to a lower fixed rate. As with $ 2,000.00 many old wives' tales, there are Closing Costs $ 102,000.00 misleading "rules of thumb" which Loan Amount Interest Rate 9.50% 8.50% should be discarded as guiding conTerm in Months 360 360 cepts immediately. For instance, it Monthly Payment $ 840.85 $ 784.29 is commonly understood that there Monthly Savings $ 56.56 should be a 2% reduction in interest Number of Months before Closing Costs are rate in order for the refinance to be Repaid 35.36 feasible. While it is certainly more opportune to reduce your interest rate as much as possible, it is not necessary to reduce it by 2%. The critical concept is to compare the closing costs against the monthly savings to determine the length of time the borrower intends to spend in the home required before there are actual cash savings. This is a method of determining refinance feasibility. To begin the comparison you should determine the borrower’s current interest rate and monthly payments, exclusive of taxes and insurance (T&I) (take out the TI - these are going to be the same before and after). Then, calculate the costs (closing costs) of the transaction that the borrower absolutely must pay in order to refinance. These costs will vary depending on the jurisdiction. These closing costs may be financed or may be paid in cash. However, they should always be added to the loan amount for comparison purposes because, whether paid in cash or financed, this is the only way of accurately amortizing the cost over time. The actual cost of $2000, in this example, results in savings of $56/mo. Dividing these savings by the cost results in the length of time the borrower will take to break even on a cash flow basis. This is only one analysis of refinance feasibility, as it does not take into consideration the payment of points in the closing cost scenario. Take the comparison one step further and finance points. A borrower can elect to pay points or not pay points and this has an effect on the cost of the transaction. It is one way of getting a more attractive interest rate. The break-even cost over time must be considered. Reducing the interest rate further increases the monthly savings but measure the costs. It takes almost 5 years to break even on the cost of refinancing, even though the interest rate is much lower. A question you may ask is "If this is how long it takes to break even, am I going to be in the home less than 3 or 5 years?" This is the reason to include all costs in gauging refinance feasibility. Time really is money. The cost applied to the savings gives the amount of time it takes to save money. In a rate reduction refinance the costs of the transaction over the existing loan balance must be calculated to accurately determine the length of time it takes to actually save money in

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refinancing. It should not be construed that the costs of the transaction cannot be paid in cash. They may be paid in cash; however, you should still amortize the costs in this way in order to achieve an objective formula for measuring the costs. Ba sic Ra te /Pa yme nt Re duction Fe a sibility Ana lysis Re finance

Current Balance

Curre nt Propose d Proposed w / Mortga ge w /o Points Points $ 100,000.00 $ 100,000.00 $ 100,000.00

Closing Costs Loan Amount Interest Rate Term in Months Monthly Payment Monthly Savings Number of Months before Closing Costs are Repaid

$

$

2,000.00

$

2,000.00

$

3,000.00

$ 102,000.00 $ 105,000.00 9.50% 8.50% 7.75% 360 360 360 840.85 $ 784.29 $ 752.23 $

56.56 35.36

$

88.62 56.42

A disadvantage of points is that, because of amortization, the loan balance declines over time. Points are based on the original loan balance. As the loan balance decreases, the value of those original points paid decreases. Points financed increase the amount of time to recapture costs. Points paid out of pocket increase cash required at closing. Term Reduction Refinances If you have ever seen a book or an ad that says "How To Save $100,000" on your home mortgage loan, the term reduction refinance is the principle behind it. In a refinance where you pay off a 30-year mortgage with a new 30-year mortgage, you have increased the total amount of time it will take to own the home free and clear. The drawback of periodic refinancing is that, without a disciplined approach, the loan never amortizes or achieves a –0- balance. Combining a rate reduction with a reduction in loan term can be one way of saving money over time. Reducing the loan term – a shorter amortization increases the speed at which the loan must be paid off, thereby increasing the amount of principal to be paid each month - higher payments. A term reduction takes on much more of a personal financial planning facet because higher payments may be involved. Term reductions benefit:   

An individual planning on retirement at the end of the loan term. An investment property with significant positive cash flow that could carry higher payments. An individual who wishes to force himself or herself to make a higher payment, thereby accumulating more equity. Obviously a borrower who can do this does not need a refinance if interest savings are not achieved.

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Since most lenders can offer fixed rate loan terms of 30, 25, 20, 15 and 10 years, why not consider the reduction in term in conjunction with a reduction in rate to enhance the savings of a refinance? Slightly lower interest rates may be available for 20, 15 and 10 year loans. Term Reduction Analysis

Loan Balance Closing Costs New Loan Initial Term Interest Rate Payment Monthly Savings Remaining Months

$

Payments Remaining Life of Loan Savings

$

$

Current 100,000.00 $ $ $ 360 6.500% 632.07 $ $ 324 204,790.04

$ $

Proposed 25 Year 100,000.00 2,000.00 102,000.00 300 6.000% 657.19 (25.12) 300 197,156.23 7,633.81

$ $ $

$ $ $ $

Proposed 20 Year 100,000.00 2,000.00 102,000.00 240 5.875% 723.42 (91.36) 240 173,621.58 31,168.46

$ $ $

$ $ $ $

Proposed 15 Year 100,000.00 2,000.00 102,000.00 180 5.500% 833.43 (201.36) 180 150,016.52 54,773.52

$ $ $

$ $ $ $

Proposed 1 Yea 100,000.00 2,000.00 102,000.00 120 5.375% 1,100.66 (468.59 120 132,079.32 72,710.72

This example illustrates that, while a term reduction does not necessarily result in monthly payment savings, there is a definite savings over the life of the loan. The significant savings are realized over time, accomplished through regular monthly payments of principal and interest. Always be prepared to compare these as an alternative to simple payment reduction. Refinancing to “Cash Out” - Recapture Equity in Your Property An "Equity Recapture" or "Cash Out" refinance allows the borrower to take money from some of the equity in their home for any legal purpose. Loan Amount Interest Rate Term Principal and Interest Deductible Interest Portion (Loan Amount x Interest Rate Divided by 12) Multiply By Tax Rate Tax "Savings" After Tax Payment

Current $ 100,000.00 6.500% 360 $ 632.07

Proposed $ 125,000.00 6.000% 360 $ 749.44

$

$

$ $

541.67 28% 151.67 480.40

$ $

625.00 28% 175.00 574.44

Pre-Tax Payment Additional Savings Increase due to increased $ 117.37 tax deductible interest After Tax Payment $ 23.33 Increase $ 94.04

When a borrower recaptures equity they are “re-leveraging.” Financial leverage is a loan on an asset. The idea is that you purchase a large asset, like a house, with relatively little of your own assets. The financed asset – like the house – appreciates on its own regardless of the financing, at a far greater pace than the relatively small amount of your own assets would have appreciated even at a very high rate of return. It is important that borrowers who are re-leveraging understand the power of their equity. A borrower with a large equity position in their home isn’t receiving any more appreciation on the home than a borrower with little or no equity.

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Taking cash out becomes a smart idea for a number of other reasons.   

Mortgage interest is tax deductible. Most loans can be prepaid without penalty. Almost any other investment will outperform real estate equity.

Reasons to Take "Cash Out"      

To pay off other "high cost" loans which may not be tax deductible To pay for the cost of education To make home improvements To purchase investment property To make other investments To finance retirement

Low Cost of Cash Because of the fact that mortgage rates are predominantly much lower rate products than any other lines of credit, it should be the first source for cash in a borrowing situation. In addition, there are tax benefits due to mortgage interest deductibility. Borrowers who need tax deductions are essentially volunteering to pay a higher tax when they keep a lot of equity in their homes. Cash Out for Debt Consolidation There are few situations where a borrower who is overextended with consumer debt will not be able to take advantage of debt consolidation even if the rate on a new mortgage is substantially higher than the existing rate. As such, for the loan officer it is an easy sale. However, there are certain processes that must be addressed to make the most effective use of the homeowner’s equity. 

 

Payoff the debts with the highest payment proportionate to the balance. Select these by dividing the payment by the balance. The lower percentage payments should remain. In addition, accounts with very low interest rates (lower than the mortgage) should probably not be paid off. If there is limited equity and all debts cannot be paid from proceeds, investigate lines of credit that the borrower can make use of to consolidate smaller accounts into one larger payment independent from the refinance. If the borrower needs to pay off debts to qualify, those accounts MUST BE CLOSED, not just paid off.

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D e b t C o n s o lid a tio n An a ly s is P roperty V alue

Loan M ortgage B alanc e Interes t Rate Term P ay m ent O ther O bligations Total Cas h F low

Cu rre n t L o a n $ 125,000.00

P ro p o se d L o a n M ax LTV /Loan M ax P roc eeds Cos ts Net P roc eeds A vailable Interes t Rate Term P ay m ent O ther O bligations Total Cas h F low S a vin g s

$ 75,000.00 9% 360 $ 603.47 $ 1,785.00 $ 2,388.47

De b t Co n so lid a tio n An a lysis B alanc e P ay m ent In sta llm e n t L o a n s F ord M otor $ 16,250.00 $ 361.00 Chry s ler $ 10,250.00 $ 420.00 $ $ Cre d it Ca rd s M B NA $ 12,250.00 $ 389.00 S ears $ 1,900.00 $ 168.00 Dis c over $ 2,900.00 $ 79.00 V IS A $ 5,900.00 $ 178.00 M as terc ard $ 4,650.00 $ 190.00 $ $ $ $ $ $ $ $ $ $ Totals $ 54,100.00 $ 1,785.00

80% $ 100,000.00 $ 25,000.00 $ 5,000.00 $ 20,000.00 9% 360 $ 804.62 $ 1,127.00 $ 1,931.62 $ 456.84

Term /B alanc e

n/a n/a n/a n/a n/a

P ay off A m ountP ay m ent A fter 36 $ $ 361.00 25 $ $ 420.00 0 $ $ $ $ 3.18% $ 12,250.00 $ 8.84% $ $ 168.00 2.72% $ 2,900.00 $ 3.02% $ $ 178.00 4.09% $ 4,650.00 $ $ $ $ $ $ $ $ $ $ $ $ 19,800.00 $ 1,127.00

In this example, the borrower is saving $456 a month. Most borrowers would be happy with this outcome and leave it at that. However, you should show them the additional savings they could realize if they took a financial planning approach. The borrower has already adjusted their personal cash flow to account for this $456 savings. What if he or she took that savings and, instead of investing in personal expenditures, applied them to principal prepayment on their new mortgage? Applying Debt Consolidation Savings to Principal Prepayment Mortgage Amount Rate Term Note Payment Debt Consolidation Savings Loan Term After Prepayment Number of Months Saved Monthly Payment Savings

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Ad v a n ta g e s o f M a x im u m F in a n c in g P roperty V alue M inim um E quity Loan A m ount

$200,000.00 20% $160,000.00

W ithout Le ve ra ge Loan A m ount P rinc ipal & Interes t Tax es * Ins uranc e Total Tax S avings * Inves tm ent Return Net Cas h Flow

$ 109,000.00 $ 946.46 $ 137.42 $ 41.67 $ 1,125.54 $ (257.81) $ $ 1,125.54

A fter Tax Cas h Flow

$

867.73

Cas h flow is enhanc ed by Tax B enefits enhanc e Cas h Flow by On a c as h flow bas is the effec tive rate is On a tax advantage bas is the effec tive rate is

Loan Ty pe 30 Y ear CD/A lternative Inves tm ent Y ield A m ortiz ation in Y ears W ith M a x im um Le ve ra ge Loan A m ount P rinc ipal & Interes t Tax es * Ins uranc e Total Tax S avings * Inves tm ent Return Net Cas h Flow Com pare (S avings )/Los s A fter Tax Cas h Flow Com pare (S avings )/Los s ($45.37) $9.47 6.22% 5.80%

5.875% 4.500% 30 $ 160,000.00 $ 1,183.08 $ 137.42 $ 41.67 $ 1,362.16 $ (312.64) $ 191.25 $ 1,170.91 $ (45.37) $ 858.27 $ 9.47

*As s umes 28% b rac k et with interes t and real es tate tax deduc tions

Cash out for Investment Whether to purchase stocks, invest in a company, purchase investment property, or just put money into a CD or mutual fund, the tax benefits of mortgage interest offset the cash flow cost so that even a marginally positive investment makes sense. In this example, the mortgage rate is higher than the rate of return on a Certificate of Deposit. Still, the investment, combined with tax benefits, created a positive cash flow exceeding the cash flow of the smaller mortgage – simply by unleashing the equity in the property. Cash Out to Purchase Investment Property The same theory applies to any investment. The appeal to a borrower in this situation is that they are already going through the home financing process – why not use the same documentation for the refinance transaction to purchase an investment property? In this case the benefits are doubled because the tax advantages continue to flow from the investment property. Instead of the income being taxed, it is offset by depreciation. To the extent that the depreciation exceeds the actual income from the property, it becomes a deduction. The source of the down payment is the equity in the current residence. The larger the down payment in the new property, the more positive cash flow the investment property will yield.

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FINANCING ANALYSIS

Investment Property Cash Flow

Incom e /Ex pe nse Assum ptions Sales Price Down Payment (% ) Down Payment ($) Loan Amount

$ $ $

150,000.00 25% 37,500.00 112,500.00

30 Year Fixed at Annual Taxes Operating Expenses Total Monthly Rent

8.750% $ 2,500.00 $ 1,800.00 $ 1,600.00

CASH FLOW ANALYSIS Cash Flow Based on Current Rent

Cash Flow after 10% Increase

Gross Income Principal and Interest Real Estate Tax Hazard Insurance Total Payment Plus Other Operating Exp. Plus Vacancy (10% ) Total Expense Net Cash Flow Yield of Alternate Investment (CD, Mutual Fund)

Rental Income Principal and Interest Real Estate Tax Hazard Insurance Total Payment Plus Other Operating Exp. Plus Vacancy (10% ) Total Expense Net Cash Flow

$ 1,760.00 $ 885.04 $ 208.33 $ 31.25 $ 1,124.62 $ 150.00 $ 160.00 $ 1,434.62 $ 325.38

Cash Flow of Alternate Investment

$

$ $ $ $ $ $ $ $ $

1,600.00 885.04 208.33 31.25 1,124.62 150.00 160.00 1,434.62 165.38

7.50%

234.38

Cash Out for Retirement The same rationale for maximizing mortgage financing applies when considering the needs of individuals planning for retirement. Mortgage refinance proceeds are not taxable as income, and so can be invested in a non-qualified plan such as an annuity, which can compound without the dividends, interest or capital gains subject to taxation. Often individuals object to maximum financing on the basis that they want to own their property free and clear and not have a mortgage. This is particularly true for individuals who are planning for retirement – they see their home being paid off as a cornerstone to their retirement. However, if the retirement is a few years away, they still will have income that they need to minimize the tax consequences. The mortgage they may take out will not have a prepayment penalty – if the equity is cashed out for retirement planning purposes is placed in liquid investments. The borrower can pay off the mortgage any time it is beneficial. It is merely a balance sheet transfer. Self-Employed individuals in particular can benefit from the advantages of being able to recapture equity in their home and fund Simplified Employee Pension Plan Individual Retirement Accounts (SEPP-IRA) in an amount up to 15% of annual income or $30,000 – whichever is less. Within these plans, assets grow without regard to taxation. The key benefits of cash out for retirement are:   

The residence or property being financed continues to appreciate The equity is released to invest and yield a return The funds may be invested in qualified or non-qualified plans

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  

The equity invested continues to compound The tax benefits of home mortgage interest are increased The loan can be paid off any time the borrower decides they no longer wish to carry the debt service.

Refinance to eliminate Private Mortgage Insurance One of the best reasons Refinancing to Eliminate PMI for refinancing is to 30 year $100,000 Mortgage eliminate Private MortProposed Savings Current gage Insurance - the in9.00% 8.50% 0.50% surance a lender will Payment $ 804.62 $ 768.91 $ 35.70 require protecting PMI (@ .34% Renewal) $ 28.33 $ 28.33 $ against default losses Total $ 832.95 $ 768.01 $ 64.93 when there is less than $ 2,000.00 20% equity in the prop- Refinance Cost Feasibility Analysis $ 64.93 = 30.80 Months to Break Even erty. A lender may allow a borrower to petition to remove PMI as a requirement. This can occur under certain conditions, but generally involves documenting significant improvements or prepayment of the mortgage to a level below what would be required on a new loan application. For instance, if there were 20% equity in a refinance transaction PMI would not be required. However, if you are petitioning to have PMI removed from an existing loan you may have to substantiate 25% equity, depending on the amount of time in a house. When refinancing to remove PMI the amount that the interest rate must be reduced to save money over time is also reduced. In the example above, if the closing costs were approximately $2,000, the break-even formula would indicate the refinance to be feasible if the loan would be held for more than 31 months. When you take into consideration the fact that PMI is not generally tax deductible, the savings over time are more significant. This demonstrates, again, that a large reduction in interest rate is not necessary to achieve savings. Reduce the Cost of PMI if it can’t be Eliminated

Loan Amount with PMI Premium Financed Existing loan x PMI Premium Factor One Time Premium Existing Loan New Loan Amount

$ $

100,000.00 1.58% 1,580.00 100,000.00 101,600.00

When PMI cannot be avoided because of low $ equity, another approach would be to com$ pare the premium costs for various PMI plans. The standard plans require an initial Comparing PMI Plans One Time "Classic" premium and then require the lender to colLoan Amount $ 101,600 $ 100,000 lect 1/12th of the renewal premiums with the Payment $ 781.21 $ 768.91 monthly payment. Because PMI is not tax PMI Payment (.34%) $ $ 28.33 $ 781.21 $ 797.24 deductible, there are no benefits to paying Total Payment $ 16.03 this monthly. However, if there is sufficient Monthly Savings Cash at Closing $ equity, the borrower may be eligible for a premium financing plan where one payment is made at closing and is financed into the loan. The first step in comparing this is to determine what the new loan amount would be with the new

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PMI premium financed, and then compare the costs against the loan with a standard payment plan. In this example, where PMI is a requirement and the choice is between premium plans, the one time program offers monthly savings as well as cash savings at closing. There are also plans which finance the initial premium only, as under the standard plans, and then take 1/12th of the renewal premium with the monthly payments, but this does not provide the benefit of the entire payment being tax deductible, and does not result in a payment reduction. Using a 1st and 2nd Mortgage to Solve Equity Problems In the same way that 80-10-10’s are used when purchasing a property, a 2nd mortgage combination, “tandem,” “piggy-back,” or “blend” can be used to allow more flexibility in the structuring of a refinance. The benefit is that there are no extra costs for a 2nd mortgage and the paperwork for the borrower is no different than what is required for the first mortgage. Property Value Equity PMI Transaction Term in Months Interest Rate 1st Trust Amount P & I Payment Monthly PMI Payment w/ PMI

$

$ $ $ $

200,000.00 10%

360 8.75% 180,000.00 1,416.06 81.67 1,497.73

1st & 2nd "Blend" 1st Trust Balance @ LTV 1st Trust Payment @ Rate 1st Trust PMI 2nd Trust Balance @ LTV 2nd Trust Payment @ Rate Payment w "Blend" Savings with "Blend"

80% $ 160,000.00 8.75% $1,258.72 $ 10% $ 20,000.00 9.50% $ 168.17 $ 1,426.89 $ 70.84

A more effective way of removing mortgage insurance is to combine a 1st and 2nd mortgage in a refinance transaction. If the current loan has Private Mortgage Insurance and still has a property value too low to allow PMI removal, structure the transaction with a “Blended” 1st and 2nd mortgage. The same effect applies when a borrower has a fantastic interest rate on a 1st mortgage, but a very high rate on a 2nd mortgage. The borrower will often say “Well, I’ve got a great rate on my 1st trust, but my 2nd mortgage rate is really high.” This indicates that the only potential for refinancing in this case might be to refinance the 2nd mortgage. But this isn’t always the case – particularly if the first mortgage is relatively small. Benefits of “Blended” Financing The benefits of “blended” financing are:   

The borrower avoids PMI and may receive a lower overall rate The borrower is able to more effectively make periodic prepayments and eventually retire a smaller 2nd mortgage at a higher rate – then is left with only a 1st mortgage Can structure a transaction with more favorable terms by putting the higher rate 2nd mortgage on a smaller balance and leaving the larger portion of the transaction on the more

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favorable 1st mortgage Using Blended Financing to Achieve Payment Savings Property Value Loan Term (Months) Current Financing 1st Trust Balance @ LTV 1st Trust Payment @ Rate 2nd Trust Balance @ LTV 2nd Trust Payment @ Rate Payment w "blend"

$ 200,000.00 360 40% 6.75% 50% 11.00%

$ 80,000.00 $ 518.88 $ 100,000.00 $ 952.32 $ 1,471.20

Proposed Financing 1st Trust Balance @ LTV 1st Trust Payment @ Rate 2nd Trust Balance @ LTV 2nd Trust Payment @ Rat Payment w "blend"

80% $ 160,000.00 8.50% $1,230.26 10% $ 20,000.00 9.50% $168.17 $1,398.43

Refinancing a 1st and 2nd Mortgage Note that there may be situations in which a borrower may want to refinance a first mortgage without paying off the second mortgage. For instance, when the second mortgage has very attractive terms, or because it is a home equity line that will be used again and paid down. There are some things to be remembered in this situation:  

With a home equity line of credit, even if the borrower owes no money, the qualification is performed as if there was a full balance. This is because the borrower can, at any time, increase the balance and take on an additional debt burden. A subordination agreement is required in order to leave the second mortgage in place. This requires the approval of the 2nd mortgage lender. The 1st mortgage lender will require a subordination agreement that stipulates that the new 1st mortgage will remain as a prior lien chronologically. With certain balloon and ARM loans there are inherent contradictions. A conversion option may be offered as an escape to the balloon feature or as a low cost means of fixing the rate for the remainder of the loan on an ARM. This conversion feature will generally prohibit any second liens at the time of exercising the conditional refinance rendering the option moot. This could expose the borrower to potential risk or loss.

Refinancing an FHA Loan The underwriting philosophy of the FHA refinance program is simple. Are you reducing your current payment? If so, it stands to reason that, if the borrower can afford a higher payment it will be even easier to afford the lower payments. To facilitate this, FHA has implemented what is known as a "Streamline Refinance.” This is a simple reduction of the interest rate. The borrower only needs to provide the following information:   

12 month payment history - current mortgage Uniform Residential Loan Application Current appraisal to document that the property value has not declined. This may not be required if the new loan amount is not being increased over the current loan amount. (Effective 10/1/09 appraisal is always required)

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Verification of any funds needed to complete the closing and evidence of 1 month's PITI in reserve.

A Streamline Refinance can be used to refinance an investment property or a loan that was assumed under the assumption program. Under an assumption, however, the borrower must have made at least 6 mortgage payments. As a mortgage insurance plan, FHA insures loans. Under section 203 (b), the fund that insures single-family homes, are subject to the UFMIP (Up Front Mortgage Insurance Premium) AND monthly MIP. Condos [234(c)] and Graduated Payment Mortgages [245(a)] are not subject to the UFMIP, but are subject to MONTHLY Mortgage Insurance Premiums. A new UFMIP is collected at closing. This premium is determined by subtracting the FHA MIP refund on the old loan from the amount of new (MIP) to be financed allowing for the appropriate refund on the old loan. An owner-occupied property is also eligible for cash out refinance. The amount of cash out allowed on FHA cash out is contingent upon the value of the property. Up to 85% of the acquisition cost may be borrowed. A temporary buydown is not allowed under the cash out guidelines, and qualifying ratios are a strict 29/41. When paying off a FHA loan, it is important for the borrower to review the original loan documents to determine if there is a prepayment penalty. The current holder of the note may require an additional 1-month of interest on the mortgage if there is not a 30-day notice of prepayment. In addition, it is important to close on an FHA transaction at the end of the month because the note holder has a right to collect interest from the date of the payoff until the end of the month. If you are refinancing an FHA loan, the settlement agent must give payoff notice at least 30 days prior to closing. An existing FHA loan should be paid off prior to the end of the month to avoid paying an additional 30 days of interest. Refinancing a VA Loan Much like the FHA program, VA allows for Streamline Refinancing. The same documentation is required when the interest is being reduced. The key is to reduce the interest rate or the payments.    

12 month payment history - current mortgage Uniform Residential Loan Application Current appraisal to document property value has not declined. This may not be required if the loan amount is not being increased over the current loan amount. Verification of any funds needed to complete the closing and evidence of 1 month's PITI in reserve.

Unlike the FHA program, the VA program is a guarantee program. The fees paid for the guarantee do not get refunded at any time, unlike FHA insurance where the unused portion of the premium is refunded when the loan is paid off. On refinances, the premium is stiff -1.875% of the loan amount regardless of loan to value. More affordable is the rate and term version of the VA

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refinance - the premium is only 0.5%. The benefit of the VA Refinance Program is that you can refinance ANY loan, not just an existing VA loan, and be able to utilize the VA program guidelines - higher ratios and loan to values on a refinance. Important Facts With Regard to Refinancing The process of settling a refinance loan is much like a purchase. Because title is not changing hands, many documents ordinarily required may be waived:      

Initial Truth-in-Lending Disclosure may not be required by the lender on a no cash out refinance. Termite Inspection may not be required depending on whether the appraiser states that there are conditions existing conducive to termite infestation. House Location Survey may not be required if the title insurance policy does not take exception to encroachments and the borrower certifies that no changes have been made to the physical structure of the property. Well & Septic Certification, as with a termite report, may be waived. There are circumstances where the certification is required – such as when an appraiser notes an issue upon visual inspection. Generally, a well and/or septic system would not have visible signs of problems. Title Insurance - There may be reduced rates for title insurance. "Reissuing" an existing policy may save the customer money. Title Search - A full abstract may not be necessary if there is an existing title insurance policy in effect - many title companies will simply "bring down" the title, meaning they will review from the time that the last search was made, rather than reinvestigate the entire chain of title.

Escrow Accounts and Prepaid - Understanding Costs of Refinancing When there is an existing loan with an Escrows Financed vs. Paid in Cash escrow account for the payment of real Paid Cash Financed estate taxes, homeowner's insurance, or Existing Loan $ 100,000.00 $ 100,000.00 PMI, these items will generally (unless Escrows Placed $ 2,000.00 $ there is an escrow waiver) have to be Financed Amount $ 102,000.00 $ 100,000.00 funded by the borrower in a new escrow Payment @ 8.5% $ 784.29 $ 768.91 account at closing. This is an interim $ 15.37 measure because the old lender will re- Difference in Payments Cost of $2000 @ 18% $ 28.00 fund the escrow balance to the borrower once the existing loan is paid off. The question for the borrower is, can he or she reasonably afford to put the required money into escrow from their own funds or should this be financed? Since this is the current practice, unless the lender is refinancing a loan held in its own portfolio, the borrower receives the refund of the escrow balance after the old loan is paid off, and after the old lender performs an escrow analysis to determine whether there has been any shortfall. As a result, it normally takes 4-6 weeks for the borrower to receive this refund. While this may be a considerable sum of money, in contemplating a rate and/or rate and term refinance, it is advisable to not finance these costs, but place them into escrow with the new lender. Replenishing the

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escrow account from existing funds will reduce the cost over the life of the loan. Even at an extreme cost, it makes sense to pay escrows in cash if possible. It appears on face value that it would be more beneficial to finance the $2000 in the mortgage amount. If you borrowed the money on your credit card, wouldn't it cost about $30 per month? Not necessarily. If you received a check from your current lender for $2000, would you send it in and pay off your credit card debt - probably not. Think of it as a savings account. It is $2000 that will pay you $15.37 per month for the next 30 years! 15.37 x 360 = $5533.20 over the life of the loan. Problems with Existing Financing In refinancing it is often encountered that there is a problem with the way the existing financing or titling is in place. Some problems are solved following these suggested solutions. Title Held In The Name Of A Corporation: When property is owned in the name of any entity other than a "natural person" - an individual - the title must be transferred. This is because a corporation automatically is a commercial enterprise, not residential in nature. The difficulty comes when transfer tax or other municipal charges apply to this transfer. Because no title normally transfers in a refinance, this would technically be called a purchase transaction. There is the potential for a less than arm’s length transaction - presenting risks for the lender because the sales price could be artificially inflated in order to obtain maximum financing. However, if it can be demonstrated that the individual wishing to refinance closely holds the entity, the fear of a less than arm’s length transaction can be mitigated. Spousal Buyout: In a divorce situation the parties may wish to dispose of their interest in a property or redistribute the equity. While this is not an ideal personal situation, it can be an excellent opportunity to purchase an estranged spouse’s interest. This is not a transfer, because one person is simply assigning his or her interest in a property to someone who already owns the property. However, from a loan to value point of view, this can be treated as a purchase. The separation agreement sets forth the sales price, an appraisal is performed, and normal purchase loan to value limitations apply, as well as normal underwriting guidelines. Existing Loans with Conversion Options With certain 5 and 7-year balloons, and adjustable rate mortgages, an existing loan may have a conversion feature. Prior to pursuing a refinance on an existing balloon or ARM, examine the note for evidence of a conversion option. It may benefit the borrower to exercise the conversion option in lieu of refinancing. See Chapter 2, Loan Programs, for a detailed description of conversion options. Another version of a conversion option is in a situation where a borrower has an existing loan with a specific lender. That lender may offer a "modification" which is a streamlined refinancing process. This is generally only available from lenders who retain the servicing (collection of the monthly payments and payment of taxes and insurance) on a specific loan and that loan exists in their portfolio.

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Chapter 10 – The Secondary Market Selling Loans – The Basis of our Industry Secondary marketing is how we arrive at pricing for our loans, the guidelines and products. Often in the course of the day we hear that the reason something is being done a certain way is because of secondary marketing. Succinctly, secondary marketing is the process of buying and selling loans after the money has been lent. Mortgage companies making loans to homebuyers represent the primary market. The buyers of these loans create the guidelines for the business. It is therefore important to know what it is and how it works. It is also the way the financial aspect of the mortgage business reconciles itself. Secondary Marketing takes into consideration not only the fees that are earned in the origination of a mortgage, but the hedging value, and the servicing value, financially, to the mortgage industry.

Lock or Float Secondary marketing is abstract except when a customer calls and asks about interest rates. Most frequently, the request is for a “lock-in” of the interest rate. A lock-in is a rate guarantee and is insurance against rates going up. Alternately, the customer can defer the decision to lockin. This is referred to as “floating.” Floating is insurance against rates going down. Understanding these options can help you guide your customer through the interest rate lock decision process. Lock Option Lock-in

Float

Float Down Lock

Description A lock in fixes a borrower’s interest rate and point options for a specific period of time. If a lock in expires prior to the borrower’s closing the borrower receives the market interest rate or the original interest rate, whichever is HIGHER. If a borrower decides to guarantee the rate and point option, the loan officer must assure there is sufficient time to process and close the loan under that lock term. The benefit of locking in is that there is certainty in the final interest rate. A float is a deferral of the decision to fix the interest rate. Regardless of whether interest rates increase or decrease, the borrower can lock in at those rates in the future. The benefit of floating is that the loan application can be processed and approved prior to locking in – the borrower can then execute an “immediate delivery lock” for 5, 7 or 15 days, which can be substantially better pricing than the 60 day lock-in The borrower can cap or lock in their interest rate at a current rate. If rates decline within a specific period of time prior to closing, the borrower can “re-lock” at a lower interest rate. The benefit of the Float

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Protects Against Rates rising dramatically

Rates falling or staying the same

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Lock Option

Description

Protects Against

Down Lock In is that the borrower is protected against dramatic fluctuation in rates.

The problem with lock-ins is that many people rush to lock in after interest rates have already risen. This is like buying insurance AFTER a car accident. Rates rise and fall – within a generally predictable seasonality pattern. There are periods of time when rates traditionally rise – such as, in the spring or fall home buying seasons as demand for mortgages tends to drive interest rates up - where no one should defer the lock decision. Seasonality Patterns

May – June November

January

August-September

Immediate Delivery The longer the rate lock-in period required, the higher the interest rate. Typical Lock Term Pricing Matrix This is because the further away you 7 15 30 45 60 90 180 go into the future, the greater the 7.625 -0.25 0.00 0.25 0.50 0.75 1.00 1.25 amount of uncertainty regarding fu7.500 0.25 0.50 0.75 1.00 1.25 1.50 1.75 ture rates. Conversely, while we are 7.375 0.75 1.00 1.25 1.50 1.75 2.00 2.25 used to looking at 45- or 60-day lock7.250 1.25 1.50 1.75 2.00 2.25 2.50 2.75 ins, there are very short-term lock-ins that can offer a lower rate because there is virtually no rate uncertainty. This is an argument for deferring the interest rate lock-in decision in a period where interest rates are anticipated to stay at or near current interest rates, or go lower. This is illustrated to show that there are rate lock options that can add value to the customer. IN NO CIRCUMSTANCE SHOULD YOU EVER LOCK IN AN INTEREST RATE FOR A CUSTOMER AND NOT LOCK IT IN WITH AN INVESTOR OR SECONDARY MARKETING. This is called “Playing the Market.”

The Secondary Market The secondary mortgage market is simply a network of investors whose common thread is investment interest in one financial instrument -- the mortgage. A mortgage is a loan that is secured against real estate as opposed to personal property or unsecured loans. These mortgages

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can be first or second liens and can be secured against residential single-family units, multifamily units, or commercial properties. When a borrower obtains a loan secured against real estate, the process is termed primary origination. Lending directly to the owner of the property makes an "originator" a primary originator and thus is a transaction in the primary market. When an investor purchases a mortgage or many mortgages from a primary originator, the investor is obtaining an asset - the loan. Here this loan becomes a commodity that can be bought or sold the same way sugar, pork bellies or gold are. Like commodities, the future price can be locked in with options on the futures exchanges. Normally the mortgage enters the market in the form of a security after it has been packaged with numerous other mortgages into pools or packages of loans. However there are also individual buyers and institutional buyers. The mortgage securities market is relatively robust because it is a fixed income market. The same buyers of treasuries, municipal bonds and corporate bonds buy mortgages. Who’s Who in the Secondary Market Fannie Mae (FNMA - Federal National Mortgage Corporation) was created by Congress in 1938 as a Government Corporation, and became partially private in 1954. In 1968 it was partitioned into GNMA (Government National Mortgage Association) and FNMA and became a private corporation. Initially FNMA purchased only government insured loans, but in 1970 it entered the conventional loan market. Now it purchases 1st & 2nd mortgages, multi-family property loans and programs originated by local agencies and federal subsidy programs. Ginnie Mae (GNMA- Government National Mortgage Association) was created in 1968 by Congress to stimulate mortgage credit markets for Government Insured or Guaranteed mortgages. Congress created Freddie Mac (FHLMC - Federal Home Loan Mortgage Corporation) in 1970 to enhance the liquidity of mortgage investments. Freddie Mac is a congressionally chartered corporation. The President appoints the members of the board of directors, who also oversee the operation of the 12 Federal Home Loan Banks and all federally chartered savings institutions. There are also a number of private secondary market entities that purchase loans and use them as collateral for securities (referred to as “securitizing”) mortgages and mortgage-backed securities - names like RFC (Residential Funding Corporation), General Electric Credit, Sears Mortgage Securities, Norwest, and Nomura. The secondary market also includes small banks purchasing mortgages originated by local mortgage bankers, private individuals who buy seconds "taken back" by sellers, life insurance companies investing premiums against future claims, pension plans investing contributions to provide future benefits and individuals who purchase "GNMAs" from a stock or financial broker. The Development of the Market As rates in general started to rise in the late ‘60’s and early 1970’s, there was a greater demand for mortgage money than local banks and savings and loans could absorb. There were pockets of

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demand that created shortages in financing. Then there were areas in which there was not enough demand and bankers could not obtain a desired yield. These cyclical swings would create mini real estate booms and depressions throughout the country. The answer to the question of how to make home finance money more readily available was the creation of a place where loans could be bought and sold - a secondary market. “Standardization” of the Mortgage Investment By standardizing the loans in accordance with secondary market guidelines, the mortgages became liquid commodities. This market then makes a redistribution of mortgage money possible throughout the U.S.A. This standardization is one reason that rates on loans that are sold to FHLMC can be lower. Because FNMA, GNMA and FHLMC are quasi-governmental agencies, the credit risk is improved. Standard & Poors, and Moody’s are rating agencies that assign various levels of risk to investments. Obviously, treasury securities carry the lowest level of risk. However, FNMA, FHLMC and GNMA are assigned “Agency” ratings by these services. As a result these carry lower risk and lower yield than commercial paper. Speaking of Risk Another advantage of the secondary market is the diminution of mortgage lending risk. There are two types of risks associated with any type of mortgage lending: the borrower will not pay the money back and the loan itself will decrease in value. Standardization ensures that the mortgage carries an acceptably low level of risk of default. The secondary market has required the mortgage industry to develop standard underwriting criteria with regard to credit, income and property risk. It is this rigorous risk aversion strategy that spawned the growth of private companies that developed insurance programs to protect the lender against default. This private mortgage insurance (PMI) has also increased the flow of investor money into the mortgage markets and has proven to be a viable alternative to Government insurance (FHA) and guarantee (VA) programs for high loan to value (LTV) mortgages. In addition, the risk in mortgage investment is mitigated by the fact that the loans themselves are secured - by real estate. A mortgage is a secured loan against a very durable type of asset. Real property is an asset that keeps its value (they aren’t making any more of it). As a matter of fact, it may appreciate rather than depreciate. In addition, real property has a formalized legal ownership system. All ownership is recorded with our government, and mortgages can be recorded and tracked. In addition, by investing in mortgage across the country an investor receives geographic diversity allowing risk to be spread across the country instead of just one area. Par is not a Golf Score How two loans of different interest rates are compared illustrates the function of yield over time versus purchase price today. The market is seeking a certain yield among all of the options available. Let’s assume, for the purpose of illustration, that yield is 8.5%. A $100,000 in-

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strument bearing an 8.5% yield would Illustration of Typical Discounts in 1985 be worth $100,000 in the market. Yield 10% 10.50% However, a yield of 9.0% would be a Price for Delivery in higher rate of return. The market com- October 97.12 94.14 pensates for this higher value by mak- November 94.06 97.04 ing the purchase of this yield more ex- December 93.18 96.24 93.02 96.16 pensive. If you were a yield seeking January investor you could buy a 8.5% yielding Example: a 10.5% $100,000 loan for delivery in October instrument for $100,000, or a 9.00% would be worth $97,120. The lender would have to charge yield for $103,000. Conversely, an 3 discount points to make up the difference. 8.00% yield would be worth less to an investor, but “discounting” the cost of purchasing this instrument could make up this deficit in value. The value of the 8.00% instrument might be $97,000. In this way the market equalizes yield and allows individual loans with different interest rates to be packaged together for a blended yield. In describing this, keep in mind that this is a vast oversimplification of the pricing mechanism. There are also the concerns of prepayment - where borrowers repay their loans at a much faster rate than anticipated and the general risks of investing in interest rate-based derivatives. If a bank lent $10 million in mortgages at prevailing rates, their value could decline rapidly in a very short time period, representing a potential huge paper loss. Long-term investors are not subject to intermediate fluctuations, in the short term, and make the most ideal holders. The secondary market enables an institution to make mortgage loans and then sell them to not be subject to the risks of long-term interest rate fluctuations. How Lenders Make Money Mortgages are sold in the secondary market in several forms. A simple sale of an individual mortgage is known as a "whole loan" sale. The sale of partial interest in a mortgage is known as a "participation" sale. Third, mortgages or participation in mortgages are collected together in aggregations, known as "pools,” which are used to back securities. Principal and interest collected by the securities issuer for the pooled mortgages are passed through to the securities holders. Each of the mortgage-backed securities holders has an individual beneficial interest in the pool’s cash flows. Pools of mortgages are also used to secure mortgage-backed bonds - debt securities issued in the secondary market. As mentioned earlier, though mortgages are usually for 15 or 30 years and are priced in tandem with long-term “non-callable” assets, their average life is much lower due to mobility of our populace or refinancing at times of lower interest rates. Therefore, the eventual "holder" of the mortgage will not own it for 30 years, but closer to 7-10 years. Mortgage companies’ profits are not driven by the "interest" rates they charge. They make the same amount of money regardless of whether rates are 14% or 4%. Principal sources of revenue are:

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1. Origination fee income. If the mortgage company charges a 1% origination fee this equates to $1,000 of income on a $100,000 loan. Usually this income is used to cover the overhead of making the loan. 2. Marketing Gain/Loss. Marketing gain occurs if the individual loan appreciates in between the time the loan was made and the time it is sold. It should be noted that these commodities are usually priced in the present and sold in the future. Therefore, if the value of the commodity goes down a marketing loss may result. Since there is equal risk of prices going in either direction, it is understandable that marketing gain can equally be a loss. 3. Servicing income - If the mortgage company "retains the servicing" for a loan it originates and then later sells the loan itself, but maintains the role of passing the principal and interest payments through to the securities holder, the owner of the loan, this is referred to as retained servicing. There is a fee earned for this service, which normally Following a Loan Through the Secondary Marketing Process Step By Step means that the servicer retains a small percentage of the interest 1. A $100,000 loan application is taken on October 1, 1987. each month. Unlike the origina- 2. Loan is "locked" at 11 % with 2 discount points and 1 origination fee for 60 days. tion of loans, servicing is a year 3. Lender buys a commitment to deliver the closed loan on Janround source of income for the uary 15. 4. Loan is processed and approved. bank. 5. Settlement documents are prepared for December 20 clos4. Sale of Servicing Rights - Being. cause of the fee that can be 6. Settlement department requests a warehouse line of credit advance from bank. earned, the rights to collect and 7. On date of settlement, funds are wired from warehouse bank pass through monthly payments to closing agent's account. can be quite valuable. Often the 8. Money is disbursed to applicant and seller for consummation of transaction. value of these rights will appreci9. Settlement agent sends completed documents back to Mortate to the point that there can be a gage Company. significant gain realized in the 10. Post closing/delivery sends original mortgage note to warehouse bank and closed loan package to investor that pursale of the rights. Typical servicchased commitment. ing rights sales yield between .75 11. Loan is purchased by investor - Note is delivered by bank to and 2.5 points, depending on the Investor. 12. Loan is assembled warehoused at investor’s bank pending loan type. accumulation of enough mortgages to issue a “pool” of mort5. Other Fees - Lenders also may gages. charge fees for document prepa- 13. Pool of 1000 loans assembled yielding 10%-11%, face value $100,000,000 +/- 5%. ration, underwriting, tax service, 14. FNMA purchases pool and investor’s warehouse line is reetc. Some of these fees are a passplenished through only. Others are an income source. 6. Warehouse Differential - When a lender funds a loan with a "line of credit" or warehouse line at a bank, the lender pays interest on the line until the loan is sold. If the interest charged on the loan exceeds the interest rate paid to the bank, there will be additional income. Likewise, there may be a shortfall. Into the Tranches The mortgage now is part of a pool and all of the primary and secondary originators have replenished their lines of credit. Nothing is simple anymore and with a $100,000,000 security, there is

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little likelihood that any one investor is going to purchase the entire security. Enter the CDO (Collateralized Debt Obligation) which is the pool of loans and their 10.5% yield divided up to suit the needs of a wider array of investors with differing needs. These divisions are called “tranches” (pronounced like “launches”) which split the interest and principal payments into different components. A typical CDO has between 7 and 13 tranches. The tranches are packaged into separate securities known as “derivatives. A portion trades like bonds, yielding various interest rates at various maturities to anticipate the imminent prepayment of the underlying mortgages. Some trade like regularly renewable corporate obligations with a rate floating over short-term rates. Then there is a residual tranche that captures whatever is left. This is a derivative type gamble because, if interest rates stay low, there will be a large amount of interest coming into the residual. However, it may come up short if there is a great deal of prepayment. How the Secondary Market for Home Loans Generates Cash for Mortgages Consumers get a home loan from a commercial bank, mortgage banker or thrift.

Freddie and Fannie bundle the loans into “pools” and sell securities backed by the loans. The sale of these securities allows Freddie Mac and Fannie Mae to purchase more loans, allowing the cycle to start again.

The bank or thrift now holds a loan in place of the cash. This is the primary market where loans are created.

The lenders now sell the loans to Freddie Mac or Fannie Mae. This is the secondary market, where existing home loans are bought and sold. It takes the home loans off the hands of the lenders in exchange for cash that the lenders use to make more loans.

Interest Rate Drivers At the most basic level interest rates are driven by inflation. This is because a lender’s biggest fear is that money lent today will be worth less in the future - a textbook definition of inflation. As a result “real interest rates” are a composite of what money is really yielding from an interest rate perspective less the common belief regarding future inflation. To understand what drives interest rates, you must understand what drives inflation, as well as other economic and market factors. Remember that John Kenneth Galbraith said, “There are only two kinds of people when it comes to knowing about the future of interest rates - those that don’t know, and those that don’t know they don’t know…” Energy Prices

Unemployment

Every product or service is in some way affected by how much energy costs, because energy is used in the manufacture or delivery of every good or service. If oil prices rise, inflation will rise and interest rates will follow. The cost of labor comprises roughly 2/3 of the cost of any good or service. If labor becomes scarce, prices will rise. Conversely, if there is

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Demand/Supply

Currency Values

Instability

high unemployment, labor costs should be low. Fundamental variations in seasonal demand drive up interest rates. If the government, industry and individuals are all borrowing at the same time, there will be a scarcity of money that will tend to drive rates up. Conversely if the government doesn’t borrow money (budget surplus), then demand for credit will be low reducing rates. If the dollar is strong relative to world currencies, it can take more foreign currency to lend in dollars, diminishing the supply of lending capital. This can be opposed by a higher demand to invest in dollar denominated securities. Uncertainty of any kind will generally drive interest rates higher in the interim, regardless of outcome. War, falling markets, political crises all tend to create higher interim rates.

Playing the Market Loan officers are admonished to never “play the market.” Playing the Market is when a loan officer gives the borrower a lock-in, but doesn’t actually lock it in with secondary marketing. The loan officer hopes that interest rates will improve, meaning a bigger commission. However, if rates don’t improve, the loan officer and, more likely the company, will have to fund the loan. This can be a large loss. While markets change throughout the day, lenders try to price their commodities to the market once a day. If your lender allows you to lock in a loan (generally only new loans) until a specific time (e.g. 9:30 a.m.), you can take advantage of this anomaly by watching the news for any sign that rates are going to decline. If you meet with a customer in the evening, and there is a probability that rates will be lower in the morning you may offer the current market price. If the morning’s data appears to indicate a lower interest rate environment, simply wait until new pricing is available to lock in the rate. If the data is unfavorable, lock the loan in immediately.

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Chapter 11 – Practical Compliance Understanding Federal Laws Introduction For new loan officers, the first instruction they receive is indoctrination into the world of federal regulation known as “compliance” or “licensing training.” In fact, if you didn’t know better, you might think that the primary concern of our business WAS compliance. Our industry’s primary business goal gets lost in this overemphasis on rules; we are here to help the consumer purchase or finance a home. We are not lawyers – we are mortgage originators. Federal regulation represents a critical area of awareness for industry participants. Fear of violating a rule can make us obsess on compliance for compliance’s sake. Rather than feeling constrained by what we cannot do, we should work to discover what we CAN do. In this way, we can use borrower education as tool to increase our business through increased trust and rapport. Instead of concealing the rules in an effort to spare a customer mental effort, embrace the rules and show him that you can help navigate a regulatory process that was designed to protect him. Test Preparation We have designed this chapter to give the line industry participant – loan officer, processor, underwriter or closer – an understanding of Federal laws affecting the mortgage industry. Knowledge of the most important aspects of these laws is required to pass state and federal licensing exams. However, remembering these rules in an abstract way through rote memorization is more difficult than understanding where they fit in to the mortgage process. We recommend preparing for basic Federal law examinations by becoming familiar with the mortgage process and understanding how the laws affect your job. More in-depth reviews of the rules, for edification or analysis, are available from the regulators themselves, continuing/pre-licensing education providers and your compliance officer. The value of this book is not contained in the simple compliance elements, available anywhere, and If you want a more in-depth review of the individual laws we devote the remainder of the book to a more exhaustive review of the practical applications of the federal laws.

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Regulators – The Consumer Financial Protection Bureau The Dodd/Frank Act, also known as the Dodd/Frank Wall Street Reform and Consumer Protection Act, contained substantial changes for the financial services industry. Because of its size and scope, many of the reforms still remain unimplemented, and some rules remain unwritten. For this reason, expect changes to this material. Regulatory compliance no longer represents a static monolith. Among the changes is a new Federal agency – The Consumer Financial Protection Agency (CFPB) which, effective July 21, 2011, became the primary regulator for the mortgage industry. The CFPB aggregates all of the lending related rules into one enforcement authority. It oversees large non-federally regulated lenders and creates a uniform regulatory platform to enforce consumer financial related laws. For lenders, this means the CFPB has become the primary enforcement agency for lending and credit related provisions of RESPA, TIL, ECOA and others. Even though the CFPB has the primary role of arbiter of mortgage lending rules and regulations, other agencies also can enforce these regulations. Ultimately, as the role of the CFPB becomes defined and as the regulatory process, audit and examination powers, and policy making agenda of this agency become more well-known, we will expand this section. Until then, understanding the legacy of enforcement of the original regulatory agency will assist you in understanding the spirit of the laws.

The Rules Regulation B Regulation C Regulation F Regulation G Regulation H Regulation N Regulation O Regulation P Regulation V Regulation X Regulation Z

Equal Credit Opportunity Home Mortgage Disclosure Fair Debt Collection Practices Act S.A.F.E. Mortgage Licensing Act – Federal Registration of Residential Mortgage Loan Originators S.A.F.E. Mortgage Licensing Act – State Compliance and Bureau Registration System Mortgage Acts and Practices-Advertising Mortgage Assistance Relief Services Privacy of Consumer Financial Information Fair Credit Reporting Real Estate Settlement Procedures Act Truth in Lending

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Housing Crisis of 2008 The housing crisis of 2008 spawned emergency legislation including increased loan amounts for FHA and FNMA/FHLMC.

Housing and Economic Recovery Act (HERA) HERA was the enabling legislation for the creation of the Wall Street Reform and Consumer Protection Act, known commonly as "Dodd-Frank Act." HERA create the FHFA and the "SAFE" Act.

Dodd-Frank Creates CFPB The Dodd-Frank Act required the creation of a Consumer Financial Protection Bureau - the CFPB - to oversee all consumer-related finance activity.

The Housing and Economic Recovery Act of 2008 (HERA) Background The turmoil surrounding the collapse of the real estate and financial markets beginning in 2007, caused by what some have dubbed “The Sub-Prime Mortgage Melt-Down”, spawned several legislative efforts. Some of these actions were temporary. Others created permanent long term changes in the industry and how it works. These included the SAFE Act, the new regulator for Fannie Mae and Freddie Mac, and emergency loan limit increases. Regulator – Federal Housing Finance Agency HERA created a consolidated regulator for all the federally related housing finance concerns. The Office of Federal Housing Enterprise Oversight (OFHEO) and the Federal Home Loan Banks (FHLB) are now under the umbrella of the Federal Housing Finance Agency (FHFA). It regulates Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks.

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Secure and Fair Enforcement for Mortgage Licensing (SAFE Act) Background Many believe that the housing crisis’ inception lay in the lax regulation of mortgage originators. While originators who work for insured banks have substantial federal regulator oversight, mortgage brokers and non-bank lenders did not have a consistent level of regulation from state to state. SAFE aimed to eliminate this disparity. SAFE does NOT license individual loan originators; it creates a mandate for states to have their own licensing process. The structure for licensing tracking is the Nationwide Mortgage Licensing System (NMLS). The Conference of State Banking Supervisors (CSBS) and American Association of Residential Mortgage Regulators (AARMR) participated in creation of this system. The NMLS tracks the licensing of mortgage lenders, brokers and mortgage originators and the registration of federally supervised lenders. Process   

When hiring new employees we always verify license status. Unlicensed/unregistered applicants must submit an application to the state through the NMLS Branches must be licensed/registered through NMLS

State Licensed Originator Employed by non-federally supervised lender, nondepository Minimum Standards: Fingerprints Background Check Pass National and State Test 20 Hour Initial Education – Federal Law, Ethics, Non-traditional mortgages 8 Hours Continuing Education Obtain license for each state

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Federally Supervised Originator Federally supervised institution Minimum Standards FFIEC background check, fingerprints 20 Hour Initial Education – Federal Law, Ethics, Non-traditional mortgages 8 Hours Continuing Education Pass Test Register with NMLS


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The Dodd/Frank Act – Originator Compensation (Anti-Steering) Background Beginning April 1, 2011 the Anti-Steering component of the Truth-in-Lending Act, commonly known as the Dodd-Frank Loan Originator Compensation Rule, regulates the compensation of lenders, mortgage broker employers and employees and mortgage loan originators generally. Policy - Dual Compensation Mortgage originators may only receive compensation from either the borrower, or the lender/creditor but not both. This has been interpreted to mean that you can either be paid via yield spread (YSP), or by direct payment from the borrower. This policy eliminates the unscrupulous practice of receiving a fee from the borrower and an undisclosed premium from the investor/creditor. Process Loan originators may receive no undisclosed or hidden compensation. This includes  

Contests or prizes Profit sharing or pooled compensation  Point Banks

Compensation Not Based on Loan Terms Compensation is capped, based on the company’s compensation plan. It may not vary based on loan terms other than loan amount.  

Volume based commissions driven by a set pricing model. Flat fee based pricing

Steering into Higher Commissioned Products When a company departs from one of these compensation models it puts itself at risk of allegations of “steering”. Steering is a recommendation of a mortgage product that results in a higher commission. This is illegal unless the originator can prove that the higher commission product offers a superior benefit to the consumer – because of the difficulty proving customer’s best interests, and the unknowns of whether a legal process will concur, we want to avoid problematic compensation structures, such as those with vague parameters or those which may appear to increase compensation based on loan terms. The Qualified Mortgage Rule (QM) and Steering

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The CFPB has stated that making loans which meet QM definitions will not, in itself, represent a potential anti-steering rule violation. The “Safe Harbor” is a technical analysis. In order to complete a “Safe Harbor Analysis” prepare a “side by side” comparison of the different products; showing 1.) lowest rate 2.) lowest fees, and if there are prepayment penalties, 3.) lowest rate and/or fees with or without prepayment penalties. Then, allow the consumer to choose the product directly. This consumer choice indication should allow the regulator to interpret the Safe Harbor.

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RESPA – The Real Estate Settlement Procedures Act While the CFPB assumed primary regulatory responsibility for consumer financial protect, the Department of Housing and Urban Development (“HUD”) retains joint responsibility for matters related to housing. Due to its pervasive influence in the housing markets and because of its proximity to consumer housing related programs, expect HUD to continue to participate in elements of enforcement, particularly in areas such as anti-discrimination (Fair Housing) and Antikickback provisions. RESPA, known as Regulation X, contains a number of rules to which we must adhere. Purpose of the Law The purpose of the law is to protect consumers from excessive settlement costs and unearned fees. RESPA    

Establishes prohibited practices to protect consumers from unearned fees (Kickbacks and Controlled Business Arrangements) Allows consumers to obtain information on the costs of closing so that they can shop for settlement services. (Good Faith Estimate and Closing Cost Booklet) Gives consumers a complete and accurate accounting of all funds collected and disbursed in conjunction with the transaction. (HUD-1 Settlement Statement) To protect customers from financial loss when their loan or the servicing of their loan is sold. (Servicing Practices Act)

Exempt Transactions       

Loans for 25 acres or more Loans for business, commercial, or agricultural purposes Temporary financing, such as bridge loans Loans secured by vacant land Loan assumptions which are permissible without lender approval Loans sold in the secondary market Loan conversions, when a new note is not required and the provisions are consistent with those of the original mortgage

Transactions which ARE subject to RESPA are loans secured by a first or subordinate lien on residential property which are made with funds insured by the federal government, from a lender regulated by the federal government, intended for sale to Fannie Mae or Freddie Mac, or any creditor regulated under the Truth in Lending Act.

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The Anti-Kickback Rule - Payment or Receipt of Non-Approved Fees Prohibited - Kickbacks and Referral Fees Section 8(a) of RESPA prohibits anyone from giving or receiving a fee, kickback, or “anything of value” pursuant to an “agreement or understanding” for the referral of business related to the purchase or financing process. The purpose of the prohibition is to protect consumers from the payment of fees when no additional work is actually performed. Kickbacks tend to increase the cost of the transaction, since the borrower will have to be charged more in order to cover the cost of the referral fee. All personnel should avoid even the appearance of accepting or paying for non-approved services. An “Agreement or Understanding” does not have to be a formal agreement, but can be a verbal agreement or even an agreement established through a practice, pattern, or course of conduct. Prohibited Payment – “Anything of Value” Payments include, but are not limited to A “Thing of Value” Money Discounts Commissions Salaries Stock Opportunities to participate in a money-making program Special or unusual banking terms Tickets to theater or sporting events Services of all types at special rates Trips and payments of another’s expenses

Prohibited - Fee Splitting Fee splitting is when a service provider inflates charges and splits the excess funds with another service provider in exchange for the referral of business. This is tantamount to a kickback and is a prohibited practice. Service providers may attempt to circumvent this prohibition by establishing joint ventures or entering into business arrangements that allow referrals between organizations and conceal the fee splitting arrangement. Permitted – Approved Affiliated and Controlled Business Arrangements In some cases, there can be fee splitting or referral fees paid under what is known as an “affiliated business arrangement”. An affiliated business arrangement is where a person who refers set-

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tlement services has an “affiliate relationship” or “an ownership interest of more than one percent in a provider of settlement services.” The payment of reasonable fees is acceptable as long as the relationship is disclosed to the borrower and the referrer actually performs a service – or somehow adds value. The referral service provider may NOT be a REQUIRED provider of services, such as an appraiser or credit bureau that the lender must select. An affiliate relationship structured simply to legitimize the payment of a fee is referred to as a “sham”. Affiliates must be a “Bona Fide Provider of Services” to receive a referral fee legally. Approval Required - Desk Rental Arrangements Because of the level of oversight, and the potential for the payment of desk rental to masquerade as payment for a referral, all Desk Rental Arrangements must be approved in advance. Provide the following:  

Copy of the lease/rental agreement Document market value of desk rental services through Craig’s list, square footage analysis or other verifiable source

Approval Required – Joint Marketing Arrangements Similar to a Desk Rental, partnering with referral sources to advertise or market must also be evaluated for potential conflicts and approved by management. Particularly when this relates to commercial communication, the material must also be reviewed against the Provide:  

Any advertising agreement Copy of publication or proposed media

Required Disclosures   

Affiliated Business Arrangement – if Applicable Required Provider Disclosure – From LOS Approved Settlement Services Provider List

Operating Areas Affected  

Origination - Production Compliance

Penalties for Non-Compliance Penalties for violations of the anti-kickback provision include fines of up to $10,000 and up to one year in prison.

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Application Disclosures - The Closing Cost Worksheet The Good Faith Estimate (“GFE”) is required to be given at the time of application, or mailed within three business days after completion of loan application. Business days do not include federal holidays and Sundays. The purpose of the Good Faith Estimate of closing costs is to give the borrower advance notice of the costs of the transaction. A properly explained GFE will help borrowers understand cash requirements better and will result in a borrower who shops less. The new GFE form is a simplification of costs into categories related to who receives payment. The originator’s estimates of its own costs may not change. Closing costs paid to required providers may not change by more than 10%. Costs related to services the borrower selects are not subject to change limitations. A relatively small portion of the costs reflected on the GFE are paid to the lender whereas the borrower’s perception is that they are ALL paid to the lender. Lenders provide the GFE, in concert with The Settlement Costs Booklet, (the “Special Information Booklet”) to help the borrower understand how to shop for settlement services. The Good Faith Estimate Form Since the inception of the Good Faith Estimate as a closing cost disclosure, HUD has worked to reform two weaknesses in the previous disclosure protocol: The form’s revisions provide transparency on loan originator compensation and reduce the over-itemization that tended to conceal the nature of costs. The 2010 GFE (we refer to the 2010 GFE because of pending changes in the consolidated disclosure which do not go into effect until 2015) includes a disclosure of loan terms, lock-in period, and a “shopping cart” showing the trade off between upfront fees and closing costs. In this way HUD created a form which discloses overall loan terms in addition to actual costs. The form eliminates the detailed itemization of most charges and aggregates them into main categories. HUD felt that over-itemization tended to inflate closing costs. In addition, originator compensation is clearly outlined so that, whether compensation comes from above par pricing (yield spread), borrower paid fees, or a combination of these, borrowers will see the total compensation paid to the originator. Lender charges and charges for services from providers selected by the lender cannot change between application and closing, creating a “firm Good Faith Estimate”. If the borrower cannot shop for a third party service, those fees cannot change by more than 10%.

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GFE – page 1 includes lock-in terms, loan features, such as prepayment penalties and adjustments, and information about Escrows

GFE – page 3 includes an explanation of which fees can or cannot change, a comparison table, and a shopIn 1.) the total fee to the originator is disclosed ping cart. – it cannot change. In 2.) The yield spread, or discount charges indicate whether the borrower is receiving a higher rate to pay the originator. A.) is the adjusted (net) origination fee. In 3.) Services that we select are Appraisal fees, credit report fees, flood certifications and tax service fees. This was NOT intended to itemize other lender charges like processing, underwriting or document preparation. These rd are 3 party fees that cannot change. In 4) & 5) all title related services are combined into one fee, with a line for “optional” owner’s title insurance. In 6) Services that you can shop for includes termite reports, survey, inspections, etc. In 7) & 8) Recording Fees and Transfer Taxes – Taxes CANNOT change 9) Prepaid items paid to escrow – escrow for real estate taxes, insurance and PMI 10) per diem interest 11) One years’ Homeowner’s insurance policy.

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Application Disclosures - The Special Information Booklet The Special Information Booklet is what HUD calls the Settlement Cost Booklet. The borrower acknowledges receipt of the document at the time that the Good Faith Estimate is signed, so it must be provided at application, or mailed within three business days after completion of loan application. Loan originators can use their own booklet, or use the HUD booklet entitled, “Buying Your Home”, “Understanding Settlement Costs”, or any other name that contains prescribed content explaining the settlement process. Most importantly, this booklet tells borrowers that they have the right to negotiate the terms of a loan and shop for providers of settlement services. Application Disclosures - Notice of Transfer of Servicing As with the Good Faith Estimate, the lender must deliver at application, or within 3 business days of application, a statement from the lender telling them that their loan servicing may be transferred to another lender. The Transfer of Servicing disclosure describes the percentage of loans the lender currently intends to sell – from 0-25%, 25-50%, 50-75%, or 75-100%. In addition, the Transfer of Servicing Act protects the borrower in that 1.) The borrower must be notified 15 days prior to a servicing transfer by both the selling and purchasing lender 2.) Late payment charges may not be levied within 60 days of the transfer 3.) The borrower’s escrow accounts can never include more than a 2 month cushion (plus one current month) for real estate taxes and insurance. Servicing transfer practices mandates that the borrower receive an escrow analysis at the time of closing, at least annually thereafter, and at the time the loan servicing is transferred. Section 6 of RESPA, the Transfer of Servicing Act, allows consumers to file individual or class actions against loan Servicers for RESPA violations. In individual actions loan Servicers may be liable for damages up to $10,000. In class actions damages may not exceed $1000 for each member of the class and total damages may not exceed $500,000 or 1 percent of the net worth of the Servicer. Section 10 of RESPA provides special protections for escrow accounts. Failure to submit initial or annual escrow statement can result if a civil penalty of $55 with a $1,000,000 limitation on the penalty for any one loan servicer. Disclosures - at Closing - HUD-1 Settlement Statement

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The borrower has a right to obtain the HUD-1 Settlement Statement 24 hours in advance of closing. It is the final accounting for all the fees and charges in conjunction with the transaction, which may change prior to final funding if errors are discovered. Disclosures – at Closing – Aggregate Escrow Disclosure Since 1992 servicing rights transfers – when one lender sells the right to collect a borrower’s monthly payment - have been regulated. The regulations have changed over time to address the key problems consumers face problems with – how much money may a lender hold in escrow above and beyond what is really needed. The key benefit to borrowers is the limitation on the “cushion” that a lender can hold in escrow. Previously lenders could hold any amount. Today, they must provide an accounting at the time of closing and at least once a year. The “cushion cannot exceed 2 months of required reserves, plus the current month.

The Truth-in-Lending Act (TILA) - Regulation Z The Board of Governors for the Federal Reserve is the federal agency responsible for issuing implementing regulation (Regulation Z) for TILA and the Federal Trade Commission (“FTC”) is responsible for enforcing the law and the regulations. Purposes of Truth-in-Lending Act   

To protect consumers by disclosing the costs and terms of credit; To create uniform standards for stating the cost of credit, thereby encouraging consumers to compare the costs of loans offered by different creditors; and To ensure that advertising for credit is truthful and not misleading.

Mortgage Disclosure Improvement Act of 2009 (MDIA) In 2008 Congress passed the Housing and Economic Recovery Act (HERA) which included amendments to the Truth in Lending Act (TILA) known as the Mortgage Disclosure Improvement Act (MDIA). This legislation has resulted in recent revisions to Regulation Z which became effective with loan applications taken on and after July 30, 2009. Definitions Specific to MDIA “General business the days on which our offices are open to the public for carrying on day” substantially all of it’s business functions (Monday through Friday) excluding Saturdays, Sundays and specified Federal legal public holidays. “Precise business all calendar days (Monday through Saturday) excluding Sundays and day” specified Federal legal public holidays. “Consummation” the date the Borrower(s) execute loan closing documents.

We must provide the following disclosures: Initial APR (Early Truth-in-Lending) disclosure that is to be delivered or mailed to the Borrower(s), no later than 3 general business days after we received the written application from the Borrower(s) and at least 7 precise business days before consummation. This must include the

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added statement: “You are not required to complete this agreement merely because you have received these disclosures or signed a loan application.” Corrective Truth-in-Lending Disclosures Whenever the APR on the most recent TIL disclosure increases or decreases by more than the .125% tolerance due to changes in loan terms, fees, etc. a corrected Truth-in-Lending disclosure must be sent to the borrower(s) at least 3 precise business days before consummation. If it is mailed it must be sent at least 6 precise business days before consummation.     

We may not impose fees other than that for a credit report until the borrower has received the EARLY TIL disclosure. The MDIA clarified the delivery and timing requirements for the truth-in-lending APR disclosures, and provided guidelines for how lenders must notify borrowers of changes. Borrowers must receive the FINAL (100% Correct) APR disclosure a minimum of 3 business days prior to closing. Borrowers must receive initial Truth-in-Lending disclosures BEFORE the lender can receive any payments from the borrower (except credit report fee) and at least 7 days prior to closing. Re-disclosures must be made at any change and borrower must receive re-disclosure at least 3 days prior to consummation

At Application - The “Early Disclosure” The lender must provide an APR disclosure at the time of application. This must be delivered to the borrower within 3 business days of application. The APR disclosure is a document that is the source of much confusion on the part of lenders and the home buying public. Much of this confusion stems from the fact that Annual Percentage Rate sounds a lot like “interest rate” to most borrowers. The primary issue is that the APR isn’t the contract interest rate, but the cost of credit expressed as an “effective” percentage rate. The APR equation includes the contract interest rate and adds the costs of the loan (NOT the closing costs). The APR equation has nothing to do with whether the costs are financed into the new loan or not. To understand the Truth-in-Lending disclosure (TIL), start with the concept that it is only a theoretical measure of the cost of credit. For example: If you borrow $100, but there is a $1 charge for the loan, then you really have only received $99 in usable cash. However, you will still make payments on the loan based upon the $100 principal balance. The TIL determines what the theoretical rate on the loan is considering the fact that there was a fee due to make the loan - that is the APR. The $1 in this example is a “prepaid finance charge”. APR Tolerance Loan Type Fixed ARM

Tolerance 0.125% up or down 0.250% up or down

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Figure 5 - APR tolerances apply, regardless of whether the rate is higher or lower

At the time of application the borrower receives an Annual Percentage Rate disclosure, also referred to as a “T-I-L”, or APR disclosure. During the process of the loan, if the terms of the loan change, the lender must re-disclose the APR. If the terms do not change, the APR must still be re-disclosed at closing. That FINAL Truth-in-Lending statement must be correct as to the actual loan terms. The margin of error for the final disclosure is referred to as “tolerance”. Determining the Amount Financed - What are Prepaid Finance Charges? Everything that one must pay for in exchange for obtaining a loan (charges you wouldn’t incur if you were paying cash for the property) is considered a prepaid finance charge. This includes loan fees such as discount points, origination fees, private mortgage insurance; miscellaneous fees such as tax service, underwriting, document preparation, and lender review fees. In addition, prepaid items such as per diem interest and escrows for PMI or prepaid PMI, FHA upfront MIP, and the VA funding fee are considered finance charges. So are credit life insurance premiums. Interestingly, appraisal fees, credit reports, termite reports and other inspections such as completion inspections (except for construction loan draw inspections), well and septic inspections that are required by lenders are not considered finance charges. Neither are fees for recording a deed of trust. These are excluded from the amount-financed calculation because a buyer or borrower would incur them regardless of whether a loan was involved. Appraisal and credit report fees are "passed through" to service providers. The initial APR disclosure may suffice as the final APR disclosure if the APR has not changed by more than the threshold. Any change in the APR beyond the threshold requires a new APR disclosure a minimum of 3 days prior to closing. The Truth-in-Lending Disclosure must also include a statement that the customer is not required to complete the transaction simply because of receiving the disclosure. Disclosures at Application – ARM Disclosure If the loan is an Adjustable Rate Mortgage (a Variable Rate Transaction) the borrower must also receive an ARM disclosure at the time of application. The ARM disclosure gives the specific details of how the ARM interest rate can change – how often the rate changes, what the initial and periodic changes are based on (the margin and index) and how much the interest rate can change at the adjustment (caps). The ARM disclosure must provide a specific example of how the interest rate would have changed based on historical examples. In addition to the ARM disclosure, the borrower must receive The Consumer Handbook on Adjustable Rate Mortgages (“CHARM” Booklet), which explains how ARMs, in general, work. Home Equity Lines and Open-Ended Credit

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Closed-end credit is credit that is advanced for a specific time with a fixed schedule of payments. Purchase money mortgages are an example of closed-end credit. Open-end credit is consumer credit that is used repeatedly - the consumer pays a finance charge on the outstanding balance. A home equity line of credit is an example of open-end credit. Open-ended lines of credit, such as home equity lines of credit, require additional disclosures. When Your Home is on the Line The Booklet “When Your Home is on the Line - What You Should Know About Home Equity Lines of Credit” is provided by the Federal Reserve and describes how failure to repay the loan could result in the loss of the consumer’s dwelling. In addition, negative amortization may occur, resulting in an increase in the principal balance and a reduction in equity in the home. The consumer should consult with a tax advisor regarding the deductibility of interest and charges. Notice of Right to Cancel (Right to Rescind) Rescission is a legal remedy that voids a contract between two parties, restoring each to the position held prior to the transaction. No right to rescind exists for purchase money mortgages. Home equity credit lines or refinancing of credit already secured by the borrower’s principal dwelling are the types of loans which are subject to a right of rescission. Creditors must provide two copies of the notice of right to rescind on a document that is separate from other disclosures. They must provide each party who has a right to rescind with 2 copies of the notice. The notice states that there is a security interest in the borrower’s principal dwelling, instructions on how to exercise the right to rescind, including a form with the borrower can use, and stating the creditor’s business address, the date the right of rescission expires. Waiver of Right to Rescind A consumer can waive the right to rescind in situations in which credit is needed “…to meet a bona fide financial emergency.” The written waiver must include a description of the emergency and signatures of all parties that have a right to rescind a particular transaction. It may not be a pre-printed form. Right to Rescind in Open-end Transactions In open-end transactions, such as home equity credit lines, when the lender has a security interest in the borrower’s principal dwelling, a borrower can exercise his/her right to rescind the transaction until midnight on the third business day after the following events occur:   

The credit plan is opened – loan documents are signed Credit extensions are made above previously established limits A security interest is added or increased to secure an existing plan

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Three Day Right to Cancel In calculating the time limitations for the right to rescind, note that “business days” include Saturdays. Regulations - Advertising TILA governs the advertising of consumer credit. An advertisement – which is “any offer to extend credit” that states an interest rate must also state an “annual percentage rate”, using the term “APR”. The APR must have the same prominence as the contract interest rate advertised. The act does not require the disclosure of lending terms in an advertisement, unless specific trigger terms are used. An advertisement may not mislead consumers by promoting the most advantageous terms of a loan while failing to mention other terms that are less attractive. For example, an advertisement cannot offer consumers a loan with “low monthly payments” without also stating the number of payments, the interest rate (expressed as an APR), down payment, monthly payments, and other terms related to the cost of the loan Section 32 of Truth-in-Lending Act In 1994 Congress amended TILA to protect consumers from a number of “predatory” lending practices associated with high cost loans. The Home Owners Equity Protection Act (HOEPA) creates protections for consumer from certain abusive lending practices in conjunction with high interest rate loans. Loans Subject to Section 32 HOEPA covers closed-end home equity loans and refinance mortgages that meet certain interest rate and points/fee triggers. Interest Rate Trigger – High Cost For 1st lien mortgages the rate trigger is 8 percentage points above the rate of Treasury securities with a comparable maturity. For 2nd or subordinate liens, the rate trigger is 10 percentage points.

Points and Fees Trigger A loan is classified as high cost if 8% or more of the loan amount (or $583 - adjusted annually for 2009) is charged for loan related fees. Points and fees include loan points, mortgage broker fees, loan service fees, fees of a required closing agent, premiums for mortgage insurance, and debt protection fees. Section 32 Disclosures

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Three business days prior to closing, the borrower must receive a disclosure stating the amount borrowed, whether credit debt-cancellation insurance is included, or whether there is a balloon. The APR disclosure must be given with large, 32 point bold type across the top stating the borrower is not required to complete the transaction and that loss of the home could result from the loan if payments are not met. Section 32 Prohibitions On high cost loans lenders are prohibited from “loan flipping” which is defined as the repeated refinancing of a loan with no true benefit to the borrower. No HOEPA loan can be refinanced within twelve months of the initial extension of credit unless the refinancing is in the borrower’s interest. Lender must assure the borrower can qualify for the loan – no lending without regard to the borrower’s ability to repay. There may be no direct payments to home improvement contractors. Negative Amortization and interest rate acceleration features are prohibited.     

Due on Demand Clauses are only allowed to protect the creditor from misrepresentation or from any action by the borrower that adversely affects the lender’s security for the loan. Balloon Payments are not allowed for loans with terms of less than five years, except for bridge loans. Advance payments are restricted, and do not allow from more than two periodic payments to be paid from the proceeds of the loan. Prepayment penalties can only be assessed within the first five years of the loan. Single Premium Credit Life insurance premiums may be financed, but the cost must be included as part of the APR calculation.

Penalties for HOEPA Violations Creditors who violate HOEPA may be liable for all the finance charges and fees paid by the borrower. In class action suits, damages are limited to $500,000 or 1% of the creditor’s net worth. “Higher Priced Mortgage Loans” - Section 35 New Reg. Z Section 35 defines a higher-priced mortgage loan as a consumer credit transaction secured by the consumer’s principal dwelling with an annual percentage rate (APR) exceeding a certain percentage. The classification as a higher-priced mortgage loan is based solely on the following APR thresholds: Threshold for first liens – The APR exceeds the average prime offer rate for a comparable transaction as of the rate-lock date by 1.5% or more. Threshold for subordinate liens – The APR exceeds the average prime offer rate for a comparable transaction as of the rate-lock date by 3.5% or more.

Higher-priced mortgage loans include closed-end purchase money as well as refinances and home equities, but exclude HELOCs, reverse mortgages, construction only loans, and bridge loans with a term of no more than 12 months. Defining a “Prime Rate Offer” Mortgage Chapter 11 – Understanding Federal Laws - Page 206


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Higher-priced mortgage loans are subprime loans that fall between “prime” mortgages and “high-cost” mortgages. While it was the Board’s intention to cover the entire subprime market and generally exclude the prime market, the Board is aware that the new loan category will capture a portion of the alt-A market as well. Restrictions on “Higher Priced” mortgages include:      

No Lending without ability to repay – must have verified income, employment stability, assets and consider current and future obligations. Prepayment Penalty is prohibited on loans with fixed periods of less than 4 years. May not apply a prepayment penalty on loans which are being refinanced by the same lender Must have escrows for Taxes and Insurance for at least 1 year May not utilize deceptive advertising as well as Servicers must timely credit payments, provide payoffs and may not “pyramid” late fees

The Equal Credit Opportunity Act (“ECOA” or “Fair Lending” Equal Credit Opportunity Act (“ECOA”) and Fair Housing Act Also known as Regulation “B” Regulate how decisions are made and prohibit discrimination in lending

Purpose The purpose Equal Credit Opportunity Act is to discriminatory treatment against credit applicants. The Federal Reserve is authorized to promulgate regulations for implementation of ECOA known as Regulation B. The enforcement of ECOA is left to the regulatory institutions that supervise the lending activities of particular institutions. Financial institutions are regulated by The Office of the Comptroller of the Currency, the Office of Thrift Supervision, Federal Deposit Insurance Corporation, The Board of Governors of the Federal Reserve, National Credit Union Administration. Mortgage Bankers and Brokers are regulated by The Federal Trade Commission (“FTC”). The FTC has enforcement responsibility that is not specifically delegated to another agency. Unlawful Inquiries Lenders may not base decisions on questions regarding marital status, gender, child bearing, race, color, religion, or national origin, or age. Lenders may not make oral or written statement that would discourage prospective applicants from applying for a loan. Prohibitions

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Lenders may not refuse to consider public assistance as income, assume a woman of childbearing age will stop work to raise children, refuse to consider income from a pension, annuity, or retirement benefit or refuse to consider regular alimony or child support. Borrowers don’t have to disclose alimony and child support unless they want to use it as qualifying income. Notification Requirements Timing requirements are the most critical elements as to mortgage applications and ECOA regulations. Lenders MUST notify consumers of action taken on an application within 30 days of its receipt. Lenders must provide notification of ALL reasons for adverse action. In addition, notification is required when loan terms are changed for any reason, if an application is withdrawn, whether additional information is required, or even if the customer withdraws the loan. Lenders must disclose all bases for making decisions. As a consequence, the borrower may receive a copy of all documents used in making the loan decision. This includes the appraisal, credit report or any other 3rd party verification. Penalties Violations of ECOA are subject to civil penalties of up to $10,000 in individual actions or $500,000 or 1% of the creditor’s net worth in class actions.

ECOA Related Consumer Protection Laws Fair Housing Act The Fair Housing Act is enforced in conjunction with ECOA by the Federal Trade Commission and the department of Housing and Urban Development, and is designed to prohibit housing discrimination. Since discrimination in Housing is more pervasive and more difficult to document, Department of Housing and Urban Development and the Federal Trade Commission each have “shoppers” who will pose as buyers or renters to determine if discrimination is present. The Fair Housing Act prohibits Discrimination on the basis of race, color, religion, gender, handicap, familial status or national origin in residential real-estate related transactions. The Fair Housing Act prohibits “redlining” which is the practice of denying applicants loans in certain neighborhoods, even though they would otherwise be eligible for credit. Racial redlining has been held to be illegal, and lenders and appraisers cannot use this as a basis for credit or value determination. HUD is the agency responsible for issuing regulations and for enforcement pursuant to the Fair Housing Act. Violations of the law are reported to HUD. If an administrative law judge finds

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that a discriminatory housing practice has occurred, financial penalties may be imposed. Penalties are more severe if there is a finding of a “pattern or practice” of discrimination. Fair Credit Reporting Act (“FCRA”) The purpose of FCRA is to ensure accuracy and privacy of information used by credit reporting agencies. The Federal Trade Commission enforces FCRA. Under this act, consumers have the right to correct errors on their credit reports, and may require a written request prior to release of his or her credit report. Chapter 7 Bankruptcies over ten years old and other negative information that is more than seven years old unless must be removed. Many of the provisions of the FCRA allow consumers to repair incorrect items or have them deleted if the creditor cannot substantiate them. The Fair and Accurate Credit Transactions Act (FACTA) FACTA defines a consumer’s rights with respect to credit information shared with a creditor. For mortgage lenders, the “Red Flag” provisions represent the most significant feature of FACTA. These define identity theft, and the measures firms must take to detect whether a customer is a victim of identity theft. Effective December 1, 2004, a phase in of FACTA began, allowing consumers to obtain free copies of their credit reports. The phase in was completed in September, 2005. This provision of the Fair Credit Reporting Act allows the consumer to block the accounts that may have been opened as a result of identity theft and allows consumers to place a fraud alert on their credit report to keep new accounts from being opened. Today, lenders must have a consumer identity theft protection plan in place, along with a red flag program to detect if a consumer’s identity may have been stolen.

Home Mortgage Disclosure Act (“HMDA”) Home Mortgage Disclosure Act (“HMDA”) Also known as Regulation “C” Governs the Disclosure of Lender Data to the Public

HMDA is a reporting law that allows the Federal Reserve to determine if depository institutions are meeting the housing needs of their communities to identify discriminatory lending practices. This data adds in the determination of how to distribute public-sector investments. Depository Institutions Subject to the Act Financial institutions that have a branch office in a metropolitan area, have originated at least one home purchase or refinance during the preceding year and are federally-insured or regulated, or

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originate loans that are federally-insured, or intended to be sold to Freddie Mac or Fannie Mae. Depository institutions with assets of $39 million or less as of December 31, 2008, are exempt from collecting data in 2009. HMDA also applies to not-for-profit institutions which originated home purchase or refinance loans that equaled 10% of its loan-origination volume, were at least $25 million or more than 100 home purchase loans. State-chartered or state-licensed financial institutions are exempt. Reportable Events and Transactions Institutions must report data on loan originations, purchases and applications. They must also report pre-approval requests.         

The purpose and amount to the loan; The action taken on the loan; The location of the property related to the loan; The owner/occupant status of the property; Ethnicity, race, sex, and income of the applicant; The difference between the loan’s APR and the yield on Treasury securities with comparable periods of maturity. If the difference is greater than 3 percentage points for first liens on a principal dwelling, or greater than 5 percentage points for loans secured by subordinate liens; Identification of a loan that is subject to HOEPA

This data helps to show if different or more onerous lending terms are offered to different loan applicants on the basis of personal characteristics such as ethnicity, race, or sex. Data Collection Lenders collect HMDA data on the Real Estate Loan Application Form 1003. The form requests that loan applicants disclose information on their national origin, race, and sex, but allows them to opt out of providing the information. Lenders must attempt to collect this data, and must designate the data if the borrower refuses. Community Reinvestment Act (CRA) Enacted in 1977, the CRA is intended to encourage depository institutions to meet the credit needs of the communities where they are located. The Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision conduct periodic examinations of the depository institutions which they supervise in order to determine if the institutions are meeting the credit needs of their communities, particularly those communities characterized by low incomes.

Common Consumer Protection Laws Relating to Mortgages

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Home Owner’s Protection Act Congress passed the Homeowners Protection Act in 1997 to protect consumers from excessive payments on private mortgage insurance (PMI). PMI protects the lender if a borrower defaults on a loan. The risk of default decreases over time, thereby reducing the need for PMI. PMI Cancellation When the LTV reaches 78% PMI cancellation is automatic, and does not require a borrower’s request. Although the law does not apply to FHA loans, FHA made a change to its MIP premium structure to drop the Monthly MIP portion of the borrower’s monthly payment, based upon projected amortization (for example – after 12 years on a 30 year fixed rate mortgage). If the LTV reaches 80% based on the value of the home at the time of the loan origination, and the borrower requests termination, lenders are forced to honor the request. These provisions apply to mortgages closed on or after July 29, 1999. PMI for loans closed before that date can be cancelled at the borrower’s request after he/she has paid 20% of the principal on the loan. The provisions of the Homeowners Protection Act do NOT apply to FHAinsured or VA guaranteed loans. Gramm-Leach-Bliley Act Informational privacy is an issue of increasing concern to Americans, and both state and federal legislators have responded by offering statutory solutions. In response to this need Congress created the Gramm-Leach-Bliley Act (GLB Act) of 1999. Information Security is the most important provision of this law. The Disposal Rule, which is part of the FTC Act, and is incorporated by reference into the Gramm-Leach-Bliley Act, requires that companies who use sensitive information (like credit reports and borrower’s personal information) dispose of it properly. This is referred to as the “Safeguards Rule” which mandates Companies must have an information security policy. In addition, financial institutions, including mortgage brokers, are required to provide notice to consumers about their information practices, and to give consumers an opportunity to direct that their personal information not be shared with non-affiliated third parties. This is referred to as “opting out” of information sharing. The anti-Pretexting provision of GLB provides that financial institutions may not contact a consumer who has opted out, and ask them to allow the release of financial information under the pretext of maintaining their accounts. Flood Disaster Protection Act (FDPA) The Flood Disaster Protection Act (FDPA) was passed in 1973 to expand the National Flood Insurance Program, initially established by the National Flood Insurance Act of 1968. The FDPA

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mandates participation in the National Flood Insurance Program (NFIP) as a condition for receiving federal aid in financing construction, purchase, repair or improvement of a home located in a special flood hazard area (SPHA). The FDPA was amended in 1974 to require all federally regulated or insured lenders to notify prospective borrowers before closing a loan if the property that is securing their loan is located in a SFHA and, again, in 1994 to broaden the mandatory flood insurance requirements of the NFIP. Flood insurance is required on loans if the community where the property is located participates in the NFIP and any portion of the structure that secures the loan lies in a SFHA. The lender must conduct and document a flood hazard determination and, if in a SFHA, required flood insurance. Lenders must notify borrowers prior to loan closing that the property is in a SFHA and that flood insurance is mandatory to make the loan. If insurance coverage lapses the lender may “force-place” insurance. The National Flood Insurance Act is administered by the Federal Insurance Agency (FIA), working with the Federal Emergency Management Agency (FEMA). USA Patriot Act The USA Patriot Act of 2001, , Section 326, enacted because of terrorist attacks, impacts mortgage lending by requiring positive borrower identification and by requiring that private financial information be released to the government. The Act requires increased due diligence by banks, trust companies, savings associations and credit unions in establishing the identity of consumers who apply for loans. Proof of identity will be required, even in lending institutions where the consumer has a long-standing account. These procedures are referred to as the Customer Identification Program (CIP). Personnel must obtain the name, date of birth, address and identification number of all customers. Verification is by review of 1 primary identification form or two secondary forms of identification. All documentation must be valid or unexpired

Citizens (1 Primary or 2 secondary)

Non Citizens (2 primary or 1 primary and 1 secondary)

Primary Identification Forms Government ID w Photo Permanent Drivers License US Passport Consular Card US Military ID State Issued ID Student ID w Birth Certificate Permanent resident card Non-permanent resident alien card U.S. citizen identification card Employment authorization card Temporary resident alien card Non-U.S. passport Non-immigrant visa and border crossing card Non-resident alien border crossing card

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Secondary Identification Forms Birth certificate Auto registration Pay stub - within 30 days Matching utility bill Employer ID with photo Insurance Card Voter Registration Card Auto registration Pay stub - within 30 days Matching utility bill Employer ID with photo Insurance Card Voter Registration Card Student ID w Birth Certificate


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In addition the act overrides the FCRA as a consumer-protection statute. The Patriot Act requires consumer reporting agencies to furnish all information regarding a consumer to a government agency if the government certifies that the records are relevant to intelligence action in response to terrorist threats or activities. Adequate Customer Notice The following language must be made available to each applicant, either verbally, in writing that the applicant may keep or by being placed in the branch or lending area in a location that the applicant will be able to view during the application process. “To help the government fight the funding of terrorism and money laundering activities, federal law requires all financial institutions to obtain, verify and record information that identifies each person who opens an account. What this means for you: When you open an account, we will ask for your name, address, date of birth, and other information that will allow us to identify you. We may also ask to see your driver’s license or other identifying documents.”

Appraiser Independence Rules (Formerly HVCC) The HVCC was abolished in August of 2010 by the Dodd/Frank Act (Dodd-Frank Wall Street Reform and Consumer Protection Act). It is replaced by a federal regulatory structure which memorializes the terms of the old HVCC, which was an industry code, into a Federal rule. Most importantly the Appraiser Independence Rule applies to ALL mortgage loans, not just conventional and FHA loans. History of the Appraiser Independence Rule It’s easiest to understand the Appraiser Independence rule by understanding its history. In 2008, the New York Attorney General entered into an agreement with FNMA and FHLMC to change the role of third party originators (mortgage brokers) in the appraisal process. The Home Valuation Code of Conduct (HVCC) agreement bars FHLMC and FNMA from purchasing loans with appraisals ordered by mortgage brokers, among other things. Until the HVCC, brokers controlled the property valuation (appraisal) process. The HVCC attempted to eliminate the abusive practices perpetrated by third party originators that resulted in inflated appraisals and loans based on questionable collateral. The abusive practices involve pressuring appraisers to provide a predetermined value through coercion. Under the Appraiser Independence Rule, mortgage loans may not have broker ordered appraisals. In addition, it prevents other practices that tend to corrupt the legitimate valuation of real property. Process Multiple Appraisals Ordering Appraisals Appraiser Approval Process

Limitation If the lender obtains 2 appraisals, the lender may not use the higher value. May not suggest a property value on the appraisal request Lenders may not “black-list” appraisers without written notice. Must have written appraiser approval and review process in place

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Borrower Appraisal Copy Appraiser Conflict of Interest

Borrower must receive a copy of the appraisal – signed acknowledgement May not own any portion, or be an employee, of lender, settlement service firm

Appraiser Independence Rule now applies ALL loans, not just to FNMA and FHLMC, FHA/VA or other sources. This represents a huge change in the way mortgage brokers do business. Until Appraiser Independence Rule, brokers could hold themselves out to the public as lenders. This process makes it clear that the mortgage broker is a middleman with no real function in the process beyond consultation and income documentation assembly.

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Chapter 12 – The Real Estate Settlement Procedures Act (RESPA) Key Concepts Department of Housing and Urban Development as a Regulator

Fair Housing Act RESPA

Anti-Kickback Provisions

Controlled Business Arrangements

Early Disclosure Regulations

Good Faith Estimates HUD-1 Settlement Statement Yield Spread Disclosures

Loan Servicing Regulations

Transfer of Servicing Escrow Account Management

Introduction to RESPA One of the most extensive pieces of regulation affecting the mortgage business is the Real Estate Settlement Procedures Act (RESPA). The law focuses on the real estate transaction and all of the parties to it including real estate agents and brokers, lenders, settlement, escrow and title companies. Since it is such an all-encompassing regulation covering not just the loan transaction, but the entire real estate transaction, we will develop an understanding of the law by following a transaction from start to finish. This will allow us to see the law, its purposes and its practical applications, in the context of today’s mortgage business. Congress enacted the Real Estate Settlement Procedures Act (RESPA) in 1974 to protect homebuyers from incurring unnecessary costs in settlement services. One goal of the law is to provide consumers with sufficient information to enable them to make informed choices regarding settlement services. To do this, participants in the real estate transaction have a myriad of regulations with which they must comply.

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Transactions Subject to the Law RESPA applies to “federally related mortgage loans.” A federally related mortgage loans is “Any loan secured by a first or subordinate lien on residential real property designed for the occupancy of one to four families and made, in whole or in part, by a lender whose deposits and accounts are insured or regulated by an agency of the Federal Government.” The transaction types shown here are exempt from enforcement under RESPA.

Transactions Exempt from RESPA A loan on property of 25 acres or more. Extensions of credit to be used primarily for business, commercial, or agricultural purposes. Temporary financing; bridge loans, construction loans less than 2 years in duration - unless it is a constructionperm transaction Lot Loans secured by vacant land, unless funds from the loan will be used to build a structure within 2 years. Assumptions, as long as lender approval is not required (no release of liability) Loan conversions.

Issues Relating to Business Practices – Kickbacks People hear the word “kickback” and it may conKickback jure images of dishonest, sleazy dealings between participants colluding to defraud consum- Section 8 of RESPA prohibits the acceptance ers in a transaction. The reality is that the real of fees, kickbacks or “anything of value” in estate transaction is heavily influenced by per- exchange for referrals of settlement business sonal relationships. It is also an extremely com- (unless the referring party has actually performed a settlement service to earn the petitive business saturated with players. There is payment). tremendous pressure among related service providers – lenders, real estate companies, title companies and others - to add value to their referral relationships by including financial incentives for the partnership. At some level this seems perfectly natural – why wouldn’t you give consideration for referral of business? Common sense seems to indicate that someone who is already being compensated for their services through their own work would have a conflict of interest in receiving compensation for a referral from a related service provider. It implies that the impetus for giving the referral has less to do with the value added for the service and more to do with how much compensation is involved. This, by itself, would probably not be enough to create a prohibition on referrals. The problem is that referral fees tend to inflate the costs in the transaction without the consumer’s

How Referral Fees Impact the cost of a Transaction Loan Amount Referral Fee Loan Officer Commission % Rate Points Required to pay commission Loan Officer Commission $ to Pay Referral Point Cost to Borrower Increased Cost to Borrower

Transaction 1 $ 100,000.00 $ 50% 2% $ 1,000.00 $ 2,000.00

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Transaction 2 $ 100,000.00 $ 500.00 50% 3% $ 1,500.00 $ 3,000.00 $ 1,000.00


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knowledge. Another goal of the law is “...the elimination of kickbacks or referral fees that tend to increase unnecessarily the costs of certain settlement services” 12 U.S.C. Section 2601 (b)(2). Referral fees inflate the cost of a transaction, because in order for everyone to receive compensation, someone must pay. That person is the unsuspecting buyer or borrower. Prohibition on Kickbacks, Fee-Splitting and Unearned Fees Figure 4 illustrates a fairly obvious example of a Anything of Value loan officer paying a real estate agent for a referral. While this is a straightforward example there are RESPA broadly defines “anything of value” many instances where the effect of payments for re- as “...any payment, advance, funds, loan, ferrals “per transaction” is much smaller and more service, or other consideration.” difficult to quantify. To insure against violating RESPA’s prohibitions, it is important to understand the law’s definition of “anything of value”. You also must understand how HUD determines what constitutes a compensable settlement service – something the borrower can legitimately pay for. . RESPA broadly defines “anything of value” as “...any payment, advance, funds, loan, service, or other consideration.” Any benefit could fall within this definition. Compensable Settlement Services – What the Borrower can Pay For RESPA’s definition of “settlement services” is very broad. The statute provides that “...the term ‘settlement services’ includes any service provided in connection with a real estate settlement...” Noting that the list is not all-inclusive, the law cites examples of settlement services ranging from title searches to the taking of loan applications (see 12 U.S.C. Section 2602 (2)). In its Policy Statement of 1999, HUD provided an even more comprehensive list of compensable services (see Appendix for a copy of the HUD List of Compensable Settlement Services). Are Fees Earned? HUD’s considerations in determining if fees are earned in exchange for services received is pivotal in understanding the its position on the Controlled Business Arrangement. HUD considers specific factors     

Did the lender’s agent or contractor take loan application? Was the number of services provided commensurate with the compensation? Was a fee paid for borrower counseling? Did the loan counselor receive the fee from lenders who sold the loan? Is the compensation reasonably related to the value of the services?

Not only does HUD consider the nature of the services performed, but it also considers “...whether the payment is reasonably related to the value of the...services actually performed.” HUD considers payments to be related to goods provided and services performed if they are

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“commensurate with the amount normally charged for similar services....” Statement of Policy 2001-1 at 53055. Controlled and Affiliated Business Arrangements (ABA) An “affiliated business arrangement” (ABA) or Controlled Business Arrangement is defined in RESPA as an arrangement where a person who refers settlement services has an “affiliate relationship” or “an ownership interest of more than one percent in a provider of settlement services.” Why an ABA is not a RESPA Violation HUD tacitly understands that there are circumstances where a borrower’s interests are best served by working with an entity that “bundles”, or packages, services. If the process results in lower costs for the borrower, it is obviously advantageous to use a provider who can add value. For HUD, the concern is in areas where the borrower ends up paying more, not less, for services. The Controlled Business Arrangement is a circumstance where, if unmonitored or unregulated, borrowers could be steered to a provider which does not add value, but adds cost. As a result, HUD places three limitations on affiliated and controlled business arrangements. 1. Disclosure of the Relationship The service provider must disclose a Business Relationship. This provides the borrower with advance knowledge that there is a potential for abuse. For “in-person”, electronic and written referrals, disclosures must be made at the time of the referral. For telephone referrals, disclosures must be made within three business days of the call. Lenders who make referrals (including referrals to affiliated lenders) make their disclosure at the time they provide the borrower with a Good Faith Estimate of closing costs (GFE). 2. Required Providers If the borrower is required to use a particular service provider, such as an appraisal firm, credit bureau, or title company, the relationship cannot be a controlled business arrangement that results in a fee to the borrower. The borrower must have the right to choose a settlement service provider that is not affiliated with the lender if the service provider is required. If a settlement service provider refers the consumer to another provider with whom he/she shares an ownership or other beneficial interest, he/she must give the consumer a Controlled Business Arrangement (CBA) Disclosure. Unless the second provider is an attorney, a credit reporting agency, or a real estate appraiser representing the interests of the lender, the referring party cannot require the use of a particular provider without violating RESPA’s prohibition on affiliated business arrangements. 3. Services Must Add Value

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HUD considers whether the party that receives referrals is a valid provider of settlement services, or if the entity is merely a vehicle for payment of referral fees. Certain services do not add value and if these fees are charged without a service provided this is what is referred to as a “sham” business arrangement. “When assessing whether such an entity receiving referrals of business...is a bona fide provider of settlement services or is merely a sham arrangement used as a conduit for referral fees, HUD balances a number of factors in determining whether a violation exists....” Statement of Policy 1996-2 at 29262. Mortgage Brokers are Controlled Business Arrangements Mortgage brokers are considered controlled business arrangements. This sheds light on the HUD belief that Yield Spread Premiums are tantamount to kickbacks. However, the value of the services that mortgage brokers provide is not in question. RESPA reform seems intent on limiting the amount of compensation a broker can earn for providing permissible services. Services that Are Permissible – Lender to Broker Taking Application Analyzing Income/Debt Qualification Educating Homebuyer on Process Collecting Financial Information Verifying Financial, Property or Transaction Information Providing Federal Disclosures Assisting Borrowers with Contingencies and Advising of Loan Status Ordering Legal Documentation Participating in Loan Closing

Other Controlled Business Arrangements In allowing controlled or affiliated business arrangements, HUD had to be prepared to distinguish what is an allowable arrangement. The questions HUD asks are designed to be a “Sham” business arrangement test. SHAM Business Arrangement Test (1) Does the new entity have sufficient initial capital and net worth, typical in the industry, to conduct the settlement service business for which it was created? Or is it undercapitalized to do the work it purports to provide? (2) Is the new entity staffed with its own employees to perform the services it provides? Or does the new entity have ``loaned'' employees of one of the parent providers? (3) Does the new entity manage its own business affairs? Or is an entity that helped create the new entity running the new entity for the parent provider making the referrals? (4) Does the new entity have an office for business which is separate from one of the parent providers? If the new entity is located at the same business address as one of the parent providers, does the new entity pay a general market value rent for the facilities actually furnished? (5) Is the new entity providing substantial services, i.e., the essential functions of the real estate settlement service, for which the entity receives a fee? Does it incur the risks and receive the rewards of any comparable enterprise operating in the market place? (6) Does the new entity perform all of the substantial services itself? Or does it contract out part of the work? If so, how much of the work is contracted out?

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(7) If the new entity contracts out some of its essential functions, does it contract services from an independent third party? Or are the services contracted from a parent, affiliated provider or an entity that helped create the controlled entity? If the new entity contracts out work to a parent, affiliated provider or an entity that helped create it, does the new entity provide any functions that are of value to the settlement process? (8) If the new entity contracts out work to another party, is the party performing any contracted services receiving a payment for services or facilities provided that bears a reasonable relationship to the value of the services or goods received? Or is the contractor providing services or goods at a charge such that the new entity is receiving a ``thing of value'' for referring settlement service business to the party performing the service? (9) Is the new entity actively competing in the market place for business? Does the new entity receive or attempt to obtain business from settlement service providers other than one of the settlement service providers that created the new entity? (10) Is the new entity sending business exclusively to one of the settlement service providers that created it (such as the title application for a title policy to a title insurance underwriter or a loan package to a lender)? Or does the new entity send business to a number of entities, which may include one of the providers that created it?

Even if the entity passes the test, HUD would continue to question whether the entity is bona fide based upon a reasonable compensation test of the entity. Earnings “Test” of Controlled Business Arrangements (1) Has each owner or participant in the new entity made an investment of its/their own capital, as compared to a ``loan'' from an entity that receives the benefits of referrals? (2) Have the owners or participants of the new entity received an ownership or participant's interest based on a fair value contribution? Or is it based on the expected referrals to be provided by the referring owner or participant to a particular cell or division within the entity? (3) Are the dividends, partnership distributions, or other payments made in proportion to the ownership interest (proportional to the investment in the entity as a whole)? Or does the payment vary to reflect the amount of business referred to the new entity or a unit of the new entity? (4) Are the ownership interests in the new entity free from tie-ins to referrals of business? Or have there been any adjustments to the ownership interests in the new entity based on the amount of business referred? Responses to these questions may be determinative of whether an entity meets the conditions of the CBA exception. If an entity does not meet the conditions of the CBA exception, then any payments given or accepted in the arrangement may be subject to further analysis under Section 8(a) and (b). 12 U.S.C. Sec. 2607(a) and (b).

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Non - Required Providers must be listed when there is a financial interest, along with the charge or range of charges normally levied. The borrower has the right to shop for these services.

Required Providers are those that the borrowers CAN NOT choose, and that the lender assigns. The borrower does not have the right to shop for these services. By the same token, the fees estimated as a required provider must be firm estimates.

Figure 6 - The Affiliated Business Disclosure identifies business partners that have an ownership interest in the lender. This warns the consumer that the lender makes money from other services besides the loan.

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Sample Cases – Is it a Controlled Business Arrangement? Scenario 1 – Real Estate Broker and Title Insurance Company Joint Venture

An existing real estate broker and an existing title insura joint venture with “leased” employees and ance company form a joint venture title agency. Each Is shared facilities a bona fide provider? participant contributes $1000 towards the creation of the joint venture title agency, which will be an exclusive agent for the title insurance company. The title insurance company enters a service agreement with the joint venture to provide title search, examination and title commitment preparation work at a charge lower than its cost. It also provides the management for the joint venture. The joint venture is located in the title insurance company's office space. One employee of the title insurance company is ``leased'' to the joint venture to handle closings and prepare policies. That employee continues to do the same work she did for the title insurance company. The real estate broker participant is the joint venture's sole source of business referrals. Profits of the joint venture are divided equally between the real estate broker and title insurance company. Scenario 1 - HUD Analysis

After reviewing all of the factors, HUD would consider this an example of an entity which is not a bona fide provider of settlement service business. As such, the payments flowing through the arrangement are not exempt under Section 8(c)(4) and would be subject to further analysis under Section 8. In looking at the amount of capitalization used to create the settlement service business, it appears that the entity is undercapitalized to perform the work of a full service title agency. In this example, although there is an equal contribution of capital, the title insurance company is providing much of the title insurance work, office space and management oversight for the venture to operate. Although the venture has an employee, the employee is leased from and continues to be supervised by the title insurance company. This new entity receives all the referrals of business from the real estate broker participant and does not compete for business in the market place. The venture provides a few of the essential functions of a title agent, but it contracts many of the core title agent functions to the title insurance company. In addition, the title insurance company provides the search, examination and title commitment work at less than its cost, so it may be seen as providing a ``thing of value'' to the referring title agent, which is passed on to the real estate broker participant in a return on ownership. Scenario 2 – Title Company and Real Estate Broker

A title insurance company solicits a real estate broker to a referral venture staffed by one vencreate a company wholly owned by the broker to act as Does ture’s employees qualify as a bona-fide proits title agent. The title insurance company sets up the vider? new company for the real estate broker. It also manages the new company, which is staffed by its former employees that continue to do their former work. The new company also contracts back certain of the core title agent services from the title insurance company that created it, including the examination and determination of insurability of title, and preparation of the title insurance commitment. The title insurance company charges the joint venture company less that its costs for these

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services. The new company's employees conduct the closings and issue only policies of title insurance on behalf of the title insurance company that created it. Scenario 2 - HUD Analysis

As was the case in the first example, HUD would not consider the new entity to be a bona fide settlement ser- Is a joint venture where 100% of the business vice provider. The legal structure of the new entity is ir- comes from one of the partners a bona fide relevant. The new company does little real work and con- provider? tracts back a substantial part of the core work to the title insurance company that set it up. Further, the employees of the new company continue to do the work they previously did for the title insurance company which also continues to manage the employees. The new entity is not competing for business in the market place. All of the referrals of business to the new entity come from the real estate broker owner. The creating title insurance company provides the bulk of the title work. On balance HUD would consider these factors and find that the new entity is not a bona fide title agent, and the payments flowing through the arrangement are not exempt under Section 8(c)(4) and would be subject to further analysis under Section 8. Scenario 3 – Mortgage Lender and Real Estate Broker - Mortgage Broker Joint Venture

A lender and a real estate broker form a joint venture mortgage broker. The real estate broker participant in the Does a joint venture with where neither entity joint venture does not require its prospective home buyers has complete control of the functions of the to use the new entity and it provides the required CBA business qualify as a bona fide provider? disclosures at the time of the referral. The real estate broker is the sole source of the mortgage broker’s business. The lender and real estate broker each contributes an equal amount of capital towards the joint venture, which represents a sufficient initial capital investment and which is typical in the industry. The mortgage broker uses its own employees to prepare loan applications and perform all other functions of a mortgage broker. On a few occasions, to accommodate surges in business, the new entity contracts out some of the loan processing work to third party providers, including the lender. In these cases, the new entity pays all third party providers a similar fee, which is reasonably related to the processing work performed. The new entity manages its own business affairs. It rents space in the real estate broker's office at the general market rate. The mortgage broker submits loan applications to numerous lenders and only a small percent goes to the lender. Scenario 3 - HUD Analysis

After reviewing all of the factors, HUD would consider this an example of an entity which is a bona fide provider of settlement service business and not a sham arrangement. The new entity would appear to have sufficient capital to perform the services of a mortgage broker. The participant's interests appear to be based on a fair value contribution and free from tie-ins to referrals of business. The new entity has its own staff and manages its own business. While it shares a business address with the real estate broker participant, it pays a fair market rent for that space. It provides substantial mortgage brokerage services. Even though the joint venture may contract out some processing overflow to its lender participant, this work does not represent a substantial

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portion of the mortgage brokerage services provided by the joint venture. Moreover, the joint venture pays all third party providers a similar fee for similar processing services. While the real estate broker participant is the sole source of referrals to the venture, the venture only sends a small percent of its loan business to the lender participant. The joint venture mortgage broker is thus actively referring loan business to lenders other than its lender participant. Since the real estate broker provides the CBA disclosure and does not require the use of the mortgage broker and the only return to the participants is based on the profits of the venture and not reflective of referrals made to the venture, it meets the CBA exemption requirements. HUD would consider this a bona fide controlled business arrangement. Scenario 4 – Real Estate and Title Company Joint Venture

A real estate brokerage company decides that it wishes to expand its operations into the title insurance business. The real estate company purchases a 50 percent ownership interest in an existing full service title agency. The title agency is liable for the core title services it provides, which includes conducting the title searches, evaluating the title search to determine the insurability of title, clearing underwriting objections, preparing title commitments, conducting the closing, and issuing the title policy. The agent is an exclusive title agent for its title insurance company owner. Under the new ownership, the real estate brokerage company does not require its prospective home buyers to use its title agency. The brokerage has its real estate agents provide the required CBA disclosures when the home buyer is referred to the affiliated title insurance agency. The real estate brokerage company is not the sole source of the title agency's business. The real estate brokerage company receives a return on ownership in proportion to its 50% Scenario 4 HUD Analysis

A review of the factors reflects an arrangement involving a bona fide provider of settlement services. In this example, the real estate brokerage company is not the sole source of referrals to the title agency. However, the title agency continues its exclusive agency arrangement with the title insurance company owner. While this last factor initially may raise a question as to why other title insurance companies are not used for title insurance policies, upon review there appears to be nothing impermissible about these referrals of title business from the title agency to the title insurance company. This example involves the purchase of stock in an existing full service provider. In such a situation, HUD would carefully examine the investment made by the real estate brokerage company. The real estate brokerage company paid a fair value contribution for its ownership share and receives a return on its investment that is not based on referrals of business. Since the real estate brokerage provides the CBA disclosure, does not require the use of the title agency and the only return to the brokerage is based on the profits of the agency and not reflective of referrals made, the arrangement meets the CBA exemption requirements. HUD would consider this a bona fide controlled business arrangement. Scenario 5 – Ownership Interest in Referral Entity

Is a joint venture with profit sharing based on the number of referrals sent a bona fide provider?

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A mortgage banker sets up a limited liability mortgage brokerage company. The mortgage banker sells shares in divisions of the limited liability company to real estate brokers and real estate agents. For $500 each, the real estate brokers and agents may purchase separate ``divisions'' within the limited liability mortgage brokerage company to which they refer customers for loans. Ownership distributions are based on the business each real estate broker or real estate agent refers to his/her division, not on the basis of their capital contribution to the entity. The limited liability mortgage brokerage company provides all the substantial services of a mortgage broker. It does not contract out any processing to its mortgage banker owner. It sends loan packages to its mortgage banker owner as well as other lenders. Scenario 5 - HUD Analysis

Although HUD would consider the mortgage brokerage company to be a bona fide provider of mortgage brokerage services, this example illustrates an arrangement that fails to meet the third condition of the CBA exception. 12 U.S.C. 2607(c)(4)(C). Here, the capitalization, ownership and payment structure with ownership in separate ``divisions'' is a method in which ownership returns or ownership shares vary based on referrals made and not on the amount contributed to the capitalization of the company. In cases where the percent of ownership interest or the amount of payment varies by the amount of business the real estate agent or broker refers, such payments are not bona fide returns on ownership interest, but instead, are an indirect method of paying a kickback based on the amount of business referred. 24 CFR 3500.15(b)(3). Enforcement of Section 8 RESPA provides for administrative, civil, and criminal actions for violations of its provisions. Violations of Section 8 of RESPA can result in a fine of $10,000, imprisonment, or both. Violators are also liable to the person charged for settlement services in an amount equal to three times the fees that they were charged. Alleged violators are not subject to criminal sanctions if they can prove that the violations were not intentional. Actions for violations of Section 8 must be reviewed within three years. Prohibition on Seller-Required Title Insurance RESPA prohibits a seller from requiring the use of a particular title insurance company as a condition of sale. Violations of this section make the seller “...liable to the buyer in an amount equal to three times all charges made for such title insurance.” 12 U.S.C. Section 2608(b).

Application Disclosure – Good Faith Estimate of Closing Costs IMPORTANT NOTE – BEGINNING August, 2015, the Truth-in-Lending disclosure (APR statement) and Good Faith Estimate (2010 GFE) become a single combined LOAN ESTIMATE form. This instruction, as it applies to cost disclosure, may become outdated at that time. Contact us to obtain updated material. RESPA seeks to control the costs of settlements with a series of disclosure requirements. The disclosures are intended to advise consumers of all costs associated with the settlement of a

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mortgage loan so they can shop for the best rates and to discourage lenders and mortgage brokers from engaging in unethical practices. This regulation changed substantially in December, 2008, although the provisions affecting the revised Good Faith Estimate do not become final until January 1, 2010. In this text we will provide information on the old GFE (Legacy GFE) as well as the new GFE (2010 GFE). This does serve a purpose. Although the 2010 GFE has been simplified for consumer comparison purposes, the underlying costs have not changed. To properly aggregate the multitude of charges and explain them to a borrower, the loan originator must still understand closing costs. Timing and Delivery of the GFE The 2010 GFE must be given to the borrower after they have provided enough information for the originator to adequately qualify the borrower. At a minimum the borrower must provide a social security number, gross monthly income, loan amount, sales price or estimated property value, and real estate taxes. The legacy GFE was a reasonable estimate of all charges which are due at the time of settlement. The 2010 GFE is a “Firm Estimate” which cannot change between the time of application and closing without a documented “reasonable change in circumstances.” RESPA Reform and the Good Faith Estimate When HUD initially proposed reform of the GFE, it intended to simplify cost estimates for comparison shopping purposes. It cited its own statistics that borrowers were dissatisfied with the quality of the initial disclosures they received - less than 20% of borrowers surveyed reported receiving sufficient information. To solve this problem HUD redesigned the disclosure forms to Delivery

Legacy GFE 3 business days from application

Tolerance

Voluntary accuracy level

Itemization Lock-in

Lines 800 – 1400 completely itemized None

Enforcement

Only require providing form

Loan Terms Comparison

Not included Voluntary Shopping tool included in Settlement Costs booklet

2010 GFE 3 business days after having qualified the borrower for the terms being quoted Mandatory adherence to closing cost quote All costs aggregated into 9 categories Lock-in period for closing costs must allow consumer to compare (5 days) Accuracy enforced, changes at closing must be documented and retained All mortgage terms disclosed Originator must complete trade-off comparison

“simplify” them. This section will compare the legacy GFE process with the 2010 GFE process. It is the loan officer’s duty, whether he or she works for a mortgage lender or broker, to explain the costs associated with the transaction. The failure of mortgage professionals to adequately explain the costs receives much of the blame for many of the problems Americans are experiencing today.

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Preparing the Good Faith Estimate Preparing a GFE consists of filling in blanks. An accurately prepared GFE represents the most comprehensive settlement cost estimate that a consumer receives. The legacy GFE process did not mandate any tolerance for accuracy. The 2010 process mandates that lender charges, government taxes, and interest charges may not vary between application and closing. The remaining charges may not vary by more than 10%, unless the borrower can shop for his or her own providers. If the borrower shops for his or own service providers, there is no limitation on changes. The “Legacy” GFE has multiple lines, with many subcategories. These lines correlate to lines on the HUD-1 Settlement Statement. One of the concerns that prompted HUD to revise the GFE was the “over-itemization” that multiple lines encouraged. They called this “death by 1000 cuts.” Over-itemization caused borrowers to become confused and thus made the GFE a poor tool for real cost comparison. HUD solved this problem by aggregating, or combining, the various costs and services by provider. The legacy GFE potentially has hundreds of itemized numbers. The 2010 GFE has 9. This simplification allows a borrower to com- The Legacy GFE, which will be obsolete 1/1/2010, is an expare those costs that a lender has control over ample of what HUD refers to as “Over Itemization.” with other providers, without having the sort out charges that are paid to other providers. While this simplification makes it easier for the customer to compare, the originator must be better at estimating costs and correctly aggregating them into the 9 categories.

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Preparing the 2010 GFE

In 1.) the total fee to the originator is disclosed – it cannot change. In 2.) The yield spread, or discount charges indicate whether the borrower is receiving a higher rate to pay the originator. A.) is the adjusted (net) origination fee. Legacy GFE Lines 1 & 2 In 3.) Services that we select are Appraisal fees, credit report fees, flood certifications and tax service fees. This was NOT intended to itemize other lender charges like processing, underwriting or document preparation. These are the remaining 800 section from the Legacy GFE In 4) & 5) all title related services are combined into one fee. These are the 1100 and 1200 Sections of the Legacy GFE. In 6) Services that you can shop for include several 1100 and 1300 section items. In 7) & 8) Recording Fees and Transfer Taxes – Taxes CANNOT change – From 1200 9) Prepaid items paid to escrow – escrow for real estate taxes, insurance and PMI 10) per diem interest 11) One years’ Homeowner’s insurance policy. From the Legacy GFE – sections 900 and 1000.

Calculating the Components of a Buyer's Closing Costs Although the 2010 GFE makes it appear that there are nine categories of costs, these can really be compressed into four: 1.) Loan fees or points; 2.) "Hard" closing costs which are fixed transaction fees charged by the service providers to the transaction; 3.) Municipal and governmental charges which are the taxes and fees required by the jurisdiction in which the property is located; and 4.) prepaid items. Within certain categories, charges may be adjusted. Loan Fees There are many considerations with respect to paying points. When cash is at a premium and seller contributions are limited by program guidelines, seller paid points may not be an alternative. By eliminating the loan fee/point component of closing costs a borrower can increase his or her leverage. As housing costs increase, purchasers may find that they have the income for a large mortgage, but not the cash for a large down payment and closing costs. A home buyer may

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find that a "zero point" option can help minimize closing costs, which might allow a larger down payment, or money for other expenses related to a new home purchase, such as furniture, repairs or sundries. "Hard" Closing Costs There are many, many necessary services performed in conjunction with the settlement of a real estate transaction. A fee at closing accompanies each of these services. The 2010 GFE has aggregated these fees because, as you can see in this example, we know what the costs are, detailed itemization does not add to the customer’s understanding. The fees for these services are fairly standard within a range and so will stay roughly the same for each transaction regardless of size. Government/Municipal Title Related Charges Of course, the Government may want revenue from each transaction, whether city, township, county and/or state. Depending on the jurisdiction, these charges may be called transfer tax, recordation tax, tax stamps, sales tax, or other fees. Some states or jurisdictions may offer homeownership incentives under which the buyer’s portions of these charges are waived, such as homestead exemptions. The charges may be levied against the buyer, the seller or both. Some jurisdictions may simply not levy these charges. These charges must be known in advance with precision. The transfer indicates the amount of consideration, or sales price, upon which a levy is based. In addition, there may be a tax levied for recording a mortgage or deed of trust that would be based on the amount of the loan. While these taxes vary depending on the sales price and loan amount, knowing the jurisdiction allows the originator to estimate with accuracy. Title Insurance Title insurance is designed to indemnify you against your legal fees and expenses should someone else file a legal claim to your property. In the event of a total loss, referred to as a forfeiture or reversion, the policy insures your equity and, theoretically at least, would reimburse you for your loss. There are two types of Title Insurance: Lender's and Owner's. The lender's policy will always be required if there is a loan involved in the purchase - the lender requires it and the borrower pays for it. The owner's policy, however, is a discretionary purchase for the buyer. The 2010 GFE strongly indicates the “optional” nature of the owner’s policy, and provides a separate line item for it. For borrowers, understanding whether owner’s title insurance is an advisable purchase requires understanding the mechanics of the title insurance business.

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Prepaid Items As the term implies, a prepaid item is something paid for at closing which will come due in the future. Pro-rated real estate taxes, homeowner's and flood insurance, PMI, Interest is due in advance at closing and interim interest are among the most common prepaid items. These are also the most confusing component of closing costs best cause they are not fixed or immuThe 1 payment is due at the beginning of the table and can change depending on next month the closing date and the jurisdiction. The key concept to underth this example, the borrower closes on March 16 . Interest is due at closing standing prepaid items is that inter- In th from the 16 of the month until the end of the month. The First Mortgage est on a mortgage is always paid in Payment is due May 1 – after the interest has accrued on the balance. arrears - after interest has had a chance to accrue on the balance. This is why the first payment date on the mortgage is usually at least one month after the closing date. People who are accustomed to paying rent think they are getting a "free month" because the first day of the next month after closing arrives and their payment isn't due for another month. Interim Interest Also referred to as per diem, or per day, this is an adjustment of the interest from the closing date until regular principal and interest payments start accruing under the term of the loan. This is the easiest place to see the interest in arrears concept, because at closing the settlement agent collects interest from the date of settlement until the end of the month. This is where the common misconception of "closing at the end of the month" being a money saving function comes from. If you close at the beginning of the month, you would pay 30 days of interest. The cost is just a mortgage payment in advance - and this is the only time one would pay interest in advance. Just like staying in a hotel, you pay interest on the loan for the days that you have it. It doesn't mean you are paying more at closing because, more than likely, you are not paying to stay in a hotel, your old home or a rental anymore. If the cost of the per diem interest is too much to bear it is possible to arrange for an interest credit at closing for a closing early in the month. This means that the lender does not collect any per diem interest at closing, but simply moves the first payment date to the first day of the month following closing. The first payment would be the regular principal and interest payment less interest for the number of days that into the month that the closing occurred. Note that, regardless of closing date, FHA requires that you include at least 15 days of interest in the closing cost calculation for qualifying purposes.

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Insurance Escrow

Next Year, the Insurance Premium is due this day

One of the most frequent complaints about escrows for homeowner's, flood and private mortgage insurance is "why do I have to pay money into escrow when I have already paid the insurance premium for a year?" The key to understanding this is to understand that all insurance requires that the premium be paid in advance - regardless of whether it is Beginning in May, we collect 10 payments financed or not. Again, the reguuntil March, next year. lar monthly payment for principal and interest, taxes and insurance the same example – at closing the borrower pays for one year of insurance. (PITI) doesn’t come due for at In The renewal insurance premium is still due on the anniversary of the closing. least one month because the At closing we collect March and April’s premium for next year, leaving May payment is due in arrears. This has to be reconciled with the fact that the insurance anniversary date is the closing date. Usually there are 10 monthly PITI payments that the lender receives prior to the insurance anniversary or premium due date. The insurer will expect to receive the annual premium that is 12 times the monthly insurance portion of the payment. To make up for the 2 month shortfall, the lender places 2 months insurance into the escrow account so that there will be enough money to pay the premium when it comes due. With private mortgage insurance (PMI), the issue is the same. When utilizing PMI under the traditional plan, there is an initial premium paid at closing. The 1 year renewal premium will come due after the borrower has only made 10 regular PITI payments. So to offset the expected shortfall, the lender collects 2 times 1/12th of the renewal premium at closing. If the PMI is a monthly plan, there is no initial premium, but the premiums must start being remitted from the date of closing. In this case the lender will collect two months of the premium again, to make up for the fact that the first regular PITI payment is not expected for 30-60 days. Real Estate Tax Escrows This can be the most confusing prepaid because, on top of the fact that real estate taxes may come due at different times within neighboring jurisdictions, sometimes the real estate taxes are paid in advance, or partially in advance. When this is the case, the lender has to make sure that it collects enough in escrow with the expected PITI payments to pay the taxes when due. The loan officer has to make sure that the borrower understands that they must repay the seller for any amounts that the seller has paid in advance. For instance, if the seller has paid 1/2 year in advance and the tax bill is based upon an annual assessment, the borrower could pay as many as 14 months real estate taxes at closing; 6 months to pay back the seller, 6 months to the jurisdiction and 2 months into escrow.

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The Special Information Booklet – HUD Guide to Settlement Costs The Special Information Booklet is what HUD calls the Settlement Cost Booklet. The borrower acknowledges receipt of the document at the time that the Good Faith Estimate is signed, so it must be provided at application, or mailed within three business days after completion of loan application. Loan originators can use their own booklet, or use the HUD booklet entitled, “Buying Your Home”, “Understanding Settlement Costs”, a “Special Information Booklet”, “The Settlement Cost Booklet”, “A HUD Guide to Closing Costs”, “Understanding Closing Costs” or any other title as long as it contains prescribed content explaining the settlement process. Most importantly, this booklet tells borrowers that they have the right to negotiate the terms of a loan and shop for providers of Settlement services. For everyone involved in the process, it is useful to have an understanding of what the closing costs described actually are. What These Costs Represent Understanding what the actual costs represent and who they are paid to can also help to explain the Good Faith Estimate and Settlement Statement. The allowable charges are changing effective January 1, 2010 and many of these fees will be consolidated for simplification. HUD-1 Line/2010 Paid to Paid By - Description GFE line 700. Real Estate Broker Seller - This is the total dollar amount of the real estate Sales/Broker's broker’s sales commission, which is usually paid by the Commission seller. This commission is typically a percentage of the GFE – N/A selling price of the home 800 Section - Items Payable in Connection with Loan. These are the fees that lenders charge to process, approve and make the mortgage loan. 801. Loan Lender or Broker Buyer - This fee is usually known as a loan origination fee Origination but sometimes is called a “point” or “points.” It covers the GFE – 1 +/- 2 lender's administrative costs in processing the loan and the costs of commissioned sales people. Often expressed as a percentage of the loan, the fee will vary among lenders. Generally, the buyer pays the fee, unless otherwise negotiated. 802. Loan Lender Buyer/Seller - Also often called "points" or “discount points,” Discount a loan discount is a one-time charge imposed by the lender GFE – N/A or broker to lower the rate at which the lender or broker would otherwise offer the loan to you. Each "point" is equal to one percent of the mortgage amount. 803. Appraisal Fee Appraiser Buyer - This charge pays for an appraisal report made by an GFE-Line 3 appraiser 804. Credit Report Credit Bureau Buyer - This fee covers the cost of a credit report, which Fee – GFE–Line 3 shows your credit history. The lender uses the information in a credit report to help decide whether or not to approve your loan.

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HUD-1 Line/2010 GFE line 805. Lender's Inspection Fee GFE-NA 807. Assumption Fee GFE - NA 808. Mortgage Broker Fee GFE Line 1 +/Line 2

Paid to

Paid By - Description

Lender

Buyer - This charge covers inspections, often of newly constructed housing, made by employees of your lender or by an outside inspector. Lender This is a fee which is charged when a buyer “assumes” or takes over the duty to pay the seller’s existing mortgage loan. Mortgage Broker Buyer/Borrower, Seller, Lender - Often, lenders will not allow brokers to charge an origination fee and will insert the fee as a mortgage broker fee. In some cases, the fee paid to the broker is a yield spread premium and does not come out of the borrower’s funds at all. If this is the case, the fee may show up as P.O.C. – (Paid Outside Closing) 809. Tax Service Tax Service Buyer/Borrower – The Tax Service Contract runs for the life Fee Company of the loan and reports to the lender when real estate taxes GFE Line 3 go past due. This is important because delinquent taxes allow the government to force the sale of the property without the lender’s consent to satisfy back taxes. 810. Flood Flood Service Buyer/Borrower – Also known as a “Flood Zone Certification Company Determination” a flood certification is an independent GFE Line 3 confirmation as to whether a property is in a flood hazard area. If it is, the lender will require Federal Flood Insurance. Section 900. Prepaid Items Required by Lender to Be Paid in Advance: You may be required to prepaycertain items at the time of settlement, such as accrued interest, mortgage insurance premiums and hazard insurance premiums. 901. Interest Lender Borrower – Also known as per diem interest, this is the proGFE Line 10 rated amount of interest from the date of closing until regular principal and interest payments begin to accrue under the terms of the note. 902. Mortgage Lender - Mortgage Borrower – Lenders require that the first year’s private Insurance Insurer mortgage insurance premium or FHA Mortgage Insurance Premium Premium, be paid in advance. Even if the premium will be GFE Line 9 financed, it will still appear as a charge here – the increased loan proceeds cover the cost. 903. Hazard Hazard Insurance Buyer/Borrower - Hazard insurance protects against loss Insurance Company due to fire, windstorm, and natural hazards. Lenders often Premium require the borrower to bring a paid-up first year’s policy to GFE Line 11 the settlement or to pay for the first year's premium at settlement. 904. Flood FEMA Buyer – If the flood certification indicates a flood hazard, the Insurance GFE-11 lender will require flood insurance. 1000. Section - RESERVES DEPOSITED WITH LENDER – GFE Line 9 1001. Hazard Insurer or Buyer – Lines 1000 – 1008 are Escrow Account Deposits. Insurance Municipality These lines identify the payment of taxes and/or insurance 1002. Mortgage Collected by and other items that must be made at settlement to set up insurance Lender an escrow account. The lender is not allowed to exceed a 1003. City property cushion of 2 months. taxes 1004. County property taxes Section 1100. Title Charges: Title charges may cover a variety of services performed by title companies and others to conduct the closing. These costs for these services/items may vary widely from provider to provider. – GFE ALL Included in Line 4, Except Owner’s Title Insurance, Line 5

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HUD-1 Line/2010 GFE line 1101. Settlement or Closing Fee 1102-1104 Abstract of Title Search, Title Examination, Title Insurance Binder 1105. Document Preparation

Paid to

Paid By - Description

Title, Escrow Company or Attorney Title, Escrow Company or Attorney

This fee is paid to the settlement agent or escrow company. Responsibility for payment of this fee should be negotiated between the seller and the buyer. The charges on these lines cover the costs of the title search and examination, so that the closing agent can perfect the clear title for the property.

Title, Escrow Company or Attorney Title, Escrow Company or Attorney Title, Escrow Company or Attorney

This is a separate fee to cover the costs of preparation of final legal papers, such as a settlement statement, mortgage, deed of trust, note, transfer or deed 1106. Notary Fee A Notary Public takes oaths and, in the case of the real estate closing, attests to the fact that the persons named in the documents did, in fact, sign them. 1107. Attorney's An attorney is traditionally required to review any drafting of Fees legal documents. Since most loan documents are preprinted forms, an attorney may not be required for the closing. Attorney’s fees are, however, compensable settlement services. Occasionally, a vendor may place their Closing or Escrow fee here. 1108. Title Title, Escrow Lender’s Title Insurance covering the loan amount, is a Insurance Company or normal a requirement of a lender. Owner’s title insurance, Attorney which insures the owner’s equity based on the sales price less the loan amount, is not. The charge is variable based on the size of the policy. Section 1200. Government Recording and Transfer Charges 1201. Recording Jurisdiction Buyer/Borrower- The fees for accepting for record the new Fee GFE – line 7 Courthouse deed and mortgage/trust. Normally a per page charge. 1202 and 1203. State/Local Buyer/Seller/Borrower - Transfer taxes may be collected Transfer Taxes, Government whenever property changes hands or a mortgage loan is Tax Stamps made. These are taxes on the transaction and are set by GFE line 8 state and/or local governments. These may be referred to as tax stamps, recording stamps, recording taxes or other names. Section 1300. Additional Settlement Charges: 1301. Survey Surveyor Buyer/Borrower – Technically part of the title insurance, a GFE line 6 survey examines whether any property line violations exist that could impact the marketability of the title. 1302. Pest and Inspection Termite or Wood Destroying Pest Inspections assure there Other Inspections Company is no active infestation or damage. Well/Septic for non GFE Line 6 public water/sewer property. Final Completion for new construction or repairs.

The Disclosure of Yield Spread Premiums (YSP) Originator Compensation used to be disclosed as Yield Spread Premium. This amount can be used to pay the originator’s compensation, or to offset the borrower’s closing costs. Whatever you call it, this represents a payment that a lender makes to a mortgage broker or correspondent when the broker originates a mortgage loan with an interest rate above the market rate or “par rate.” The amount the lender pays to the broker is based on the difference between the interest rate and the par rate. Depending on the fee structure of the transaction, the YSP may represent

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either the originator’s entire commission (above par), a portion of the originator’s commission (above par plus origination fee), or none of the commission (origination fee only). A higher interest rate results in a higher YSP. YSP disclosure is at the crux of RESPA reform. If a borrower does not understand that the originator’s compensation is affected by the interest rate of the loan, he or she will not pay attention to how that compensation might change the loan program recommendation he or she receives. The Debate over Interest Rate Premiums To understand why yield spread premium disclosure issues are so hotly debated, you must first understand how the broker of business works and why it is different from direct lending. To the uneducated borrower, on the surface there is very little difference between a direct retail lender and a mortgage broker. They take loan applications, process loan applications, and discuss the same products. This is where the similarities end. The way different types of mortgage businesses operate is a function of the funding mechanism, or the way that loans are sold. Preparing the “Adjusted Origination Charge” Section of the 2010 GFE Originator compensation disclosure represents the biggest single change in business process created by this reform. The problems described can be attributed to borrowers not understanding the impact of originator compensation on the program choices the borrower receives in counseling discussions. There are three scenarios (four, if you include borrower paid closing costs, above and beyond originator commission as in a “Zero Closing Cost” transaction).

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Figure 8 - This example illustrates proper completion of the Origination Charge when the borrower pays the originator.

Figure 7 - This example shows the completion of the disclosure when the origination charge is paid from YSP

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Figure 9 - This example shows the Origination Charge calculation when the borrower pays discount fees in addition to the originator compensation.

RESPA Reform and the Impact on Originator Compensation On November 12, 2008, the U.S. Department of Housing and Urban Development (HUD) announced the publication of its long-anticipated final rule amending the Real Estate Settlement Procedures Act's (RESPA) implementing Regulation X. The final rule is intended to protect consumers from "unnecessarily high settlement costs" by improving disclosures and making it easier for consumers to comparison shop. The Good Faith Estimate (GFE) and Settlement StatementHUD-1/HUD-1A

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The new forms facilitate comparing the initial GFE and final settlement statement at closing to ensure compliance with limitations restricting the differences between estimated and actual costs for settlement services. The Good Faith Estimate, Itemization, and Broker Compensation Many industry observers see the inclusion of guaranteed loan terms, a mandated loan shopping process, and a federal requirement for early disclosure of actual costs as the most troubling development in this legislation. However, disclosure of originator compensation represents a much more fundamental change in the way we conduct business. A second major change - aggregating related costs paid to one provider charge – puts service providers on the hook for exactly what their services cost and requires everyone to negotiate an exact fee in advance. The new GFE requires inclusion of yield spread premiums in the "origination charge" and treats lender payments to mortgage brokers as a credit towards settlement charges. Fee Categorization – Eliminating Death by 1,000 Cuts The most condemning evidence of the ineffectiveness of the legacy GFE was the multiple surveys indicating at least 80% of borrowers receiving one did not understand what it said. More importantly, the fact that there was no accountability for changes between the initial GFE and the final charges shown on the HUD-1 made the initial disclosure meaningless in the hands of unscrupulous originators. The legacy GFE is an itemized list allowing nearly unlimited variations in charges. The intent of detailed itemization was to provide transparency, but has led to abuse and the effect of adding more charges, as opposed to limiting the costs. The new GFE causes providers to aggregate the fees paid to one provider. In other words, the lender can’t charge 15 different fees, but must aggregate all charges into one “origination fee”. Title companies must provide the same simplification, aggregating all charges into one “settlement fee”. Title insurance premiums are broken out as to the difference between mandatory lender’s and optional owner’s policies. Chapter 12 – The Real Estate Settlement Procedures Act - Page 238


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Limits on changes –The Issue of Tolerance One of the most frequent complaints regarding closing costs has been the arbitrary changes made by originators between the time of application and the time of closing. Originators have long relied on the fact that a Good Faith Estimate is exactly that – an estimate. This reform changes that. Fees are simplified – aggregated by service provider – and, depending on whether the provider is selected by the lender or not, the fee may not change from the initial estimate. Can/Cannot Change Cannot Change

Cannot Change by more than 10%

Controlled by Lender Origination & Discount Discount (Processing, Document Preparation, Inspection, Underwriting, Wire Transfer, Commitment Fees) All abolished Appraisal Credit Report Flood Certification Tax Service

Can Change – If not required by lender

Controlled by 3rd Party Transfer and Recordation Taxes

Title Insurance Tile Services – (Document Preparation, Payoffs, Notary Fees, Payoffs, Title Commitment Fees, Binder Fee) all abolished Survey Pest Inspection Well & Septic Recording Fees Title Insurance Title Services Survey Pest Inspection Well & Septic Recording Fees

Tolerance for Variances HUD considered a 10 percent tolerance reasonable. The final rule provides flexibility to originators by allowing them to provide a revised GFE when circumstances necessitate changes. The rule is intended to only prevent increases in the originator’s charges that are made in “bad faith.” “Good faith” means that, once you have quoted a price in writing for your own services, you can’t change them without cause. Transfer taxes should be known at the time the GFE is provided, so are subject to a zero tolerance. Changes in the tax rates or in the price of the property after a GFE is provided would constitute changed circumstances. HUD is trying to prevent originators from providing “low-ball” estimates of transfer taxes that could mislead prospective borrowers. Government recording charges may not be known with any certainty at application. These charges are included with third party charges and are subject to the10 percent limit.

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The final rule provides loan originators with the opportunity to cure violations by reimbursing the borrower any amount over the tolerances. Reimbursement must be made at settlement, or within 30 calendar days after settlement. In most cases violations will be identified at or before settlement when comparing HUD-1 form with the charges on the GFE. Circumstances in Which the GFE Can Be Revised Market price fluctuations are not changed circumstances. If an appraiser raises its prices by $50, that is not an unforeseeable circumstance. New information affecting the borrower’s credit quality or a change in the loan amount fall within the types of “changed circumstances.” If underwriting and verification show that a borrower’s monthly income is different from the income relied on in providing the original GFE resulting in a change in the borrower’s eligibility, the loan originator would no longer be bound by the original GFE. Conversely, if the borrower’s total assets are not materially different from what was stated at application, then the borrower’s assets may not be used as a basis for providing a revised GFE. HUD is mindful of the potential for abuse. Unscrupulous originators might seek to avoid providing a reliable GFE by claiming not to have relied on information provided by the prospective borrower. In order to discourage this you cannot issue a revised GFE based on information collected from the borrower prior to providing a GFE. A revised GFE may be provided if a borrower requests changes in the loan product, such as changing from a 30-year term to a 15-year term, or from a fixed-rate mortgage to an adjustable rate mortgage. In new construction the original GFE is provided long before settlement. In this case a revised GFE may be provided at any time up until 60 calendar days prior to closing. Whenever a GFE is modified, records regarding the reasons must be maintained for 3 years. Single Application Process – Timing and Requirements for Delivery of GFE HUD has adopted a single application process. At the time of application, the loan originator must decide what application information is needed from a borrower, and which of that collected application information it will use to issue a meaningful GFE. Before providing the GFE, it is assumed that the loan originator will collect at least the following six items of information:      

Applicant name, Social Security Number (to obtain credit report) Gross monthly income; property address; estimate of the value of the property or Sales Prince; Loan Amount and the amount of the mortgage loan

The final rule now defines “application” to include at least these six items of information. A loan originator may ask for, or a borrower may choose to submit, more information than the GFE ap-

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plication provides. In order to prevent over-burdensome documentation demands on mortgage applicants, and to facilitate shopping, the final rule specifically prohibits the loan originator from requiring an applicant to submit supplemental documentation simply to receive a GFE. Loan originators can obtain any information they need to after the GFE process. They can also independently verify any aspect of an application. Once the applicant provides the initial 6 items, the originator has 3 business days to deliver or mail the GFE. The fee for delivery is limited to the cost of the credit report, but once the applicant has received the GFE, the lender may request additional fees needed to proceed. Understanding “Changed Circumstances” The intent of the new GFE regulation is to require a FIRM cost estimate. Once issued a GFE cannot change unless there are “changed circumstances.” This eliminates the “bait and switch”. The original information cannot be a basis for the change, unless it is later found inaccurate. If there is a changed circumstance, then it can only change that aspect of the costs that it affects; i.e.: title problem > title insurance or credit score > interest rate. Any changes have to be issued within 3 business days of discovery – by whoever discovers the change. The lender or broker can revise the GFE, so communication is crucial. Retain documents that relate to the change for 3 years. Not Changed Circumstances Any accurate information provided prior to GFE borrower Broker issued GFE inconsistent with wholesaler’s No property address at application Broker changes from one investor to another Market changes

Maybe, depending

Yes

Borrower delays closing Original vendor goes out of business

Acts of God, war, disaster, emergency Borrower changed: credit quality, loan amount, property value New information MIP/PMI factors changed Credit policy/Regulatory change Incorrect legal address initially supplied Undisclosed title or property issues Borrower changes occupancy status Borrower selects POA closing AVM – “No hit” Credit score change

Fees For Shopping – Charges Limited To Cost Of Credit Report The most that an originator can charge for providing a GFE, is the cost of the credit report it must obtain to provide a meaningful GFE. The hole in the picture - Locking in Settlement Costs – Finite Time Periods Ironically, HUD is not requiring the interest rate to be available for any specific length of time. This is because requiring GFEs to be open for too long a shopping period will unintentionally increase borrower costs. The interest rate stated on the GFE must only be available until the date set by the originator. Where an interest rate lock has expired, all interest rate-dependent charges on the GFE are subject to change.

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Although the GFE rate period is not set, the estimate for all other settlement charges and loan terms must be available for 10 business days The Tradeoff Table – Consumer’s Most Useful Tool Full completion of the comparison table is optional. Loan originators are required to complete the left column describes the subject loan, but may not have to complete the middle and right columns. That said, HUD encourages loan originators to complete the tradeoff table. Consumers found the tradeoff table to be one of the most useful and informative aspects of the GFE. The tradeoff table helps borrowers better understand the charge or credit (points) for the specific interest rate relative to what other loans may be available. There has been confusion over “otherwise identical” loans. The loan originator only has to disclose loans the borrower would qualify for. Only compare pricing options – rate and point tradeoffs – not loans with different loan amount, number and schedule of payments, term of adjustment, index or margin for any ARM, prepayment penalty or a balloon features. You don’t have to include a no cost loan in the comparison. “No Cost Loans”

A “No Cost Loan” (lender/broker paid cost) is where the origination charge in Box 1 or the credit shown in Box 2 of the GFE offset the total of other settlement service charges in Boxes 3 through 11. With a No Cost Loan, the originator has to complete the tradeoff table by showing the same loan amount with borrower paid costs as a first alternative to the GFE loan, and the

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same loan with a higher interest rate and negative closing costs as a second alternative. The purpose of the GFE tradeoff table is to ensure that borrowers understand there is a trade off between interest rates and settlement costs. Lender v. Broker Fees One of the biggest disputes over the changes in the GFE were levied by mortgage brokers who stated that lenders were not required to disclose yield spreads and other fees “packed” into funding costs and not itemized to the borrower. It may be a small concession, but a Lender disclosure on the revised form informs the borrower that some lenders may sell the loan after settlement and any fees received by the lender for selling the loan cannot change the borrower’s loan or the charges paid by the borrower at settlement. Inadvertent Errors May be Corrected Within 30 days Errors are inevitable when handling large numbers of complex transactions Inadvertent or technical errors in completing the HUD-1/1A are not a violation. Broker Compensation The requirement that a broker disclose yield spread has been in effect since 1992. Previously YSPs on the GFE and HUD-1 were shown as “payment outside closing” or “POC.” This means of disclosure has proved to be of little use to consumers. Lender payments to brokers are based on the rate of the borrower’s loan, and under previous HUD guidance these payments were not included in the calculation of the broker’s total charges for the transaction, or listed as an expense to the borrower. Many brokers hold themselves out as shopping among various funding sources for the best loan for the borrower, while failing to explain to the borrower that the payment they receive from the lender is derived from the borrower’s interest rate. While some brokers tell customers how they can use lender payments to lower the customer’s upfront settlement costs, others do not. While rate-based payments to mortgage brokers must be clearly disclosed to borrowers, mortgage brokers must not be disadvantaged in the marketplace. Many mortgage brokers offer products that are competitive with and frequently lower priced than the products of retail lenders. The most difficult aspect of testing actual transactions is finding loan originators (both brokers and lenders) willing to develop and test a form that is designed to improve consumer understanding in actual transactions and thereby reduce the originators’ information advantage and market power in those transactions. Testing that did not include the YSP disclosure found that consumers did not understand the existence of the tradeoff between interest rates and origination charges. Helping consumers understand this tradeoff is a fundamental goal of HUD’s RESPA reform effort and of the design of the GFE form.

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Mortgage Brokers Defined HUD has determined to revise the definition of “mortgage broker.” While HUD recognizes that mortgage lenders are functionally different from mortgage brokers, an exclusive agent of a lender who is not an employee of a lender, but who renders origination services and serves as an intermediary between the lender and the borrower, is essentially acting as a mortgage broker, and will be subject to the mortgage broker disclosure requirements.

HUD – 1 Revision Comparability Without accountability no originator would feel compelled to accurately complete the 2010 GFE. In order to facilitate the enforcement of the “firm cost estimate” function of the GFE HUD has developed a GFE comparison page attachment to the HUD-1 Settlement Statement. This allows the customer to compare charges directly with the aid of the individual who prepared the final settlement statement. The 2010 HUD-1, varies only slightly from the original two page legacy HUD-1. It has lines and numbers that reflect all the charges from the various service providers. In order to limit unnecessary itemization of the component parts of the charge for title services, administrative and processing services related to title services must be included at line 1101 with the overall charge for title services. Because the final rule more clearly specifies the extent of itemization permitted, HUD has determined that it is no longer necessary to define “primary title services” as a particular set of title services.

Figure 10 - Page 3 of the Revised HUD-1 is a tool that compares actual closing costs to the Good Faith Estimate.

The final HUD-1 includes a designated line for owner’s title insurance at line 1103, from GFE Block 5. HUD has determined to retain the designated lines for the agent’s portion of the total title insurance premium (Line 1107) and the underwriter’s portion of the total title insurance premium (Line 1108).

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The third page to the HUD-1 includes a chart comparing the amounts listed for particular settlement costs on the GFE with the total costs listed for those charges on the HUD-1. Average Cost Pricing and Negotiated Discounts – Kickback Violations RESPA strives for regulatory scheme that fosters mortgage settlement pricing mechanisms that “result in greater competition and lower costs to consumers”. Obviously, a regulatory change that explicitly allows negotiated discounts, including volume based discounts, between loan originators and other settlement service is important. But the changes are not being implemented yet. Discounts negotiated between loan originators and other settlement service providers where the discount is ultimately passed on to the borrower in full, is not, a violation of Section 8 of RESPA. Methodology for Average Cost Pricing The idea behind the “average cost” pricing mechanism was not to prevent the up-selling of individual settlement cost components. It was not intended to limit the amounts charged for settlement services. It was like a “shop cost” for various smaller charges included. In other words, if you spend .25 on a photocopy and you have to copy, on average, 100 sheets of paper, you could charge $25 for copying, instead of itemizing 97 copies at .25 on one transaction and 105 copies on another. It is simply an alternative means of calculating and disclosing settlement charges on the HUD-1. An average charge may be used for any settlement service, provided that the total amounts received from borrowers for that service for a particular class of transactions do not exceed the total amounts paid to the providers. AFBA – No Required Use Economic disincentives that are used to improperly influence a consumer’s choices are as problematic under RESPA as are incentives that are not true discounts. HUD does not interpret RESPA as preventing a settlement service provider or anyone else from offering a discount directly to the consumer. However, tying such a discount to the use of an affiliated settlement service provider is a violation unless the costs of using those businesses are lower than the costs associated with similar services from other providers. Providers can offer " a combination of bona fide settlement services at a total price (net of the value of the associated discount, rebate, or other economic incentive) lower than the sum of the market prices of the individual settlement services as long as: (1) the use of any such combination is optional to the purchaser; and (2) the lower price for the combination is not made up by higher costs elsewhere in the settlement process."

Transfer of Servicing and Servicing Practices Act As with the Good Faith Estimate, the lender must deliver at application, or within 3 business days of application, a statement from the lender telling them that their loan servicing may be

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transferred to another lender. The Transfer of Servicing disclosure describes the percentage of loans the lender currently intends to sell – from 0-25%, 25-50%, 50-75%, or 75-100%. Prior to the enactment of the Servicing Transfer Practices act, borrowers would routinely receive notices from a new lender that their loan had been sold. The consequences of these unannounced servicing transfers created one of the most unpopular aspects of the mortgage business – dealing with the problems having changes in the loan servicer.      

Payments applied to the old loan and not the new loan Lost or missing payments to the new lender Being required to pay large lump sum amounts to correct escrow shortages No accounting for different escrow practices Late payment charges Late payments reported to credit bureaus

The Servicing Practices Act changed several aspects of the industry to protect consumers, dictating how loan transfers are to be conducted and mandating proper management of escrow accounts. Transfer of Servicing When the servicing of a loan is sold the borrower must be notified 15 days prior to a servicing transfer by both the selling and purchasing lender. This verifies the process and assures borrowers are not being fraudulently advised to remit their payments to a non-existent lender. Because many borrowers cannot make changes in their financial arrangements on such short notice, the law requires that borrowers cannot be penalized by the servicing transfer. Late payment charges may not be levied within 60 days of the transfer, nor can the borrower be reported late to the credit bureau. This information is set forth in the Transfer of Servicing Disclosure. Penalties for Violations Section 6 of RESPA, the Transfer of Servicing Act, allows consumers to file individual or class actions against loan Servicers for RESPA violations. In individual actions loan Servicers may be liable for damages up to $10,000. In class actions damages may not exceed $1000 for each member of the class and total damages may not exceed $500,000 or 1 percent of the net worth of the Servicer. Violations of Section 6 of RESPA, including violations regarding disclosure requirements and issues relating to escrow amounts, should be addressed in writing to the loan servicer, outlining the nature of the complaint. The loan servicer has 20 days to respond to the complaint and must resolve it within 60 days. Civil actions for violations must be reviewed within three years. Servicing Transfer Disclosure

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Notice to Borrower – The borrower must receive written notice from both the transferring and purchasing lender 15 days prior to the transfer date.

Late Charges and Late Reporting – The borrower cannot be assessed a late fee and cannot be reported as late for the first 60 days following the loan transfer

Complaint Resolution – Borrowers must receive a written acknowledgement of a complaint within 20 days of the complaint and a resolution within 60 days.

Figure 11 - The Servicing Transfer Disclosure informs the borrower of his or her rights in the event a lender sells the servicing rights to a loan.

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Notice to Borrower – The lender must provide the borrower with the history of loan transfer, and advise the borrower of its past practices regarding servicing transfers.

Aggregate Escrow Accounting Servicing transfer practices mandates that the borrower receive an escrow analysis at the time of closing, at least annually thereafter, and at the time the loan is sold. Prohibition against Excessive Escrow The borrower’s escrow accounts can never include more than a 2 month cushion (plus one current month) for real estate taxes and insurance. For the period between the last charge and the first mortgage payment, a lender cannot require a borrower to deposit more in an escrow account than is needed to pay the assessments when they come due. Section 10 of RESPA provides special protections for escrow accounts. Failure to submit initial or annual escrow statement can result if a civil penalty of $55 with a $1,000,000 limitation on the penalty for any one loan servicer.

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Aggregate Escrow Accounting Disclosure

The lender makes projections as to assessments coming due in the future. The lender must collect enough at closing, along with regular monthly payments, to pay the assessment when it comes due.

The lender identifies a “cushion” to make up for short term shortfalls in the account such as late payments and increases in the amount of the assessments.

Figure 12 - The Aggregate Escrow Disclosure shows the calculations that the lender used to arrive at a maximum "cushion" in the escrow account.

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At the settlement, or within 45 days, the lender must provide an Initial Escrow Statement showing all charges that the borrower will pay from the escrow fund during the first 12 months of the

The first page of the HUD-1 is a summary of the transaction. On a refinance, there is no seller, so this side may often be omitted.

The borrower Can be confused about the “costs” of a transaction because the cash requirement is affected by items the borrower has to “pay back” to the seller.

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loan. For each year the loan servicer must provide the borrower with an Annual Escrow Statement.

Closing Costs and the HUD-1 Settlement Statement The borrower is entitled to review the HUD-1 Settlement Statement 24 in advance of closing, pursuant to the Real Estate Settlement Procedures Act. The HUD-1 should be the final version of the fees that were initially estimated on the Good Faith Estimate. It is at the closing that questions may be raised about the disparity of fees disclosed on the Good Faith Estimate and the total charges on the settlement statement. Of course, no one is concerned when the fees are lower than estimated. When they are higher, however, there is usually a panicked call to the loan officer to explain. Obviously the good faith estimate is just that - an estimate. Isolating the lender's charges from the overall closing costs can often defuse a situation where a borrower is attributing the higher number to variances in the closing costs. HUD-1 Settlement Statement lists the exact costs of closing and is the final accounting of the transaction. Much confusion exists regarding disparities between the initial Good Faith Estimate of closing costs and the final accounting given on the HUD-1. Understanding the structure of the HUD-1 document can alleviate misunderstandings on the part of the borrower. A two page document, the first page of the HUD-1 summarizes the transaction and the pro-rated charges between the seller and buyer. The second page of the document lists all the charges paid to all parties. The borrower often misapprehends that the charges are all paid to the lender. A properly explained HUD-1 will allow the borrower to see that the charges are paid to many different vendors. Fees not shown on Good Faith Estimate that may appear on HUD-1       

Pro-rated Condo Fees New Construction Assessments/Partial Levy Termite Treatment Reimbursement of Seller Paid Real Estate Taxes More Days of Per Diem Interest Optional Owner's Title Insurance Purchased Refinance - Most recent payment not accounted for in Payoff

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Section 800 itemizes loan fees and charges payable to lenders. It is here that brokers must disclose fees received from lenders, such as Yield Spread or Servicing Release premiums

Section 900 and 1000 itemizes prepaid items and escrow items. Items that are prorated between seller and buyer are on page 1

Figure 13 - Page 1 of the HUD-1 Settlement Statement is virtually unchanged from previous versions.

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Chapter 13 - Truth-InLending Act – “Regulation Z” Introduction One of the most misunderstood regulations in the mortgage business is the Truth-in-Lending Act. It is a critically important law for lenders because it relates specifically to disclosing the costs of credit and rules that protect consumers when they borrow using a home as collateral. Since it is a Federal law, states that have lending laws use the Federal rules governing extension of credit as the basis for their laws. Truth- in-Lending regulation has a noble purpose. It is designed to allow the borrower to comparison shop loan fees and the cost of credit over all. Unlike the good faith estimate which discloses the entire transaction’s cost, Truth-in-Lending (TIL) deals with the cost of the loan only. Regulation

Applies to

Documentation Required

Truth-inLending Act

Application/ Closing Application

APR Disclosure

TILA Regulation Z Federal Reserve Board Federal Trade Commission

Business Practices Closing Application/ Closing

ARM Disclosure “Consumer Handbook on Adjustable Rate Mortgages” (CHARM Booklet) “When your Home is on the Line” Advertising Originator Compensation Right of Rescission Final APR Disclosure Home Ownership Equity Protection Act (Section 32 – High Cost Loans) Disclosure and Truth in Lending.

Purposes of Truth-in-Lending Act   

To protect consumers by disclosing the costs and terms of credit; To create uniform standards for stating the cost of credit, thereby encouraging consumers to compare the costs of loans offered by different creditors; and To ensure that advertising for credit is truthful and not misleading.

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The Federal Reserve The Board of Governors for the Federal Reserve is the federal agency responsible for issuing implementing regulation (Regulation Z) for TILA and the Federal Trade Commission (“FTC”) is responsible for enforcing the law and the regulations. The Federal Reserve (the “FED”) is the nation’s central bank. The Federal Reserve was established in 1913 when President Woodrow Wilson signed the Federal Reserve Act. Its direct impact on our industry lies in its influence over the availability and cost of money and interest rates. The Federal Reserve is composed of 12 Federal Reserve Districts. A District Federal Reserve Bank serves each District. The Federal Reserve Banks are not under the control of any governmental agency, but each reserve bank is responsible to a board of directors. All nationally chartered commercial banks must join the Federal Reserve. One of the Federal Reserve’s functions is to supervise and regulate member banks. One way The Federal Reserve supervises and regulates member banks is by expanding and contracting its reserve requirements. Each member bank is required to keep reserves, equal to a specified percentage of the bank’s total deposits, with its Federal District Bank. By raising or lowering the reserve requirements, the Federal Reserve can increase or decrease the amount of money banks have available to lend. As money becomes more scarce interest rates increase. The Federal Reserve also controls interest rates by raising and lowering the discount rate, which is the rate at which banks may borrow funds from their District Federal Reserve. While this is not the only source of funds banks use for their lending, it is a benchmark of what the Fed would like to see happen to interest rates. It is not unusual to see banks set their prime rate, the rate they charge their most credit worthy borrowers, based on what the Fed discount rate is. The Federal Reserve also lends money to its member banks without requiring any collateral. These are short-term, often-overnight loans. The rate of interest charged for these loans is called the Federal Reserve Rate. Like the discount rate, the Federal Reserve Rate is another benchmark against which the banks can base the interest rates they charge to their customers. The Federal Reserve uses its open-market operations to control and influence the supply of money in the economy. These operations consist of the purchase or sale of government securities. Its Open-Market Committee - known as the FOMC - directs the Federal Reserve’s open-market operations. When the FOMC decides to buy or sell securities, it adds or removes money from the economy, accelerating or slowing growth. The Federal Reserve has a regulatory function. It is responsible for supervising the Truth-inLending Act, The Home Mortgage Disclosure Act and the Community Reinvestment Act. Creditors Regulated by TIL

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Truth-in-Lending is a consumer protection law. As a result, the primary target of the reg- A lender is regulated if it ulation is any transaction that involves indiOffers or extends credit to consumers vidual borrowers who are borrowing for per- Regularly offers or extends credit sonal, not business, purposes. As individuals Offers credit that is subject to finance charge or businesses that offer and extend credit, Offers credit primarily for personal, family, or lenders are creditors within the meaning of household use TILA. Mortgage brokers are creditors under TILA as individuals or businesses that offer credit. “Credit” is defined under TILA as “…the right granted by a creditor to a debtor to defer payment of debt or to incur debt and defer its payment.” The broad definition of “credit” extends to a large number of transactions, including mortgage loans. Transactions NOT Subject to TIL An extension of credit for business, agricultural, or commercial use Credit over $25,000 that is not secured by real property or a dwelling Public utility credit Securities or commodities accounts Student loan programs

Disclosures - At Application - The APR (Annual Percentage Rate) Disclosure Many mortgage personnel erroneously believe that the Good Faith Estimate of Closing Costs (GFE) and TIL disclosure is part of the same regulation. They are not. Drawing the distinction between closing costs and loan costs can help the borrower understand the difference in these laws. Like the GFE, the TIL disclosure must be given at the time of application. If not given at the time of application, the lender has three business days from the date of application to DELIVER the disclosure to the borrower. The borrower does not have to acknowledge receipt of the disclosure; the lender must certify they have sent it. The APR disclosure is a document that is the source of much confusion on the part of lenders and the home buying public. Much of this confusion stems from the fact that Annual Percentage Rate sounds a lot like “interest rate” to most borrowers. The primary issue is that the APR isn’t the contract or note interest rate, but the cost of credit expressed as an “effective” percentage rate. The APR equation includes the contract interest rate and adds the costs of the loan (NOT the closing costs). The APR equation has nothing to do with whether the costs are financed into the new loan or not. Understanding Truth-in-Lending

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To understand the Truth-in-Lending disclosure (TIL), start with the concept that it is only a theoretical measure of the cost of credit. For example: If you borrow $100, but there is a $1 charge for the loan, then you really have only received $99 in usable cash. However, you will still make

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payments on the loan based upon the $100 principal balance. The TIL determines what the theoretical rate on the loan is considering the fact that there was a fee due to make the loan - that is the APR. The $1 in this example is a “prepaid finance charge”.

APR (Annual Percentage Rate) The cost of your credit as a yearly rate.

FINANCE CHARGE The dollar amount the credit will cost you.

AMOUNT FINANCED The amount of credit provided to you on your behalf.

TOTAL OF PAYMENTS The amount you will have paid after you have made all payments as scheduled. 

% $ $ $ 1.) Compute total of payments by multiplying payment schedule, including PMI by amount of payments 2.) Amount Financed is the loan amount, less points, prepaid interest, PMI, and lender fees. 3.) Finance Charge is the Total of Payments less the Amount Financed 4.) Compute the APR by dividing the Total of Payments by the number of payments and apply that against the Amount Financed, as if it were the loan amount. (See Page 116 – Keystrokes)

Calculating the APR Formula Being able to prepare a TIL for a customer would illustrate the calculation, but this is rarely practical. As in the $100 illustration, the first step in determining APR is to subtract the prepaid finance charges from the loan amount. The result is the “Amount Financed.” Then the full principal and interest payment (including PMI) is applied against the “Amount Financed” as if it were the loan amount. The resulting interest rate is the APR. There are some nuances. Keystrokes to Compute the APR for a Fixed Rate Loan Enter Loan Amount Enter Interest Rate Enter Term Compute Payment Compute Prepaid Finance Charge Subtract from Loan Enter Result as PV Compute Interest Multiply by 12 for APR

100000 7.75% 360 CPT 1836 100000 98164 CPT 0.662%

PV "I%"/12 N PMT 1836 PV "I%" x 12

100000 0.646% 360 $716.41 98164 0.662% 7.943%

Figure 14 - Using any RPN financial calculator to illustrate the calculation can aid in explaining APR to consumers.

Determining the Amount Financed - What are Finance Charges? Everything that one must pay for in exchange for obtaining a loan (charges you wouldn’t incur if you were paying cash for the property) is considered a prepaid finance charge. This includes loan fees such as discount points, origination fees, private mortgage insurance; miscellaneous

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fees such as tax service, underwriting, document preparation, and lender review fees. In addition, prepaid items such as per diem interest and escrows for PMI or prepaid PMI, FHA upfront MIP, and the VA funding fee are considered finance charges. Interestingly, appraisal fees, credit reports, termite reports and other inspections such as completion inspections (except for construction loan draw inspections), well and septic inspections that are required by lenders are not considered finance charges. Fees for recording a deed of trust aren’t included either. These are excluded from the amount-financed calculation because a buyer or borrower would incur them regardless of whether a loan was involved. Appraisal and credit report fees are "passed through" to service providers. Calculating the Finance Charge Costs included in the finance charge include:   

Charges to a third party, if the creditor requires the use of services offered by a third party or retains a portion of the third party charge. Closing agent charges, if the creditor requires the particular service, requires the charge for the service, or retains a portion of the charge, Fees which a consumer pays to a mortgage broker, even if the creditor does not retain a portion of the charges.

Third Party Fees “Generally” Included in the Finance Charge Regulation Z (12 CFR 226.4(b).) lists the following charges from third parties as examples of fees and amounts which the creditor may include when calculating the finance charge:          

Interest, time price differential, and any amount payable under an add-on or discount system of additional charge Service, transaction, activity, and carrying charges Points, loan fees, assumption fees, finder's fees (paid to licensed mortgage brokers), and similar charges Appraisal, investigation, and credit report fees – if performed by the lender or lenders affiliate Premiums on insurance protecting the creditor against the consumer's default Charges imposed on a creditor by another person for purchasing or accepting a consumer's obligation Premiums or other charges for credit life, accident, health, or loss-of-income insurance, written in connection with a credit transaction. Premiums for homeowner and liability insurance sold by the creditor in connection with a credit transaction Discounts for the purpose of inducing payment by a means other than the use of credit. Debt cancellation fees.

Costs and Fees Which Are “Generally” Not Finance Charges The following types of charges are excluded from the finance charge (12 CFR Section 226.4(c): Chapter 13 – The Truth-in-Lending Act - Page 258


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       

Application fees charged to all applicants for credit Charges for unanticipated late payments, for exceeding a credit limit, or for delinquency Charges imposed by a financial institution for paying items that overdraw an account Fees charged for participation in a credit plan, whether assessed on an annual or other periodic basis Seller's points Interest forfeited as a result of an interest reduction required by law on a time deposit used as security for an extension of credit Real-estate related fees such as fees for title examination, charges for the preparation of loan documents, credit report fees, notary fees, appraisal fees, and amounts paid into escrow, if these fees are bona fide and reasonable Discounts offered to induce payment of a purchase by cash, check, or other means

Insurance and debt cancellation coverage can also be excluded from the finance charge if the coverage is not required by the creditor, the premium for the initial term of insurance is disclosed, and the consumer signs or initials a written request for the insurance. If itemized and disclosed, certain taxes and fees prescribed by law are also excluded from the finance charge. Exceptions to Finance Charge Concept Any item that the borrower does not pay for is not included as a prepaid finance charge. This would be the case when a property seller is contractually obligated to pay the fees, or in a lender funded closing cost situation. In addition, any fee that the borrower is required to pay for the use of an affiliate, or required provider, such as a title company or attorney, is included as a prepaid finance charge. The loan amount, less prepaid finance charges, is the amount financed. The Prepaid Finance Charges are itemized. In this case, the attorney was required by the lender, so the charge is considered a prepaid finance charge.

Figure 15 - Sample Itemization of Amount Financed Disclosure gives the consumer a better idea of the costs that impact the cost of credit

The explanation of the Amount Financed would be much simpler if every loan came with an “itemization of amount financed.”

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Itemization of Amount Financed Payment Schedule The payment schedule is the second half of the APR equation. If you borrow $100 and you have $99 to use, how are you repaying the $100? On a fixed rate loan, the payment schedule is quite simple - the monthly payment is the same through the life of the loan. Variable payments are also a factor when there are changing payments on the loan as in an ARM, Buydown, GEM, or GPM. The payment schedule varies in these situations. To determine the payment amount to apply against the amount financed divide the total of payments by the number of payments and utilize this average payment. PMI is considered a finance charge. The initial PMI premium, MIP or Funding Fee must be considered in the amount financed. If there is money placed in escrow for PMI or MIP, this is considered in the amount financed as well. When the PMI premium changes monthly – it is acceptable to use a range (varies from – to). The APR on ARMs can change, based upon future interest rate changes. Buydowns, GPMs and GEMs have fixed payment schedules, so the APR on these loans will not change. Finance Charge The APR, amount financed and total of payments have been calculated - what is the total finance charge? The difference between the total of payments and the amount financed represents the cumulative total of all interest and prepaid finance charges accrued on the loan. Subtracting the amount financed from the total of payments reveals this number. Program Disclosures - work in tandem with the Truth-in-Lending statement and should be given in conjunction with the TIL. They explain more fully the historical performance of an ARM, when the consumer has applied for one. All programs should have disclosure describing fully how the payment schedule works, whether there is any prepayment penalty, late charges, tax and insurance escrow treatments, due on sale clauses and any other nuances of the program. The "Refund of the Prepaid Finance Charge" - Again terminology can cause confusion between the intended meaning of a phrase and how the consumer interprets it. In the context of the TIL, this applies to prepayment and mortgage insurance. In the event that there is prepaid mortgage insurance, such as the “Up Front FHA MIP”, monthly FHA MIP or traditional prepaid or financed PMI, if the loan is paid off early the consumer may receive the cancellation value of that insurance. Consumers sometimes equate the “Finance Charge” box from the TIL with this statement and assume they will still be obligated for the interest under the loan, even though the loan is paid off. Recording Fees/Security Interest - Even though they are not included in the finance charge, fees to record a deed of trust in the jurisdiction are shown. All mortgages loans are secured by a property, the address of which should be shown.

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Late Charge - Stating what the late payment percentage is, when the payment is considered late, and that it is based on the principal and interest portion of the payment only. Assumption - States whether the loan is assumable. While there are no new unconditionally assumable loans being made institutionally, some loans are assumable with the new borrower's approval by the existing lender. However, even if assumption is allowed, many lenders will change the terms to reflect the current market or disallow the assumption. Insurance – If insurance is required as a pre-condition of the loan approval, the lender must give the terms of the insurance. APR Tolerance At the time of application the borrower receives an Annual Percentage Rate disclosure, also referred to as a “T-I-L”, or APR disclosure. During the process of the loan, if the terms of the loan change, the lender must re-disclose the APR. If the terms do not change, the APR must still be re-disclosed at closing. That FINAL Truth-in-Lending statement must be correct as to the actual loan terms. The margin of error for the final disclosure is referred to as “tolerance”. Loan Type Fixed or ARM

Tolerance 0.125% up or down, for a total of .25%

Errors in Calculating the APR The lender has 60 days to correct errors in the APR. If the borrower signs a final APR disclosure that reflects an APR which is too low, the lender must correct the financial terms of the transaction to reflect the terms which were disclosed to the borrower. The regulations applying to both open-end and closed-end credit address errors in the calculation of the annual percentage rate. The regulations provide that an error is not a violation of the law as long as the violation resulted from “...a corresponding error in a calculation tool used in good faith by the creditor...” and the creditor discontinues use of the tool and advises the Board, in writing, of the error in the tool. 12 CFR Section 226.22(a). In Staff Commentary which it has drafted on Regulation Z, the Board has emphasized that the types of errors which are not likely to lead to liability are those directly attributable to the calculation tool itself, including software programs, and that creditors will not be absolved from liability for errors arising from improper use of the tool, from incorrect data entry, or from misapplication of the law. Using APR to Compare Loan Fee Options Measuring Annual Percentage Rate (APR) allows the borrower to compare the impact of loan fees on monthly payments. One potential disadvantage of using this approach is that the APR is based on payments made “over the life of the loan.” The reality is that many homeowners do not maintain their loan for the entire term. How does the length of time the borrower has the loan impact the actual cost of credit. The following example shows the APR of loans with points and without.

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Disclosures at Application – Adjustable Rate Mortgage Terms If the loan is an Adjustable Rate Mortgage (a Variable Rate Transaction) the borrower must also receive an ARM disclosure at the time of application. The ARM disclosure gives the specific details of how the ARM interest rate can change – how often the rate changes, what the initial and periodic changes are based on (the margin and index) and how much the interest rate can change at the adjustment (caps). The ARM disclosure must provide a specific example of how the interest rate would have changed based on historical examples. Special Disclosures for Variable-Rate Transactions A borrower must receive a loan program disclosure for each variable-rate loan product the borrower is interested in. The disclosures for each product must include:      

Statement that the interest rate, payment, or term of the loan can change. The index formula used to make adjustments. An explanation of how the interest rate is determined. Recommendation that the borrower ask about the current margin value and current interest rate. Notation that the interest rate will be discounted. Frequency of interest rate and payment changes.

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    

Rules relating to index, interest rate and payment amount. An explanation of how to calculate the payments for the loan amount. Reminder that the loan contains a demand feature. Statement of the type of information that will be provided in notices of adjustments. Indication that disclosure forms are available for other variable-rate loan programs.

Figure 16 - The ARM Disclosure Provides information on the basis for interest rate changes, frequency and amount of adjustments.

The creditor also has the option of providing an example, based on a $10,000.00 loan, which shows how changes in the interest rate can affect payments and loan balance. All of these requirements are met in the generic ARM disclosures that are provided in conjunction with the APR disclosure. Creditors must provide these disclosures at the time an application is provided or before the borrower pays a non-refundable fee, whichever is earlier. If a borrower

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makes an application by phone, or through an agent or broker, the creditor must deliver the disclosures, or place them in the mail, three days after receipt of the loan application. Temporary Buydowns and APR Disclosures There is a challenge as it relates to the APR disclosure of temporary buydowns. Because the law doesn’t specifically address Buydowns, many lenders may make the decision not to offer them under the risk of incorrect APR disclosure. Each lender makes its own decision, but under 226.17(c) of Regulation Z, there is general guidance for how buydowns should be displayed. If the buydown subsidy is 100% paid by the borrower or the third party-paid portion is included in the APR one uses the sample for step-rate mortgages/ARMs. Any portion of the Buydown subsidy paid by a third-party is not included in the APR. The payment schedule, however, is disclosed as a fixed rate loan. The Consumer Handbook on Adjustable Rate Mortgages In addition to the ARM disclosure, the borrower must receive The Consumer Handbook on Adjustable Rate Mortgages (“CHARM” Booklet), “or a suitable substitute”, which explains how ARMs work. Home Equity Lines and Open-Ended Credit Closed-end credit is credit that is advanced for a specific time with a fixed schedule of payments. Purchase money mortgages are an example of closed-end credit. Open-end credit is consumer credit that is used repeatedly - the consumer pays a finance charge on the outstanding balance. A home equity line of credit is an example of open-end credit. Open-ended lines of credit, such as home equity lines of credit, require additional disclosures.

Figure 17 - This Consumer Protection Booklet must be given to ARM loan applicants

Open-End Credit is consumer credit that is used repeatedly and is credit on which a consumer pays a finance charge for the outstanding balance. Examples of open-end credit include home equity lines of credit, credit cards issued by banks and revolving charge accounts with retailers, overdraft protection, and personal lines of credit. In the field of mortgage lending, the type of open-end credit which lenders and mortgage brokers are most likely to encounter is a home equity credit line. Therefore, the disclosure requirements discussed below are those specifically related to a home equity loan, and the specific requirements of other types of open-end credit, such as credit cards is not included. Specific Disclosures for Home Equity Lines of Credit Disclosures for open-end credit secured by a consumer’s dwelling must include:

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    

        

A statement that the consumer should retain a copy of the disclosure Identification of disclosed terms that are subject to change before the consumer opens the home equity plan A statement that the consumer can elect not to open a home equity plan and to receive a refund of fees paid in connection with the plan if changes in disclosed terms occur (other than a change due to rate fluctuations in a variable-rate plan) A statement that loss of the consumer’s dwelling can result from failure to repay the loan A statement that, in certain circumstances, a creditor may terminate a home equity plan, require payment of the outstanding balance, impose fees, prohibit further extensions of credit, and implement changes in the plan, and an explanation of the conditions in which the creditor would take such action Payment terms Annual percentage rate An itemization of fees imposed by the creditor when the consumer opens and uses the home equity plan A good faith estimate of fees imposed by third parties, as well as an itemized list of the fees, or a statement that an itemization of the fees is available A statement that negative amortization may occur, which will result in an increase in the principal balance and a reduction equity in the home A statement of any limitations on the number of extensions of credit A recommendation that the consumer consult with a tax advisor regarding the deductibility of interest and charges Information regarding the computation of the annual percentage rate (when the rate is variable) including an historical example which shows how annual percentage rates and payments are affected by a change in the index value A brochure on home equity plans, prepared by The Board’s on home equity plans titled When Your Home is On the Line: What You Should Know About Home Equity Lines of Credit, or a comparable brochure

When Your Home is on the Line The Booklet “When Your Home is on the Line - What You Should Know About Home Equity Lines of Credit” is provided by the Federal Reserve and describes how failure to repay the loan could result in the loss of the consumer’s dwelling. In addition, negative amortization may occur, resulting in an increase in the principal balance and a reduction in equity in the home. The consumer should consult with a tax advisor regarding the deductibility of interest and charges. Notice of Right to Cancel (Right to Rescind)

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Figure 18 - This consumer protection disclosure is given to Home Equity Loan applicants


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Before Congress enacted TILA, consumers could not rescind a lending transaction without facing significant legal hurdles and attorneys fees. Under the common law, a borrower had to return any property which he/she obtained as a result of a lending agreement before the agreement could be considered void. Next, the borrower had to file an action to make the lender return any payments or earnest money and to void any security interest in the borrower’s property. TILA eliminates each of these requirements for the rescission of a contract and simply requires that consumers provide notification of their rescission on a form provided by the lender. Rescission is a legal remedy that voids a contract between two parties, restoring each to the position held prior to the transaction. No right to rescind exists for purchase money mortgages. Home equity credit lines or refinancing of credit already secured by the borrower’s principal dwelling are the types of loans which are subject to a right of rescission. Creditors must provide two copies of the notice of right to rescind on a document that is separate from other disclosures. They must provide each party who has a right to rescind with a copy of the notice. The notice states that there is a security interest in the borrower’s principal dwelling, instructions on how to exercise the right to rescind, including a form with the borrower can use, and stating the creditor’s business address, the date the right of rescission expires. Right to Rescind in Open-end Credit Transactions (HELOCs) In open-end transactions in which the lender has a security interest in the borrower’s principal dwelling, a borrower can exercise his/her right to rescind the transaction when:    

The credit plan is opened Credit extensions (increases) are made under an existing plan A security interest is added or increased to secure an existing plan The credit limit for a plan is increased

Borrowers do not have a right to rescind when advances are made under a previously established credit limit for the plan. Right to Rescind in Closed-end Credit Transactions (Term Loans) In closed-end transactions in which the lender has a security interest in the borrower’s principal dwelling, a borrower can exercise his/her right to rescind the transaction when an initial advance is made in a series of advances that are treated as a single transaction, such as a constructionpermanent loan. A borrower may also rescind a refinance when   

The amount financed exceeds the unpaid principal balance; The amount financed exceeds any earned unpaid finance charge on the existing debt The amount financed exceeds amounts attributed solely to the costs of refinancing of solidation of debt.

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Borrowers do not have a right to rescind closed-end transactions when    

The loan is made to purchase a home Refinancing of credit already secured by the borrower’s principal dwelling when the new loan balance does not exceed the existing loan balance. The lender is a state agency The loan is a construction or multi-advance loan. The initial advance is subject ot the right of rescission.

Notice of Right to Rescind Creditors must provide the notice of right to rescind on a document that is separate from other TILA disclosures. They must also provide each party who has a right to rescind with two copies of the notice. The notice must “clearly and conspicuously” disclose:     

The creditor’s retention or acquisition of a security interest in the borrower’s principal dwelling The borrower’s right to rescind Instructions on how to exercise the right to rescind, including a form which the borrower can use, stating the creditor’s business address The date that the right of rescission expires Disclosure outlining the following effects of rescission for the consumer.

Regulation Z includes model forms which creditors can use to ensure compliance with the requisite form and content of the notice. The regulations instruct creditors to use the model form “...or a substantially similar notice.” 12 CFR Section 226.23 (b)(2). Copies of the model notices are included at the end of this section. The forms include a general notice form and a notice for use in refinances with the original creditor. Effects of Rescission If a consumer exercises the right to rescind a lending transaction, TILA provides that the security interest becomes void and the consumer is not liable for any amount, including any finance charge. Within 20 days, the creditor must return any money or property given in connection with the transaction and must take action to show the termination of the security interest. After the creditor has fulfilled the obligations to return money or property and to terminate the security interest, the consumer must return money or property to the creditor. If the creditor does not take possession of the money or property within 20 days, the consumer may keep it “without further obligation.” Time Limitations for Exercising Right to Rescind

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Consumers have three days to exercise the right to rescind. The three day rescission period lasts for three business days, and the rescission period begins after the occurrence of the latest of one of the following events: • • •

Consummation of the transaction Delivery of the TILA disclosures Delivery of the form for rescission and end on midnight of the third day.

Note that “business days” are defined in the regulations on rescission to include Saturdays. Sundays and legal public holidays are not counted as business days. The three day rescission period ends at midnight on the third day.

Figure 19 - The "Notice of Right to Cancel" is a main feature of the consumer protection aspects of Truth-in-Lending

The lender’s greatest risk is that a borrower does not properly receive a notice of right to cancel. In this case, the borrower continues to have a right to cancel the transaction until the notice is properly given. An extended period of rescission of three years exists if the lender fails to make a material disclosure. Chapter 13 – The Truth-in-Lending Act - Page 268


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Consumer’s Waiver of Right to Rescind Consumers can waive their right to rescind in situations in which credit is needed “...to meet a bona fide personal financial emergency.” 12 CFR Section 226.23(e). In order to waive the right to rescind, the consumer must give the creditor a statement, in writing, which is dated and which describes the emergency, specifically waives the right to rescind, and includes the signatures of all consumers entitled to exercise a right to rescind. The lender may choose not to grant the waiver. There is a risk that the situation posed by the borrower as an emergency may not meet the statutory requirement of a “bona-fide” emergency. Borrowers may be counseled to obtain an attorney’s opinion that the nature of the emergency does meet the requirements of the law.

Advertising and Truth-in-Lending TILA governs the advertising of consumer credit. An advertisement – which is “any offer to extend credit” that states an interest rate must also state an “annual percentage rate”, using the term “APR”. The APR must have the same prominence as the contract interest rate advertised. The act does not require the disclosure of lending terms in an advertisement, but an advertisement may not mislead consumers by promoting the most advantageous terms of a loan while failing to mention other terms that are less attractive. For example, an advertisement cannot offer consumers a loan with “low monthly payments” without also stating the number of payments, the interest rate (expressed as an APR), down payment, monthly payments, and other terms related to the cost of the loan. Regulation of Advertising TILA does not require the disclosure of lending terms in an advertisement for a loan. However, if an advertisement for a loan references any lending terms, compliance with the advertising rules of Regulation Z is mandatory. For example, a lender could advertise: “Home Loans for Every Need: Refinances, New Home Financing, Equity Loans” General advertisements such as these are not subject to requirements. Compliance becomes mandatory with the addition of lending terms to the advertisement such as, “…starting at 3%, no closing fees, no points,”. Regulation Z uses disclosure requirements to protect consumers from misleading advertising. The disclosure requirements of Regulation Z are triggered by the use of certain terms in advertisements. Regulation Z has different “trigger terms” for open-end and closed-end credit, and home equity credit loans.

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Trigger Terms When included in an advertisement, “trigger terms” require the inclusion of additional terms (or disclosures) in an advertisement. The inclusion of Regulation Z disclosures in an advertisement ensures that an advertisement does not mislead consumers by promoting the most advantageous term of a loan while failing to mention other less attractive terms. For example, an advertisement cannot offer consumers a loan with “low monthly payments” without also stating the number of payments, the interest rate (expressed as an APR), and other terms which relate to the actual cost of a loan. The focus on “low monthly payments,” to the exclusion of other terms, places an undue emphasis on this single feature, which may be the only advantageous term of the loan. Additional terms, such as a long period for repayment and a high interest rate, negate the benefit of assuming a loan with low monthly payments and should be fully disclosed to the consumer in the advertisement. Advertising Rules Apply to All Types of Credit Regulation Z does not distinguish between mortgage loans and other types of consumer credit. Some of the “trigger terms” and corresponding disclosure requirements for open-end credit relate primarily to revolving credit (such as credit cards), and other consumer finance options. The trigger terms and requisite disclosures for open-end credit that have particular relevance to mortgage loans are underlined for quick identification. The rules relating to catalogue advertisements and multiple page advertisements are also more relevant to consumer finance products other than mortgage loans. Rules of Advertising for Open-End Credit and Closed-End Credit Only advertise loans that are available. An advertisement that states specific credit terms must only state terms that the creditor will actually offer. Use of trigger terms in an advertisement necessitates the inclusion of additional terms. If the Advertisement States “14%” or “Less than 1 ½ % per month” “Up to 30 days of free credit if you pay in full each month” “Interest will be charged on your average daily balance each month” “Minimum finance charge: 50 cents per month. “There is a $25.00 annual membership fee.”) “10% down” “$210.95 per month”

Advertisement must also include APR or the periodic rate used to compute the finance charge, and a statement, if applicable, that the rate may increase Statement of the time when finance charges begin to accrue The method of determining the balance on which a finance charge is imposed The method of determining the finance charge The amount of charge, other than a finance charge, which may be imposed Amount or percentage of any down payment The number of payments or period of repayment

“30-year mortgages available” The amount of any payment “Financing costs less than $300 per year” The amount of any finance charge Please note that the examples provided in this section are from the FTC’s online publication “How to Advertise Consumer Credit and Lease Terms”

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Catalogue advertisements or multiple page advertisements are treated as a single ad if reference is made to a table that includes the credit terms. An advertisement presented in multiple pages or in a catalog will be considered a single advertisement if it provides the required disclosures in a table or schedule and if any references on other pages of the advertisement “clearly refer” to the table or schedule. Any schedule or table must disclose not only lower-end property or services, but also “the more commonly sold higher-end property or services offered.” Rules of Advertising for Home Equity Loans In addition to the advertising requirements for open-end credit, home equity loans are subject to additional requirements. The requirements apply to home equity loans that are open-end loans secured by a principal residence or a second home. If the Advertisement States “We offer home equity loans for only 8% APR.” “There is no free ride period in this home equity plan.” “We charge interest on your previous balance” “You pay only a dollar when you use your home equity line of credit.” “No annual fees on our super home equity line”

Advertisement must also include The periodic rate used to compute the finance charge or the annual percentage rate Statement of the time when finance charges begin to accrue The method of determining the balance on which a finance charge is imposed The method of determining the finance charge

The amount of charge, other than a finance charge, which may be imposed “Up to 10 years to repay.” The payment terms of the loan Please note that the examples provided in this section are from the FTC’s online publication “How to Advertise Consumer Credit and Lease Terms”

In addition, any of these statements require a disclosure of    

Any loan fee that is a percentage of the credit limit An estimate of other fees for opening that plan, stated in a dollar amount Any periodic rate used to compute the finance charge, expressed as an annual percentage rate The maximum annual percentage rate that may be imposed in a variable rate plan

The Challenge of Compliance With differences between the “trigger terms” and mandatory advertising disclosures for closedend credit, open-end credit, and home equity loans, confusion is inevitable. The most certain means of resolving confusion is to refrain from any specific references in advertisements to repayment, finance charges, and rates. However, in a competitive lending market, information regarding the terms of credit may be necessary in order to catch the attention of consumers who encounter countless advertisements for loan products from banks, mortgage bankers, and mortgage brokers. FTC Actions for Advertising Violations

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Violations of the advertising rules of Regulation Z have been the cause of many FTC actions against lenders and mortgage brokers. The Federal Trade Commission (“FTC”) is an enforcement agency for TIL. Other federal agencies such as the Office of the Comptroller of the Currency, the Federal Reserve Board, the Board of Directors of the FDIC, and the Office of Thrift Supervision have enforcement authority over the lending institutions that are within their jurisdictions. When the FTC brings actions for the enforcement of TILA, it also has enforcement authority under Section 5 of the FTC Act which forbids unfair and deceptive trade practices. FTC complaints relating to violations of TILA and Regulation Z usually include additional allegations of violations of The FTC Act. Recent Complaints and Actions Florida-based American Nationwide Mortgage Co. used a direct mail ad stating, “30-Year Fixed. 1.95%.” However, a fine-print, virtually illegible footnote at the bottom of the ad states, “4.981% Annual Percentage Rate,” and a fine-print disclosure on the reverse side of the ad states, “Initial Annual Percentage Rate (APR) for a 30 year mortgage loan with 80% loan to value is 4.981%. Rate is fixed for 12 months and adjusts upward 7.5% of the payment amount annually for the first ten years of the loan . . .” The ad also violates the FTC Act (deceptive practices) by falsely representing that the advertised rate is a fixed rate for the full term of the loan. California-based Good Life Funding, sent a direct mail ad stating, “Your first Mortgage originally funded by [the consumer’s current lender] can be restructured to a TEN Yr fixed payment of only $116 . . . Your payment rate is only 1/4%* and is fixed for TEN years . . . This is the lowest payment in history. You can receive an additional $88,252 Cash out with a monthly payment of only $134 . . . Call Today, and have No House Payments until June 2008 (that’s 12 months)**.” The fine-print disclosure at the bottom of the ad states, “Good Life Funding is not sponsored or affiliated with [the consumer’s current lender] and the solicitation is not authorized by [the consumer’s current lender] . . . *Payment Rate 1/4% 6.75% APR. Deferred interest will accrue . . .** . . . Based on the first year 1/4% interest only payment at close . . .” In addition to the other charges, the ad violated the FTC Act by failing to disclose adequately that the mortgage offer is not made by the consumer’s current lender. Innova Financial Group, ran an Internet ad stating, “Innova Financial Group is currently offering monthly payments as low as 1%!,” without disclosing terms as required by law. Penalties Violations of TILA can result in a civil penalty which is equal to double the correctly calculated financed charge, with a minimum penalty of $100 and a maximum penalty of $1000 for individual actions. There is a higher penalty cap for closed-end real estate loans, which is $2000. For Class actions, the maximum penalty is $500,000, or 1% of the creditor’s net worth, which ever is less. Willful and knowing violations of TILA can result in criminal fines of $5000, imprisonment, or both.

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Section 32 of the Truth-in-Lending Act Also known as Home Ownership and Equity Protection Act (“HOEPA”) The Federal High Cost Loan Law

In 1994 Congress amended TILA to protect consumers from a number of “predatory” lending practices associated with high cost loans. HOEPA is enforced by the Federal Trade Commission. Recently, the rules were changed to include “Higher Cost Loans Subject to Section 32 HOEPA covers closed-end home equity loans and refinance mortgages that meet certain interest rate and points/fee triggers. Interest Rate Trigger – High Cost Loans For 1st lien mortgages the rate trigger is 8 percentage points above the rate of Treasury securities with a comparable maturity. For 2nd or subordinate liens, the rate trigger is 10 percentage points. Points and Fees Trigger A loan is classified as high cost if 8% or more of the loan amount (or $583 - adjusted annually for 2009) is charged for loan related fees. Points and fees include loan points, mortgage broker fees, loan service fees, fees of a required closing agent, premiums for mortgage insurance, and debt protection fees. Other fees such as title examination and title insurance fees, document preparation fees, costs for appraisals and pest inspections are not included if they are reasonable, if the creditor does not get direct or indirect compensation form the charge, and if the charge is not paid to an affiliate of the creditor. Interest and the time-price differentials are not included in calculating the amount of points and fees. Section 32 Disclosures Three days prior to closing, the borrower must receive a disclosure stating the amount borrowed, whether credit debt-cancellation insurance is included, or whether there is a balloon. The APR disclosure must be given with large, 24 point bold type across the top stating the borrower is not required to complete the transaction and that loss of the home could result from the loan if payments are not met.

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In addition the APR calculation, the Section 32 disclosure must contain the amount borrowed, as reflected by the face amount of the note. There is a $100.00 tolerance for minor errors. Section 32 Prohibitions – “Flipping” On high cost loans lenders are prohibited from “loan flipping” which is defined as the repeated refinancing of a loan with no true benefit to the borrower. No HOEPA loan can be refinanced within twelve months of the initial extension of credit unless the refinancing is in the borrower’s interest. Lender must assure the borrower can qualify for the loan – no lending without regard to the borrower’s ability to repay. There may be no direct payments to home improvement contractors. Negative Amortization and interest rate acceleration features are prohibited. The only exception allowed is an exception for a refinancing that is “in the borrower’s interest.” The regulations do not define the circumstances in which it is in the borrower’s interest to refinance. However, the FRB has stated that the borrower’s interest exception should be narrowly construed and a creditor must point to facts showing the benefit to the borrower, and may not rely on statement, by the borrower, that the refinancing is in his/her interest. Section 32 Prohibitions - Lending Without Regard to Repayment Ability Lenders must verify and document a borrower’s ability to pay. A failure to do so will result in a presumption that the creditors made a loan without the mandatory verification and documentation. The purpose of this regulation is to prevent creditors from making a loan that the borrower cannot reasonably afford – pre-meditated foreclosure. It is also to dissuade creditors from using inaccurate information and to ensure that they use independent sources to verify a borrower’s ability to pay. Section 32 Prohibitions - Direct Payments to Contractors A creditor cannot pay a home improvement contractor from the proceeds of a HOEPA loan unless the payment is made jointly to the borrower and the contractor or paid, at the election of the borrower, through a third-party escrow agent. Section 32 Prohibitions - Documenting Closed-end Loans as Open-End Credit

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There is a concern that lenders will structure Closed End/Installment Loans as Open Ended Lines of Credit because lines of credit are exempt from Section 32. If a loan is documented as openend credit but includes terms which demonstrate that it does not meet the definition of open-end credit, the loan is subject to the rules for closed-end credit. In order to determine if the rate or fee trigger would be met, the regulations consider   

The amount of money the borrower originally requested The amount of the first advance or the highest outstanding balance The amount of the credit line

Other Section 32 Prohibitions     

Due on Demand Clauses are only allowed to protect the creditor from misrepresentation or from any action by the borrower that adversely affects the lender’s security for the loan. Balloon Payments are not allowed for loans with terms of less than five years, except for bridge loans. Advance payments are restricted, and do not allow from more than two periodic payments to be paid from the proceeds of the loan. Prepayment penalties can only be assessed within the first five years of the loan. Single Premium Credit Life insurance premiums may be financed, but the cost must be included as part of the APR calculation.

Penalties for HOEPA Violations Creditors who violate HOEPA may be liable for all the finance charges and fees paid by the borrower. In class action suits, damages are limited to $500,000 or 1% of the creditor’s net worth. The frequency and persistence of compliance violations and whether violations were intentional are factors a court can consider in imposing penalties in class action suits. “Higher Cost” Loans- Section 35 New Reg. Z Section 35 defines a higher-priced mortgage loan (HPML) as a consumer credit transaction secured by the consumer’s principal dwelling with an annual percentage rate (APR) exceeding a certain percentage. The classification as a higher-priced mortgage loan is based solely on the following APR thresholds: Threshold for first liens – The APR exceeds the average prime offer rate for a comparable transaction as of the rate-lock date by 1.5% or more. Threshold for subordinate liens – The APR exceeds the average prime offer rate for a comparable transaction as of the rate-lock date by 3.5% or more.

Higher-priced mortgage loans include closed-end purchase money as well as refinances and home equities, but exclude HELOCs, reverse mortgages, construction only loans, and bridge loans with a term of no more than 12 months.

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Defining a “Prime Rate Mortgage” Higher-priced mortgage loans are subprime loans that fall between “prime” mortgages and “high-cost” mortgages. While it was the Board’s intention to cover the entire subprime market and generally exclude the prime market, the Board is aware that the new loan category will capture a portion of the alt-A market as well. Restrictions on “Higher Cost” loans include:    

No Lending without ability to repay – must have income, employment stability, assets and consider current and future obligations. Prepayment Penalty is prohibited on loans with fixed periods of less than 4 years. May not apply a prepayment penalty on loans which are being refinanced by the same lender Must have escrows for Taxes and Insurance for at least 1 year

Institutions are prohibited from making a higher-priced mortgage loan without regard to ability to repay from income and assets other than the home's value. They must verify income and assets relied upon and evaluate the consumer's current obligations to determine repayment ability. They are prevented from imposing a prepayment penalty on a higher-priced mortgage loan whose payments may change in the first four years and must establish an escrow account for property taxes and homeowner's insurance. Structuring a closed-end loan as an open-ended line of credit in order to evade the new requirements is prohibited. Second, for all closed-end mortgages secured by a principal dwelling, institutions are prohibited from (i) failing to credit a payment as of the date received, (ii) failing to provide a payoff statement within a reasonable period of time, (iii) "pyramiding" late fees, and (iv) coercing a real estate appraiser to misstate appraisal value. Advertising Practices Advertising must contain information about rates, payments, and other loan features. In this regard, the guidance lists seven deceptive or misleading practices that are expressly prohibited in advertisements for closed-end loans. 1. stating that a rate or payment is fixed when it can change 2. not comparing an actual or hypothetical rate to the rate that will apply for the full term of the loan 3. characterizing products offered as “government” or “government sponsored” if they are not 4. displaying the name of the consumer’s current mortgage lender when not actually affiliated 5. making claims of debt elimination if the product merely replaces one debt with another 6. creating a false impression that the mortgage broker or lender is a “counselor” 7. foreign-language advertisements with required disclosures only in English

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Chapter 14 Understanding Federal Credit-Granting Related Laws Introduction Regulations that deal with the granting of credit are among the major Federal consumer protection laws affecting mortgage lending. While RESPA, the (Real Estate Settlement Procedures Act) governs transactions, and the Truth-in-Lending (TILA) governs disclosure of loan terms, the decision making process for loans is governed by the Equal Credit Opportunity Act (ECOA). In addition to mandating how credit decisions must be made and communicated, the ECOA also regulates what information can be used as the basis for credit decisions. In this way, the Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA) are part of a national effort to eliminate discrimination and assure equitable lending to all applicants. As a national policy, these Acts were designed to facilitate home ownership and economic development. Their impact has been greatest in low income areas. The argument for Federal regulation is based on the belief that homeownership builds economic wealth and stability. Channeling credit into markets that have been historically underserved, or impaired by predatory lending practices, facilitates these benefits. The legislation that the late 60’s and early 70’s spawned may be viewed as a by-product of the civil rights movement. In fact, there was a groundswell of reform oriented legislation that spring from this period. The Truth-in-Lending Act, the Consumer Credit Protection Act and Real Estate Settlement Procedures Act were all aggressive pieces of legislation in uncharted waters. The concept of fair treatment in lending and housing may seem idealistic. The reality is that it has been essential to the economic growth the nation has seen since that time. The laws that protect consumers from discriminatory or unethical practices are constantly being updated. They are dynamic because our world is evolving so quickly. Merged in-file credit reports weren’t an issue in the 70s or 80s. With the growth of e-commerce, the flow of the consumer’s private information has accelerated. New laws are added as business tactics change. As a result, we have an ongoing history of regulations built upon the first.

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This chapter focuses on the credit and discrimination related Acts. Year 1968 1968 1970 1974 1974 1975 1977 1977 1977 1980 1988 1994 1995 1996 1996 1998 1999 2001 2003 2005

Law The Fair Housing Act (Title VIII of the Civil Rights Act) Truth in Lending Act (Consumer Credit Protection Act) The Fair Credit Reporting Act The Equal Credit Opportunity Act Housing and Community Development Act Home Mortgage Disclosure Act The Housing Financial Discrimination Act The Fair Debt Collection Practices Act Community Reinvestment Act Electronic Fund Transfer Act Fair Housing Amendments Act Homeownership and Equity Protection Act (Amendment to TILA – a.k.a. Section 32) The Housing for Older Persons Act The Fair Debt Collection Practices Act Consumer Credit Reporting Reform Act The Homeowners Protection Act Gramm-Leach-Bliley Act Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act Fair and Accurate Credit Transactions Act Bankruptcy Abuse Prevention and Consumer Protection Act

Acronym FHA TILA FCRA ECOA HCD HMDA HFDA FDCPA CRA EFTA HOEPA HOPA FDCPA CCRRA HPA GLB USA PATRIOT FACTA

While these laws are Federal, individual states are also empowered to enforce these laws. The Federal government pre-empted states in regulating these areas. States, however, may also enforce regulations. Some enforce these at threshold levels that are more rigorous than Federal laws. This is especially true in the areas of predatory lending and high-cost loans. The CFPB and Secondary Regulators The creation Consumer Financial Protection Bureau (CFPB) as a requirement of the Wall Street Reform and Consumer Protection Act (aka Dodd-Frank) consolidated primary enforcement and regulation of consumer financial protection laws under the CFPB. However, secondary regulators and agencies still preserve much of the legacy of these laws and their enforcement in that the staffs still remain at their respective agencies, despite the consolidation of regulatory authority. These agencies remain invested in the identification of compliance and referral of enforcement. There are eight federal agencies in charge of enforcing the credit related laws. Federal banks and savings and loans are regulated by the Treasury, the OCC, the OTS and the FDIC. Mortgage companies and brokers without a federal charter are regulated by the Federal Trade Commission, HUD, and the Department of Justice. TYPE OF BUSINESS:

CONTACT:

Mortgage companies, Consumer reporting agencies, creditors and others not listed below

Federal Trade Commission: Consumer Response Center - FCRA Washington, DC 20580 1-877-382-4357

National banks, federal branches/agencies of foreign banks (word "National" or initials "N.A." appear in or after bank's name)

Office of the Comptroller of the Currency Compliance Management, Mail Stop 6-6 Washington, DC 20219 800-613-6743

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TYPE OF BUSINESS:

CONTACT:

Federal Reserve System member banks (except national banks, and federal branches/agencies of foreign banks)

Federal Reserve Board Division of Consumer & Community Affairs Washington, DC 20551 202-452-3693

Savings associations and federally chartered savings banks (word "Federal" or initials "F.S.B." appear in federal institution's name)

Office of Thrift Supervision Consumer Complaints Washington, DC 20552

800-842-6929

Federal credit unions (words "Federal Credit Union" appear in institution's name)

National Credit Union Administration 1775 Duke Street Alexandria, VA 22314

703-519-4600

State-chartered banks that are not members of the Federal Reserve System

Federal Deposit Insurance Corporation Consumer Response Center, 2345 Grand Avenue, Suite 100 Kansas City, Missouri 641082638 1-877-275-3342

Equal Credit Opportunity Act – Federal Reserve Regulation B - 12 CFR Part 202 The Equal Credit Opportunity Act (ECOA) is the first law protecting consumers in their borrowing activities. It defines what decisions cannot be based on, and how the lender must communicate with the borrower regarding the decision. General Rules for Compliance §202.4 Discrimination - Do not discriminate against an applicant on a prohibited basis regarding any aspect of a credit transaction. Discouragement – Do not make any oral or written statement to applicants or prospective applicants that would discourage a reasonable person from pursuing an application Written Applications - Take written applications for dwelling-related credit Disclosure – Provide notice when the status of the application changes and provide all information used to arrive at decisions Definitions - §202.2 Term Applicant Dwelling

Application

Completed Application Credit

Creditor

Definition Any person who requests or who has received an extension of credit from a creditor, including guarantors, like co-borrowers Dwelling in this instance means a residential structure containing one-to-four family units. Individual cooperative or condominium units, mobile or other manufactured homes are also included, regardless of whether they are considered as real property under state law. An oral or written request for credit, made in accordance with procedures established by the creditor. Does not include advances on a line of credit. Mortgages applications must be in writing. The creditor has received all information the creditor regularly obtains and considers. The creditor shall exercise reasonable diligence in obtaining the information. The right granted by a creditor to an applicant to either 1.) Defer payment of a debt, 2.) Incur debt and defer its payment or 3.) Purchase property or services and defer payment therefore A person who regularly participates in the decision of whether or not to extend credit. Includes regularly referring applicants or prospective applicants to creditors, selecting or offering to select creditors to whom requests for credit may be made, like brokers.

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Term Credit Transaction Empirically Derived Credit Scoring Systems Extend Credit Judgmental System of Evaluating Applicants

Definition Every aspect of an applicant’s dealings with a creditor regarding an application for credit or an existing extension of credit A system that evaluates an applicant’s creditworthiness mechanically, based on key attributes of the applicant and aspects of the transaction, and that determines, alone or in conjunction with an evaluation of additional information about the applicant, whether an applicant is deemed creditworthy The granting of credit in any form. Any system for evaluating the creditworthiness of an applicant other than an empirically derived, demonstrably and statistically sound, credit scoring system.

What information can be Requested – Section 202.5 ECOA, and the Federal Reserve Board’s implementing Regulation B, deals with taking, evaluating and acting on applications for credit and the furnishing and maintenance of credit information. It does not prevent a creditor from obtaining information necessary to evaluate the creditworthiness of an applicant. It prohibits discrimination in any aspect of a credit transaction on the basis of         

Race Color Religion National origin Gender Marital Status Age (provided that the applicant has the capacity to enter into a binding contract) Receipt of income from a public assistance program The good faith exercise of any right under the Consumer Credit Protection Act

These factors are referred to as “prohibited bases.” Most of these don’t require much explanation. Anti-discrimination extends to personal associates, business associates or relatives. Income from public assistance programs includes Aid to Families with Dependent Children (AFDC), food stamps, rent and mortgage supplement or assistance programs, Social Security and Supplemental Security Income (SSI), and unemployment compensation. Even though creditors cannot discriminate on the basis of national origin, the applicant’s immigration status or foreign citizenship is a valid credit criterion. Unless the property is in a community property state, unsecured creditors can’t ask if the applicant is married. For a secured credit application, like a mortgage, only use the terms married, unmarried, and separated. Unmarried includes single, divorced, and widowed. Alimony, child support, or separate maintenance payments as income do not need be revealed if the applicant does not want the creditor to consider it for qualifying. A creditor can not inquire about birth control practices, intentions concerning the bearing or rearing of children, or capability to bear children – but can only ask about the number and ages of an applicant's dependents or about dependent-related financial obligations.

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A creditor can’t take into account whether there is a telephone listing in the name of an applicant for consumer credit. It doesn’t have to be in their name, but the borrower does have to have a phone in the residence. While RESPA and TIL apply only to certain types of transactions, credit transactions protected by ECOA are very broad. Business, auto, consumer, agricultural loans, and real estate loans of all types, as well as consumer leases, are subject to the law. How Applications are Evaluated – Section 202.6/202.7 Creditors have three processes that may be used to evaluate credit applications:

Figure 20 - This is a copy of the required "Credit Score Disclosure Notice" which explains the impact of the credit score to the borrower, and how it is derived, as required by ECOA.

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  

A demonstrably and statistically sound, empirically derived, credit scoring system A judgmental system A combination of credit scoring and judgment

No evaluation system can discriminate among applicants. Whatever process is used must apply to all applicants in the same manner. What is a “Statistically Sound Credit Scoring System?” Empirical means reasoning based on facts and data, as opposed to assumptions and beliefs. Empirically derived, demonstrably and statistically sound credit scoring systems (scoring systems) are:    

Based on data comparing similar groups of people in a recent period of time. Designed to analyze applicants based on the creditor’s guidelines Developed and validated using accepted statistical principles and methodology. Revalidated periodically by the use of appropriate statistical principles and methodology and adjusted as necessary to maintain predictive ability.

A scoring system has the capability of differentiating between creditworthy and noncreditworthy applicants with a statistically significant probability. Scores are assigned to credit applicants in direct proportion to the predictive value of variables employed in the scoring system. If a creditor uses a third party system, it must use its own experience to validate the model. What is a Judgmental Credit Scoring System? A judgmental system is used to evaluate creditworthiness by following guidelines as a measure. Most financial institutions have guidelines for evaluating credit requests. They use the same predictive factors used in credit scoring systems. In this type of system, loan officers subjectively evaluate the application and then accept or reject the credit request. Some institutions use a combination of the two systems to evaluate credit applicants. Loan officers review the scored applications and judgmentally render the final credit decision. This is referred to as an “override” or “manual underwriting.” Adverse Action Adverse action is a refusal to grant credit in substantially the amount or terms requested in an application unless the creditor makes a counteroffer. A counteroffer is an offer under different terms. If the applicant accepts the counteroffer, it is not considered adverse action. Adverse action also includes termination of an account or an unfavorable change in the terms of an account, unless all the lenders accounts change similarly. A denial of a credit increase is also an adverse action. It is not adverse action if the applicant agrees to the changes, if the lender forbears, if the account is inactive, or if there is a denial at a point of sale (like a credit card charge denial). Obviously, if

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the lender is prohibited by law from extending credit, or doesn’t offer the type of credit applied for, this would not be adverse. If An Application Is Rejected If the application is denied, the lender must give all specific reasons why in writing. The borrower has the right to know, within 30 days of the date of the completed application whether

All reasons for the credit action must be listed.

If the credit action was the result of information found in the credit report, the name of the agency must be listed.

Figure 21 - The "Adverse Action Notice", sometimes called the ECOA notice, must be delivered to the borrower any time a credit rejection, change, or other adverse decision is rendered.

the mortgage loan is approved. The lender has to be diligent in obtaining the necessary information, such as credit reports, property appraisals and other documentation. The lender must tell the borrower the specific reason for the rejection within 60 days. An acceptable response might

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be: "insufficient income" or "insufficient employment stability." "You didn’t meet our minimum standards" is not specific enough. Since a counter offer, if rejected, is an adverse action, the borrower has the right to know why he or she received a smaller mortgage or a higher interest rate. The application may have been rejected because of negative information in the credit report. If so, the lender must state this and provide the name, address, and phone number of the credit bureau. A borrower can receive a free copy of that report from the credit bureau if requested within 60 days. After 60 days the credit bureau can charge up to $8. If the credit report contains inaccurate information, the credit bureau is required to investigate disputes. A summary of any dispute may be included in the credit report. The borrower is entitled to a copy of the property appraisal. The appraiser cannot use illegal factors such as the racial composition of the neighborhood. Other General Requirements The Equal Credit Opportunity Act and Regulation B also require creditors to:    

Notify applicants of action taken on their applications Report credit history in the names of both spouses Retain records on credit applications Collect information about the applicant’s race and other personal characteristics in applications for certain dwelling-related loans

Right to Receive a Copy of the Appraisal While the Appraiser Independence Rule requires that all borrowers receive copies of appraisals, applicants also have the right, under ECOA and Regulation B, to receive copies of appraisal reports obtained in conjunction with credit that is to be secured by a dwelling. Creditors must provide the appraisal reports either routinely or upon the applicant’s request. This must be done whether the credit request is granted, denied, or withdrawn. If the creditor provides the appraisal report only upon written request, the applicant must be notified in writing of the right to receive a copy of the appraisal, and the notice may be given at any time during the application process but, no later than when the creditor provides notice of action taken in accordance with Section 202.9 of Regulation B.

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Lenders May Not Discourage the Filing of an Application ECOA prohibits the discouragement of applications. Creditors may not use words, symbols, models or other forms of communication in advertising that express, imply, or suggest a discriminatory preference. However, a creditor may affirmatively solicit or encourage members of traditionally disadvantaged groups to apply for credit. The ECOA Code – Who Is Responsible For the Account? The effects of the reporting section of the act are apparent on credit reports. The law requires the disclosure of relationship of a creditor to a credit. Those codes appear on the credit report. a. b. c. d. e. f. g.

U – not identified by the creditor I – individual account J – joint account A – authorized to use another’s account S – shared joint account C – co-maker B – co-signer (responsible only in case of default)

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h. i.

M – maker, individual account T – terminated, closed account

Lender Do’s and Don’ts Lenders must consider:    

Reliable public assistance income in the same way as other income. Reliable income from part-time employment, Social Security, pensions, and annuities. Consider reliable alimony, child support, or separate maintenance payments, if the borrower chooses to provide this information. A lender may ask for proof that this income is received consistently. If a co-signer is needed a lender must accept someone other than a spouse. If the property is jointly owned by a spouse, he or she may be asked to sign documents allowing a mortgage to be placed.

Lenders cannot: 

     

September 2010 - Mortgage Lender Settles FTC Charges For Violating ECOA. On September 20, the Federal Trade Commission (FTC) announced that it settled charges against Golden Empire Mortgage, Inc. (GEM) and its owner, Howard D. Kootstra, for alleged violations of the Equal Credit Opportunity Act (ECOA). The FTC had alleged that GEM illegally charged Hispanic consumers higher interest rates and up-front charges for mortgage loans than non-Hispanic white consumers. The settlement requires GEM pay $1.5 million to aggrieved customers, adopt a policy restricting loan originators' pricing discretion and implement programs to train employees and to monitor

Discourage anyone from applying for a mortgage or reject your application because of race, national origin, religion, sex, marital status, age, or because of receipt of public assistance income. Consider race, national origin, or sex; although a borrower may be asked to voluntarily disclose this information to help federal agencies enforce anti-discrimination laws. A creditor may consider immigration status and whether a borrower has the right to remain in the country long enough to repay the debt. Impose different terms or conditions on a loan based, such as a higher interest rate or larger down payment, on race, sex, or other prohibited factors. Consider the racial composition of the neighborhood Ask about plans for having a family. Questions about expenses related to dependents are permitted. Refuse to purchase a loan or set different terms or conditions for the loan purchase based on discriminatory factors. Require a co-signer even if a borrower meets lender’s standards. Review credit before a borrower applies for a mortgage.

Borrower’s Recourse for Inaccurate Credit Information Reports sometime contain inaccurate information. For example, accounts might be reported that don’t belong to you or paid accounts might be reported as unpaid. If you find errors, dispute them with the credit bureau and tell the lender about the dispute.

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If you’ve had past bill-paying problems, such as a lost job or high medical expenses, write a letter to the lender explaining what caused your past credit problems. Lenders must consider this information at your request. What Borrowers are Being Coached to Ask and Why “Try For the Best Loan Terms” “Some mortgage lenders may try to charge some borrowers more than others for the same loan product offered at the same time. This may include higher interest rates or origination fees or more points. Ask the lender if the rate you’re being quoted is the lowest offered that day.” Loan officers base their rates on pricing they are given. Borrowers are being coached to see this list of investors. You can provide the list of investors, or copies of pricing documentation. Understand that if you refuse to provide the pricing information, the borrower will be understandably suspicious. If an Application is Rejected Borrowers are told that they must be told all reason why a loan is declined. Borrowers must know within 30 days of the date of the completed application whether the mortgage loan is approved. The lender must make a reasonable effort to obtain all necessary information, such as credit reports and property appraisals. If the application is rejected, the lender must notify the borrower in writing. The lender must tell the borrower specifically why the application was rejected. The specific reason for the rejection, or the right to learn the reason, must be provided within 60 days. A loan officer may say "Your income was too low" "You haven’t been employed long enough." A loan officer may not say "you didn’t meet our minimum standards". It is not specific enough. If the Loan is “Counter-Offered” The borrower must be told the specific reason less favorable terms than applied for were offered, but only if you reject these terms. For example, if the lender offered a smaller mortgage or a higher interest rate, the borrower has the right to know why. This is only if he or she did not accept the lender’s counter offer. Find out what is in the credit report. The lender may have rejected the application because of negative information in the credit report. If so, the lender must explain this and give the name,

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address, and phone number of the credit bureau. A free copy of that report from the credit bureau may be obtained within 60 days. If the report contains inaccurate information, the credit bureau is required to investigate disputed items. Those companies furnishing inaccurate information must reinvestigate disputed items. Disputed items which are not removed are reflected in a dispute summary. The borrower is entitled to a COPY of the property appraisal. The appraisal should be reviewed to see that it contains accurate information. The appraiser cannot consider illegal factors such as the racial composition of the neighborhood. What Recourse Does the Borrower Have? Borrowers are instructed to complain to the lender. They will attempt to persuade the lender to reconsider the application. However, if this course of action doesn’t satisfy the borrower, and the borrower suspects discrimination, he or she may take additional recourse. The first level of legal recourse is to check with the state Attorney General’s office to see if the creditor violated state laws. Many states have their own equal credit opportunity laws which may be more stringent or equal to those that the federal government enforces. Since individual states are empowered with enforcing federal laws, the attorney general’s offices are able to investigate a complaint. Borrowers are also instructed to contact a local private fair housing group and report violations to the appropriate government agency. Lenders must provide the name and address of the agency to contact. Ultimately, a borrower may sue a lender in federal district court. If a borrower prevails they may recover actual damages, reasonable lawyers’ fees and court costs. They may also be awarded punitive damages if the court finds that the lender’s conduct was willful.

The Fair Credit Reporting Act The Federal Fair Credit Reporting Act (FCRA) promotes the accuracy and privacy of information in the files of the nation’s consumer reporting companies. The Fair Credit Reporting Act (15U.S.C.1681) was enacted by Congress in 1970 to ensure that information used by banks and legitimate users is accurate. It also allows customers to verify the accuracy of information found in reports. FCRA Features Identifies what steps the consumer may take when an adverse action is based on information found in the consumer report. 

consumer must authorize the release of credit information

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     

details how long credit information may be on the report Identifies permissible purposes and end users of credit report information. provides for penalties of up to 2 years imprisonment and/or fines. State law enforcement officers may file court actions on behalf of their residents based on this Act dispute errors and have them investigated within 30 days. Block or opt out of unsolicited offers of credit or insurance.

Penalties A person who obtains a credit report without proper authorization or an employee of a creditreporting agency who gives a credit report to unauthorized persons may be fined up to $5,000 or imprisoned for one year or both. Agencies may award up to $1,000 for each willful or negligent violation Procedure for Correcting Errors The Fair Credit Reporting Act (FCRA) establishes procedures for correcting mistakes on the borrower’s credit report. Both the credit agency and the reporting organization are responsible for correcting inaccurate or incomplete information in the borrower’s report. To protect the borrower’s rights under the law, contact both the credit bureau and the information provider. It’s very important to follow the procedures outlined below or the borrower won’t have any legal recourse if there is a future dispute. Disputes must be resolved 30 days after receipt of a dispute notice from the consumer. If the consumer provides additional relevant information during the 30-day period, the CRA has 15 days more. The Credit Reporting Agency (CRA) must provide the creditor with all relevant information within five business days of receipt. If the creditor does not investigate or respond within the specified time periods, the CRA must delete the disputed information from its files. Borrowers Copy of Report Borrowers have the right to receive a copy of the credit report. The copy of the report must contain all the information in the credit file at the time of the request. Note that the lender is not a credit reporting agency. As such, the borrower must receive the credit report directly from the repository.   

CBI/Equifax TRW/Experian TransUnion/Empirica

Each of the nationwide consumer reporting repositories is required to provide the borrower with a free copy of his or her credit report, upon request, once every 12 months. Beginning September 2005, consumers from coast to coast have access to a free annual credit report if they ask for it.

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Under federal law, a borrower is also entitled to a free report if a company takes adverse action against him or her. A denial of an application, for credit, insurance, or employment is an adverse action. The borrower must ask for the report within 60 days of receiving notice of the action. Otherwise, a consumer reporting company may charge up to $9.50 for another copy of the report within a 12-month period. "Imposter" Free Credit Report Sites The FTC advises consumers who order their free annual credit reports online to be sure to correctly spell annualcreditreport.com, or link to it from the FTC's website to avoid being misdirected to other websites that offer supposedly free reports, but only with the purchase of other products. While consumers may be offered additional products or services while on the authorized website, they are not required to make a purchase to receive their free annual credit reports. The borrower has the right to know who asked to review his or her report within the past year – two years for employment related requests. If a company denies an application based on information given by a consumer reporting company, the borrower has the right to the name and address of the consumer reporting company. The borrower has the right to file a dispute with the consumer reporting company if there is a question over the accuracy or completeness of information in a report. Both the consumer reporting company and the information provider are obligated to investigate a claim, and responsible for correcting inaccurate or incomplete information in a report. The borrower has a right to add a summary explanation to his or her credit report if the dispute is not resolved to his or her satisfaction. The agency will charge a fee for this service. Seven-Year Reporting Period The standard method for calculating the seven-year reporting period runs from the date that the event took place. The event is defined as the date  

a delinquent account was placed for collection, internally or by referral to a third-party debt collector, whichever is earlier charged to profit and loss, or subjected to any similar action

For example, assume that payments on a loan were late in January, but were caught up in February. It was late again in May, but caught up in July. It was late again in September, but was not caught up before the account was turned over to a collection agency in December. There were no more payments on the account, and it was charged to profit and loss in July of the following year. Under the Fair Credit Reporting Act (FCRA), the January and May late payments each can be reported for seven years. The collection activity and the charge to profit and loss can be reported for seven years from the date of the September payment, which was the delinquency that occurred immediately before those activities.

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Exceptions to the 7 Year Rule        

Chapter 7 bankruptcy information will remain on your credit reports for 10 years. Unpaid tax liens might, depending on where you live, remain on your credit reports indefinitely. Certain states require that adverse credit information remain on your credit reports no longer than 5 years. Credit information reported in response to an application for a job with a salary of more than $75,000 has no time limit. Information about criminal convictions has no time limit. Credit information reported because of an application for more than $150,000 worth of credit or life insurance has no time limit. Default information concerning U.S. Government insured or guaranteed student loans can be reported for seven years after certain guarantor actions. Information about a lawsuit or an unpaid judgment against you can be reported for seven years or until the statute of limitations runs out, whichever is longer.

Permissible Purpose for Ordering a Credit Report To make a credit inquiry, a business must have a “permissible purpose” identified under the FCRA. According to this act, access to credit reports is limited to specific situations, which are referred to as "permissible purposes."        

In response to a court order For the purposes of disclosure to the consumer As part of a legitimate business transaction which includes extending credit, reviewing the credit report of an existing customer, and collecting a debt For employment screening purposes As part of the insurance underwriting process In connection with screening requirements of a consumer’s eligibility for a license granted by the government In response to a request by state or local child support enforcement authorities to determine an individual’s capacity to pay child support To determine the risk and valuation of loans for the purposes of investing or servicing.

Lender’s Reporting Duties (Section 623) A lender is not a Credit Reporting Agency. Providing reports directly to a borrower is a violation. As a loan servicer, there are legal obligations. If a lender reports information about consumers to a CRA it is considered a "furnisher" of information. If you are a furnisher you must  

not furnish information that you know is inaccurate Correct information if you discover you've supplied one or more CRAs with incomplete or inaccurate information

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   

Not give disputed information to any CRA without also telling the CRA that the information is in dispute Investigate and report findings about any dispute and review all relevant information provided by the CRA about the dispute notify CRAs when consumers voluntarily close credit accounts Notify the CRA within 90 days of the month and the year of the commencement of the delinquency that immediately preceded your action account.

Fair and Accurate Credit Transactions Act (FACTA) The Fair and Accurate Credit Transactions Act of 2003 amended the Fair Credit Reporting Act. Aside from imposing comprehensive identity theft protections and changing notice requirements for users of consumer reports, it imposed responsibilities for appropriate handling of report information. Disposing of Consumer Report Information In an effort to protect the privacy of consumer information and reduce the risk of fraud and identity theft, a new federal rule is requiring businesses to take appropriate measures to dispose of sensitive information derived from consumer reports. According to The Federal Trade Commission, the nation’s consumer protection agency, that enforces the Disposal Rule (FTC), the standard for the proper disposal of information derived from a consumer report is flexible, and allows the organizations and individuals covered by the Rule to determine what measures are reasonable based on the sensitivity of the information, the costs and benefits of different disposal methods, and changes in technology. For example, reasonable measures for disposing of consumer report information could include:    

burn, pulverize, or shred papers containing consumer report information so that the information cannot be read or reconstructed; destroy or erase electronic files or media containing consumer report information so that the information cannot be read or reconstructed; hire a document destruction contractor to dispose of material insuring the contractor is in compliance by reviewing an independent audit of a disposal company’s operations and/or its compliance with the Rule

Identity Theft “Red Flag” Programs FACTA was updated in 2008 to require that companies that handle sensitive consumer information review that information for evidence of identity theft. Most mortgage originators already question suspicious activity in a borrower’s credit file. The process checks for suspicious activity and asks whether it is possible that the customer’s identity has been stolen. In the event of a breach, companies are required to remedy the identity theft. Usually this means providing credit monitoring services for the consumer at the company’s cost.

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FACTA and Identity Theft The Fair and Accurate Credit Transactions Act (FACTA) provides protections for consumers who are victims of identity theft. Identity theft occurs when someone uses a borrowers name, Social Security number, date of birth, or other identifying information fraudulently. FACTA, which amends the Fair Credit Reporting Act (FCRA) gives consumers specific rights when they are victims of identity theft. FACTA, the FCRA and the Gramm-Leach-Bliley Act all work together to enforce consumer privacy rights.

GrammLeach-Bliley Safeguards Privacy Notice

Fair Credit Report-

Consumer Financial Privacy Protection

Fair and Accurate Credit Transactions “Red Flag” Identity Theft

A borrower has the right to ask that nationwide consumer reporting agencies place “fraud alerts” in his or Figure 22 - There are myriad consumer protection her credit file to let potential creditors and others know laws which overlay and often rely on each other. that he or she may be a victim of identity theft. The borrower may contact the agencies directly   

Equifax: 1-800-525-6285; www.equifax.com Experian: 1-888-EXPERIAN (397-3742); www.experian.com TransUnion: 1-800-680-7289; www.transunion.com

The initial fraud alert stays in the credit file for at least 90 days. An extended alert stays in the file for seven years. An extended alert requires the filing of an identity theft report. An initial fraud alert entitles the borrower to a copy of all the information in the file at each of the three nationwide agencies, and an extended alert entitles you to two free disclosures in a 12-month period. In correcting fraud the borrower has the right to obtain documents relating to fraudulent transactions made or accounts opened. A creditor must give him or her copies of applications and other business records. A debt collector must provide information about the debt incurred by an identity thief – like the name of the creditor and the amount of the debt. Information in a file that resulted from identity theft may be blocked. The consumer reporting agency can refuse or cancel a request for a block if, the borrower doesn’t provide the necessary documentation, or a material misrepresentation by the borrower. Once a debt resulting from identity theft has been blocked, a person or business with notice of the block may not sell, transfer, or place the debt for collection. A borrower may prevent businesses from reporting information that is a result of identity theft. The borrower must identify the information to be blocked and provide an identity theft report. FACTA and the Credit Score Disclosure

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In 2003 it became the responsibility of the lender to provide the borrower with a copy of the borrower’s credit scores within 30 days of obtaining a credit report containing scores. Armed with this information, the borrower is able to see the relative strength of his or her credit. FACTA and the Risk Based Pricing Notice Effective January 1, 2011, lenders must provide borrowers who receive terms materially less favorable than other customers, as a consequence of their credit score, with the Risk Based Pricing Notice. This is a disclosure that the borrower’s loan terms have been affected by credit risk, and how that risk compares to other applicants. In its conception this disclosure was intended to be a more technical, loan level disclosure. It would have told a borrower what the best rate for his loan would have been under risk-free circumstances, then which premiums were added to arrive at the price – complete transparency. However, mortgage lenders have an exception to the detailed disclosure requirement. Instead of a detailed disclosure, mortgage lenders may aggregate credit experience into percentages (bar graph), showing a distribution of credit scores among consumers using the same model.

The Gramm-Leach Bliley Act The Financial Modernization Act of 1999, also known as the "Gramm-Leach-Bliley Act" or GLB Act, includes provisions to protect consumers’ personal financial information held by financial institutions. There are three principal parts to the privacy requirements: the Financial Privacy Rule, Safeguards Rule and “pretexting” provisions. The GLB Act gives authority to eight federal agencies and the states to administer and enforce the Financial Privacy Rule and the Safeguards Rule. These two regulations apply to "financial institutions," which include not only banks, securities firms, and insurance companies, but also companies providing many other types of financial products and services to consumers. Among these services are lending, brokering or servicing any type of consumer loan, transferring or safeguarding money, preparing individual tax returns, providing financial advice or credit counseling, providing residential real estate settlement services, collecting consumer debts and an array of other activities. Such non-traditional "financial institutions" are regulated by the CFPB AND FTC. The Financial Privacy Rule governs the collection and disclosure of customers' personal financial information by financial institutions. It also applies to companies, whether or not they are financial institutions, who receive such information. The Safeguards Rule requires all financial institutions to design, implement and maintain safeguards to protect customer information. The Safeguards Rule applies not only to financial institutions that collect information from their own customers, but also to financial institutions "such as credit reporting agencies" that receive customer information from other financial institutions.

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The “Pretexting” provisions of the GLB Act protect consumers from individuals and companies that obtain their personal financial information under false pretenses, a practice known as "Pretexting." Defining the Customer A company's obligations under the GLB Act depend on whether the company has consumers or customers who obtain its services. A consumer is an individual who obtains or has obtained a financial product or service from a financial institution for personal, family or household reasons. A customer is a consumer with a continuing relationship with a financial institution. Generally, if the relationship between the financial institution and the individual is significant and/or long-term, the individual is a customer of the institution. For example, a person who gets a mortgage from a lender or hires a broker to get a personal loan is considered a customer of the lender or the broker, while a person who uses a check-cashing service is a consumer of that service. Only customers are entitled to receive a financial institution's privacy notice automatically. Consumers are entitled to receive a privacy notice from a financial institution only if the company shares the consumers' information with companies not affiliated with it, with some exceptions. Customers must receive a notice every year for as long as the customer relationship lasts. The privacy notice must be given to individual customers or consumers by mail or inperson delivery; it may not, say, be posted on a wall. Reasonable ways to deliver a notice may depend on the type of business the institution is in: for example, an online lender may post its notice on its website and require online consumers to acknowledge receipt as a necessary part of a loan application. The Privacy Notice The privacy notice is a clear, conspicuous, and accurate statement of the company's privacy practices. It includes what information the company collects about its consumers and customers, who it shares the information with, and how it safeguards the information. Figure 23 - The privacy notice discloses a company's policies with regard to maintaining and sharing information. Consumers may "Opt Out" of sharing.

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The information is the "nonpublic personal information" the company gathers and discloses about its consumers and customers. It is most, or all, of the information a company has about them. Public information is not protected by privacy rights. Opting Out Sharing private information may be a particular concern to the borrower. Will the information be resold or will they receive an onslaught of solicitations from affiliated companies. Consumers and customers have the right to opt out of - or say no to - having their information shared with certain third parties. The privacy notice must explain how they can do that. The privacy notice also must explain that consumers have a right to say no to the sharing of certain information - credit report or application information - with a financial institution's affiliates. An affiliate is an entity that controls another company, is controlled by the company, or is under common control with the company. Consumers have this right under a different law, the Fair Credit Reporting Act. The GLB Act does not give consumers the right to opt out when the financial institution shares other information with its affiliates. The GLB Act provides no opt-out right in several other situations: For example, an individual cannot opt out if:  a financial institution shares information with outside companies that provide essential services like data processing or servicing accounts;  the disclosure is legally required;  a financial institution shares customer data with outside service providers that market the financial company's products or services. The Safeguards Rule The Safeguards Rule requires financial institutions to develop a written information security plan that describes how the company is prepared for, and plans to continue to protect clients’ nonpublic personal information. (The Safeguards Rule also applies to information of those no longer consumers of the financial institution.) This plan must include:    

Denoting at least one employee to manage the safeguards, Constructing a thorough information security and risk management plan on each department handling the nonpublic information, Develop, monitor, and test a program to secure the information, and Change the safeguards as needed with the changes in how information is collected, stored, and used and disposed of.

In the mortgage industry we produce vast amounts of paper that contain consumer’s most sensitive data. Among other things, improper disposal of this information can result in data breaches. Fraud perpetrators have targeted mortgage company dumpsters to mine this data – a practice known as “dumpster diving.” Between the safeguards rule, FACTA and FCRA, consumers have substantial protections against identity theft and the institutions that handle that data are made responsible for losses.

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Receiving Nonpublic Personal Information The GLB Act puts some limits on how anyone that receives nonpublic personal information from a financial institution can use or re-disclose the information. Take the case of a lender that discloses customer information to a service provider responsible for mailing account statements, where the consumer has no right to opt out: The service provider may use the information for limited purposes - that is, for mailing account statements. It may not sell the information to other organizations or use it for marketing. However, it's a different scenario when a company receives nonpublic personal information from a financial institution that provided an opt-out notice -- and the consumer didn't opt out. In this case, the recipient steps into the shoes of the disclosing financial institution, and may use the information for its own purposes or re-disclose it to a third party, consistent with the financial institution's privacy notice. That is, if the privacy notice of the financial institution allows for disclosure to other unaffiliated financial institutions - like insurance providers - the recipient may re-disclose the information to an unaffiliated insurance provider. Other Provisions Financial institutions are prohibited from disclosing their customers' account numbers to nonaffiliated companies when it comes to telemarketing, direct mail marketing or other marketing through e-mail, even if the individuals have not opted out of sharing the information for marketing purposes. Another provision prohibits "pretexting" - the practice of obtaining customer information from financial institutions under false pretenses. They are gaining the customer’s or consumer’s permission to share under false pretexts – such as a valuable offer. Suddenly the consumer has opted in without realizing it.

Fair Credit Billing Act (FCBA) The Consumer Consumer Financial Protection Bureau (CFPB) enforces the FCBA for most creditors except banks. The law provides a dispute and settlement process. The law applies to "open end" credit accounts, such as credit cards, and revolving charge accounts. It does not cover installment contracts - loans or extensions of credit you repay on a fixed schedule. The FCBA settlement procedure applies only to disputes about "billing errors." Specifically       

Unauthorized charges are limited to $50; charges that list the wrong date or amount; charges for goods and services you didn't accept or weren't delivered as agreed; math errors; failure to post payments and other credits, such as returns; failure to send bills to a current address - provided the creditor received a change of address, in writing, at least 20 days before the billing period ended; and charges for which an explanation or written proof of purchase has been requested.

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To take advantage of the law's consumer protections, the consumer must   

write to the creditor at the address given for "billing inquiries," not the address for sending payments, and include name, address, account number and a description of the billing error; send the letter certified mail, return receipt requested, so that it reaches the creditor within 60 days of receipt of the first bill containing the error ; Include copies (not originals) of sales slips or other documents

The creditor must acknowledge the complaint in writing within 30 days after receiving it, unless the problem has been resolved. The creditor must resolve the dispute within two billing cycles (but not more than 90 days) after receiving the letter. While the Bill is in Dispute The borrower may withhold payment on the disputed amount (and related charges), during the investigation. Any part of the bill not in question, including finance charges on the undisputed amount, must be paid, but the creditor may not take any legal or other action to collect. While an account cannot be closed or restricted, the disputed amount may be applied against the credit limit. The creditor may not threaten a credit rating or report a borrower as delinquent while a bill is in dispute, but may report that the account is being challenged. If a bill contains an error, the creditor must explain - in writing - the corrections that will be made. In addition the creditor must remove all finance charges, late fees or other charges related to the error. If the creditor determines that a portion of the disputed amount is owed, there must be a written explanation. If the creditor's investigation determines the bill is correct, the borrower must be told promptly and in writing how much is owed and why. If the borrower disagrees with the results of the investigation, write to the creditor within 10 days after receiving the explanation. If the borrower refuses to pay, the creditor may begin collection procedures. Any creditor who fails to follow the settlement procedure may not collect the amount in dispute, or any related finance charges, up to $50, even if the bill turns out to be correct.

Fair Debt Collection Practices Act The Fair Debt Collection Practices Act requires that debt collectors treat borrowers fairly and prohibits certain methods of debt collection. The law does not erase any legitimate debt. If a borrower uses credit cards, owe money on a personal loan, or pays on a home mortgage, he or she is considered a "debtor." Personal, family, and household debts are covered under the Act. This includes money owed for the purchase of an automobile, for medical care, or for charge accounts. If he or she falls behind in repaying creditors, or an error is made on accounts, he or she may be contacted by a "debt collector." A debt collector is any person who regularly collects debts owed to others. This includes attorneys who collect debts on a regular basis.

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Rules Regarding Contact with Borrowers A collector may make contact in person, by mail, telephone, telegram, or fax. However, a debt collector may not make contact at inconvenient times or places, such as before 8 a.m. or after 9 p.m., unless a borrower agrees. A debt collector also may not make contact at work if the collector knows that the employer disapproves of such contacts. A borrower can stop a debt collector from contacting him or her by writing a letter to the collector telling them to stop. Once the collector receives the letter, they may not make contact again except to say there will be no further contact or to notify the borrower that the debt collector or the creditor intends to take some specific action. The collector may contact an attorney rather than the borrower. A collector may contact other people only once for investigatory purposes. The collector may not tell anyone that you owe money. The debt collector must  

send a written notice telling the amount of money owed within five days after of first contact not make contact if the borrower sends the collection agency a letter stating there is no money owed within 30 days after written notice

Debt collectors may not                    

harass, oppress, or abuse you or any third parties they contact use threats of violence or harm; publish a list of consumers who refuse to pay their debts (except to a credit bureau); use obscene or profane language; repeatedly use the telephone to annoy someone; use any false or misleading statements when collecting a debt; falsely imply that they are attorneys or government representatives; falsely imply that you have committed a crime; falsely represent that they operate or work for a credit bureau; misrepresent the amount of your debt; indicate that papers being sent to you are legal forms when they are not; or indicate that papers being sent to you are not legal forms when they are; state you will be arrested if you do not pay your debt; state they will seize, garnish, attach, or sell property or wages, unless the collection agency or creditor intends to do so, and it is legal to do so; state actions, such as a lawsuit, will be taken when such action legally may not be taken, or when they do not intend to take such action; give false credit information to anyone, including a credit bureau; send anything that looks like an official document from a court or government agency when it is not; use a false name; collect any amount greater than your debt, unless state law permits such a charge; deposit a post-dated check prematurely;

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  

use deception to force borrowers accept collect calls or pay for telegrams; take or threaten to take property unless this can be done legally; contact a borrower by postcard

Payment of Debts If a borrower owes more than one debt, any payment you make must be applied to the debt the borrower indicates. A debt collector may not apply a payment to any debt the borrower does not believe he or she owes. Recourse for Borrowers Borrowers may sue a collector in a state or federal court within one year from the date the law was violated. They may recover money for the damages suffered plus an additional amount up to $1,000. Court costs and attorney’s fees also can be recovered. A group of people also may sue a debt collector and recover money for damages up to $500,000, or one percent of the collector’s net worth, whichever is less.

Electronic Funds Transfer Act (EFTA) Debit cards — which authorize merchants to debit bank accounts electronically — are increasing in use. Although a debit card may look like a credit card, the money for debit purchases is transferred almost immediately from a consumer’s bank account to the merchant’s account. A consumer’s liability limits for a lost or stolen debit card and unauthorized use are different from the liability if a credit card is lost, stolen or used without authorization. The EFTA applies to electronic fund transfers — transactions involving automated teller machines (ATMs), debit cards and other point-of-sale debit transactions, and other electronic banking transactions that can result in the withdrawal of cash from your bank account. A consumer is responsible for $50 in authorized use of a debit card if the loss is reported within two business days. If the loss is not report within two business days but within 60 days after the statement date, the consumer is responsible for up to $500 because of an unauthorized withdrawal. If the unauthorized transfer or withdrawal is not reported within 60 days after your statement is mailed, the consumer risks the entire loss of all funds and any overdraft protection. The EFTA’s error procedures apply to certain problems including:     

electronic fund transfers that the borrower has not made incorrect electronic fund transfers; omitted electronic fund transfers; a failure to properly reflect electronic fund transfers; and Electronic fund transfers which are in question because of a possible error.

The procedure is

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     

Notify the financial institution of the problem not later than 60 days after the statement containing the problem or error was sent. Follow-up in writing For retail purchases the financial institution has up to 10 business days to investigate after receiving the notice of the error The financial institution must provide the results of its investigation within three business days of completing its investigation. The error must be corrected within one business day after determining the error has occurred. If the institution needs more time, it may take up to 90 days to complete the investigation but it must return the money in dispute within 10 business days after receiving notice of the error.

Credit Repair Organizations Act (90-321, 82 Stat. 164) This law prohibits false claims about credit repair and makes it illegal for these operations to charge a customer until the services have been performed. It requires these companies to tell customers about their legal rights. Credit repair companies must provide this in a written contract that also spells out just what services are to be performed, how long it will take to achieve results, the total cost, and any guarantees that are offered. Under the law, these contracts also must explain that consumers have three days to cancel at no charge. A popular credit repair scheme is called “file segregation.” In this scheme, borrowers are promised a chance to hide unfavorable credit information by establishing a new credit identity. “File segregation” is illegal. Credit Repair Organizations often promote this as a legitimate process by stating that borrowers cannot be legally required to provide a social security number. This is not untrue, but it does not endorse the process of substituting a Federal Tax ID number for a social security number. This is fraud. Unsuspecting borrowers can face fines and prison sentences. There is nothing that a credit repair company can charge a customer for that a borrower cannot do for little or no cost. If a borrower is not disciplined enough to create a workable budget and stick to it, he or she should work out a repayment plan with creditors. Non profit credit counseling organizations work with borrowers to solve financial problems. But not all are reputable. An organization may say it is “nonprofit” but this does not mean that its services are free, affordable, or even legitimate. In fact, some credit counseling organizations charge high fees, or hide their fees by pressuring consumers to make “voluntary” contributions that only cause more debt. Operation Clean Sweep is the FTC’s enforcement program. On October 23, the Consumer Financial Protection Bureau (CFPB) filed actions against 33 credit repair organizations for allegedly violating the FTC Act and the Credit Repair Organizations Act (CROA). The FTC alleges that the companies made false and misleading statements when they claimed that they could remove negative information from consumers' credit reports, even if that information was accurate and timely. Further, the FTC alleges that the agencies violated the CROA by charging advance fees in connection with credit repair services.

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The Fair Housing Act The Fair Housing Act (FHA) is the short title of Title VIII of the Civil Rights Act of 1968, as amended (42 U.S.C. 3601 et seq). It extends the same concept of equal opportunity to residential real estate transactions as ECOA does for credit transactions. It is an important law as an extension of civil rights. As an anti discrimination law it addresses personal discrimination, discrimination against neighborhoods – known as redlining – and other racially motivated factors. Buyers may not be discriminated against on any of prohibited bases. Specifically            

Race Color Religion National origin Sex/Gender Familial status (the presence of children under the age of 18) Pregnancy A family or individual in the process of adopting or having legal custody of a child under the age of 18 Handicap Having a record of such impairment Persons diagnosed as being HIV-positive Recovering substance abusers

Covered Transactions The act applies to residential real estate-related transactions and how they can be sold, leased, financed, improved, and appraised. Any property that will function as a home is subject to the act. This includes one to four unit properties, a condominium, a cooperative unit, mobile homes, other manufactured homes, timesharing properties, and even land, if it will be the site for a dwelling. All housing advertisements must have the fair housing logo. Unlawful Lending Practices “Redlining” Redlining is the practice of denying loans for housing in certain neighborhoods even though the individual applicant may be otherwise eligible for credit. The term “redlining” refers to the anecdotal practice of drawing red lines on a map to show disfavored neighborhoods. It is unlawful when based upon a prohibited basis. The terms “racial redlining” refers to the practice of basing loan, insurance, or investment criteria on the racial characteristics of the people who live in a particular neighborhood. Making excessively low appraisals is may also be redlining. Racial Chapter 14 – Federal Credit-Related Laws - Page 302


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redlining is discriminatory because it presumes a perception of higher risk arising from the racial or social composition of the population. “Redlining” is a rational response to a real risk. Property located in a flood plain, in a slide area or close to a geologic fault presents a level of risk that may be unacceptable. The problem arises when the perceptions of risk are unrealistic, inaccurate, or arbitrary, or when the boundaries of the affected area are overbroad. Where institutions have excluded areas based on risks, the institutions have to substantiate that the exclusion is based solely on those considerations. This does not mean that a lending institution is expected to approve all housing loan applications or that it must make all loans on identical terms. Denying loans or granting loans on more stringent terms and conditions must be justified based on economic factors. A weaker income or credit history, condition of the proposed security property, the lack of neighborhood amenities or city services and portfolio concentration are all justifiable. A Racially Exclusive Image Creation and exploitation of a racially exclusive image, even where there may be little concurrent evidence of a discriminatory policy, may be discriminatory. Even a less than conspicuous display of the Equal Housing Lending poster can tend to create this atmosphere. It is unlawful to print a statement or advertisement indicating any preference or limitation based on a prohibited characteristic. The court has applied this prohibition to newspaper advertisements soliciting tenants and home buyers who spoke certain languages. Here we see that the evidence of discrimination is less obvious. Single race advertising exploits an exclusive image as does using media that caters to selected segments of the population. Another tactic is the use of excessively burdensome qualification standards with the effect of denying housing to minority applicants. In one instance a rental agent emphasized the security deposit to and required credit checks for black applicants, but not for whites. One of the most difficult patterns of discrimination to discern is the imposition on minority loan applicants of higher interest rates and onerous terms, conditions, or requirements. This and differing standards or procedures in administering foreclosures, late charges, penalties, reinstatements, or other collection procedures has become more readily identified as HMDA data is being more thoroughly developed. Racial Steering Racial steering is deliberately guiding potential purchasers toward or away from certain areas because of race. It is unlawful to use a word, phrase or action…which is intended to influence the choice of a prospective property buyer on a racial basis. Insurance and Discrimination

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The ECOA does not prohibit a creditor who sells or participates in the sale of insurance from differentiating in the terms and availability of insurance on prohibited bases. When dealing with housing credit the result is different. When insurance required for housing credit is denied, or made more difficult to obtain, on a prohibited basis, the law does preclude the practice if the lender is involved in arranging insurance. If the borrower obtains his or her own insurance, there is no discrimination. Congress amended the FHA in 1988 [Public Law 100-430] to include an administrative enforcement mechanism for HUD and allow increased penalties for violations. It also extended the law to the secondary mortgage market. While HUD has primary enforcement authority for compliance with the FHA, financial institutions are supervised under the FHA by the FDIC. Violations and Enforcement The protection of the law extends to people who are related to the transaction but not necessarily the subject of discrimination, like sellers and real estate agents. Employers can’t take adverse action against people who refuse to participate in discrimination or whistleblowers. Advertising The Fair Housing Act also prohibits discrimination in advertising. While many of the advertising guidelines written into law were repealed, it is still is illegal to make, print, publish; to use words, phrases, symbols, or photographs; or to express to agents, brokers, or employees a preference for or limitations; or that dwellings are or are not available to a particular group or persons because of race, color, sex, religion, national origin, familial status or handicap. Like the ECOA, under the FHA creditors may encourage members of traditionally disadvantaged groups to apply for credit. Violations     

Refusing to sell or rent housing after a bona fide offer is made, or refusing to negotiate to sell or rent, or otherwise make unavailable or deny, a dwelling to any person. Discriminating against any person with respect to terms, conditions, or privileges of sale or rental of a dwelling, or with respect to the provision of services or facilities in connection with the sale or rental. Making any oral or written statement or advertisement with respect to a sale or rental of a dwelling that indicates any preference, limitation, or discrimination or an intention to make any such preference, limitation, or discrimination. Representing to any person that any dwelling is not available for inspection, sale, or rental when such dwelling is available. Inducing or attempting to induce for profit, any person to sell or rent any dwelling by representations regarding the entry or prospective entry into the neighborhood of a certain person or persons.

Section 804 is particularly significant because it makes it unlawful not only to refuse to negotiate or complete a sale or rental, but also to “otherwise make unavailable or deny” a dwelling on a

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prohibited basis. The court has characterized this language as being “as broad as Congress could have made it” Limitations Extended to 3rd Parties In further attempting to address discriminatory actions, FHA takes the aggressive approach of identifying practices that may utilize unlawful practices. Appraisers cannot use prohibited bases for determining value. While issues that positively affect diversity, like wheelchair accessibility, can be used as positive factors, racial, gender or issues of national origin may not be. In the secondary market, knowingly buying a loan that was made on a discriminatory basis is prohibited. The pursuit of such actions must take reasonable care not to disrupt the availability of financing in neighborhoods. Allegations of Discrimination A complaint may be filed with HUD which will investigate and attempt to resolve the grievance by means of conference, conciliation, and persuasion. Persons also may sue anyone who allegedly discriminated against them, whether or not they file a complaint with HUD. The Attorney General of the United States may also sue for an injunction against any pattern or practice of resistance to the full enjoyment of the rights granted by FHA. Filing Complaints Borrowers have one year to file a complaint with HUD. The complaint should include:     

name and address; The name and address of the person or company who is the subject of the complaint; The address or other identification of the housing involved; A short description of the facts indicating rights were violated; and The dates of the alleged violation.

HUD will notify the complainant when it receives the complaint. Normally, HUD also will:   

Notify the alleged violator of the complaint and permit the person to submit an answer; Investigate the complaint and determine whether there is a reasonable cause to believe the Fair Housing Act has been violated; and Inform the complainant if it cannot complete an investigation within 100 days of receiving the complaint.

The Credit Report A credit report includes information on where you live, how you pay your bills, and whether you've been sued, arrested, or filed for bankruptcy. Nationwide consumer reporting companies sell the information in reports to creditors, insurers, employers, and other businesses that use it to evaluate your applications for credit, insurance, employment, or renting a home.

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Each repository presents information in a different format. Most mortgage lenders, mortgage brokers and banks utilize repository information consolidators that provide the information in formats required by the loan originators.

The Home Mortgage Disclosure Act (HMDA) – Regulation C HMDA, enacted by Congress in 1975, requires most mortgage lenders located in metropolitan areas to collect data about their housing-related lending activity, report the data annually to the government, and make the data publicly available. Initially, HMDA required reporting of the geographic location of originated and purchased home loans. In 1989, Congress expanded HMDA data to include information about denied home loan applications, and the race, sex, and income of the applicant or borrower. In 2002, the Federal Reserve Board (the Board) amended the regulation that implements HMDA (Regulation C) to add new data fields, including price data for some loans. HMDA does not prohibit any lending activity, nor is it intended to encourage unsound lending practices or the allocation of credit. Congress enacted HMDA to:  Provide the public with information to judge whether lenders are serving their communities;  Enhance enforcement of laws prohibiting discrimination in lending like the Equal Credit Opportunity Act (ECOA) and Fair Housing Act (FHA)  Provide private investors and public agencies with information to guide investments in housing. HMDA data covers home purchase, home improvement loans and refinance transactions. It also seeks to collect data on originations, servicing transfers, and denied, incomplete or withdrawn applications. With some exceptions, for each transaction the lender reports data about: the loan (or application), such as the type and amount of the loan made (or applied for) and, in limited circumstance, its price; the disposition of the application, such as whether it was denied or resulted in an origination of a loan; the property to which the loan relates, such as its type (single-family vs. multi-family) and location (including the census tract), and the applicant’s ethnicity, race, sex, and income. Most loans secured by primary residences are required to be reported. Home equity line of credit (HELOC) reporting is optional. A lender does not have to report HMDA data unless it has an office in a metropolitan statistical area (MSA). Banks, savings and loan associates, credit unions, and mortgage and consumer finance companies are required to report HMDA data if they meet the law’s criteria for coverage. Although the information changes annually, a lender is regulated by HMDA if: For Depository Institutions

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the assets of the institution total more than $36 million; depository institutions with assets of $36 million or less as of December 31, 2006, are exempt from collecting data in 2007. the institution has a home or branch office in a metropolitan statistical area or metropolitan division (MSA/MD) the institution originated at least one home purchase loan or refinancing of a home purchase loan secured by a first lien on a one-to-four-family dwelling? federally insured or regulated; or was the mortgage loan insured; guaranteed, or supplemented by a federal agency; or was the loan intended for sale to the Federal National Mortgage Association (FNMA) or Federal Home Loan Mortgage Corporation (FHLMC)?

a for-profit lender? home purchase loan originations (including refinances of home purchase loans) equal or exceed 10 percent of its total loan originations, measured in dollars, or equal $25 million or more? either: (a) have a home or branch office in an MSA/MD on the preceding December 31, or (b) receive applications for, originate, or purchase 5 or more home purchase or home improvement loans on property located in an MSA/MD in the preceding calendar year? either: (a) have assets (when combined with the assets of any parent corporation) exceeding $10 million on the preceding December 31, or (b) originate 100 or more home purchase loans (including refinances of home purchase loans) in the preceding calendar year?

The Loan Application Register (LAR) The LAR itemizes reportable transactions by individual application. Lenders are not required to arrange transactions on the LAR in any particular order. Any member of the public may request a LAR from any lender covered by HMDA. To help preserve consumer privacy, the law requires lenders to remove the loan or application number and the application and action taken dates before making the LAR public. Interest Rate Data One of the greatest controversies over HMDA data arose in 2004 when lenders were required loans that exceeded an APR threshold much lower than previously required. Loans subject to Section 32 of the Truth-in-Lending Act, known as The Home Owners Equity Protection Act (HOEPA) were always reported separately. Now lenders had to report “higher cost,” or SubPrime, loans at a lower threshold. Not surprisingly, a large concentration of loans made in 2004 (reported in 2005) fell into this new category. As intended, the data showed lending patterns indicating certain portions of the population were offered higher cost loans at a higher percentage. st

1 Mortgage 2nd Mortgage

HOEPA Threshold

HMDA High Cost Threshold

8% over comparable treasury 10% over comparable treasury

3% over comparable treasury 5% over comparable treasury

More specifically, the price data take the form of a “rate spread.” Lenders must report the spread (difference) between the annual percentage rate on a loan and the rate on Treasury securities of comparable maturity. For first-lien loans, the threshold is three percentage points above the Treasury security of comparable maturity; for second-lien loans, the threshold is five percentage points. The Board chose the thresholds in the belief that they would exclude the vast majority of prime loans and include the vast majority of sub-prime loans.

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Lenders do not report the APR itself. Rather, for loans with rate spreads exceeding the prescribed thresholds, lenders report the difference between the APR and the rate on Treasury securities of comparable maturity. Lenders continue to “flag” indicating loans exceeding the price triggers of the Home Ownership and Equity Protection Act (HOEPA). Those triggers are substantially higher than the thresholds for reporting rate spreads.

Figure 24 - These are the various calculations made in determining whether a loan is "higher cost" and needs to be reported as such.

COMMUNITY REINVESTMENT ACT (CRA) The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods. It was enacted by the Congress in 1977 (12 U.S.C. 2901) and is implemented by Regulation BB (12 CFR 228). The regulation was revised in May 1995. HMDA data is very important in the evaluation of an institutions CRA performance. Evaluation of CRA Performance The CRA requires that each depository institution's record in helping meet the credit needs of its entire community be evaluated periodically. That record is taken into account in considering an institution's application for deposit facilities. The CRA does not give specific criteria for rating the performance of depository institutions. The law indicates that the evaluation process should accommodate an institution's individual circumstances. The law does not require institutions to make higher risk loans that jeopardize their safety. An institution's CRA activities should be undertaken in a safe and sound manner. Home Owners Protection Act (HOPA) The Homeowners Protection Act of 1998 - which became effective in 1999 - establishes rules for automatic termination and borrower cancellation of PMI on home mortgages. With less than 20 percent down on a home mortgage, lenders often require Private Mortgage Insurance (PMI). PMI protects the lender if the borrower defaults on the loan. These protections apply to certain home mortgages signed on or after July 29, 1999 for the purchase, initial construction, or refinance of a single-family home. These protections do not apply to government-insured FHA or VA loans or to loans with lender-paid PMI. After July 29, 1999, PMI must be terminated automatically when the borrower reaches 22 percent equity based on the original property value. PMI also can be canceled upon request at 20

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percent equity, if the property is still owner occupied, if there have been no late payments in the past 12 months, and there are no 2nd liens in the property. Non-conforming loans are considered "high-risk," and the equity threshold is 23 percent. FTC's Telemarketing Sales Rule (TSR) – DO NOT CALL The Federal Trade Commission (FTC) has amended the Telemarketing Sales Rule (TSR) to establishing a national "do not call" registry (DNC). In addition, amendments to the TSR restrict call abandonment, crack down on unauthorized billing, and require telemarketers to transmit caller ID information. Telemarketing has played a major role in the development of so-called “call center lenders.” The extent to which these lenders are impacted by the rule is a function of how much outbound calling they do. If a lender is conducting outbound calls - even a small number – the lender should register with the FTC and have a process for comparing the list against the DNC. Lenders who buy leads from telemarketing firms are not required to register, but must honor any consumer request for list removal. By September 2004, telemarketers and other sellers had access to the do not call registry, and are required to “scrub” their call lists against the national "do not call" registry at least once every 31 days. A consumer's number will stay on the registry forever, until the consumer asks for the number to be removed from the registry, or until the consumer changes phone numbers. Violators are subject to a fine of up to $11,000 per violation. A telemarketer or seller may call a consumer with whom it has an established business relationship for up to 18 months after the consumer's last purchase, delivery, or payment - even if the consumer's number is on the national "do not call" registry. In addition, a company may call a consumer for up to three months after the consumer makes an inquiry or submits an application to the company. And if a consumer has given a company written permission, the company may call the consumer even if the consumer's number is on the national "do not call" registry. If a consumer asks a company not to call, the company may not call, even if there is an established business relationship. Indeed, a company may not call a consumer - regardless of whether the consumer's number is on the registry - if the consumer has asked to be put on the company's "do not call" list. Call Abandonment If a consumer is unable to speak to a sales representative within two seconds of the consumer's greeting the telemarketer is guilty of call abandonment. As long as no more than 3% of the caller’s calls are handled this way, or the telemarketer is able to play a recorded message that is not a sales pitch, and has allowed the phone to ring at least 4 times for 15 seconds, the company has protected itself against call abandonment charges. Rules for Telemarketers 

may call consumers only between 8 a.m. and 9 p.m.

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 

must promptly identify themselves as a seller and explain that they're making a sales call before pitching a product or service must disclose all material information about the goods or services they are offering and the terms of the sale. Misrepresenting any terms or conditions of the sale is prohibited.

Facsimile transmissions, electronic mail, and similar methods of delivery are direct mail for purposes of the direct mail exemption.

The USA PATRIOT ACT The most important component of the USA Patriot Act as it applies to home lending is the identification of borrowers. Financial institutions must collect positive identification for all borrowers. In addition, financial institutions must complete a “Suspicious Activity Report” for these finan-

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cial transactions over $10,000. Bankruptcy Abuse Prevention and Consumer Protection Act The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) became effective on October 17, 2005. This law is designed to reduce number of complete discharge bankruptcies (Chapter 7) that are filed by individuals. It forces borrowers who have means and income to obtain a Wage Earner Plan (Chapter 13) whereby the debts get paid off instead of charged off. We know that borrowers who have declared bankruptcy face greater challenges in obtaining loan approvals initially. Normally, after time has elapsed, the borrower is able to get a clean slate. BAPCPA requires that petitioners  

Submit a “means test” for approval by the court Complete pre-filing counseling from a court approved counseling agency

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Chapter 15 – Fraud Introduction In today’s world of information and regulation, many professionals have come to believe that they understand the concept of predatory lending. Charging a borrower a higher rate than market, or encouraging a borrower to take a transaction that is less than advantageous to him or her are easily understood examples. However, when ethics enter the equation, the question becomes “what is the right thing to do?” At the center of the debate is the issue of fraud – misrepresenting information on any level. These three concepts inextricably link the legal, industry and personal standards for behavior. The attempts to identify predatory lending and fraud practices have been memorialized in our body of law. We don’t want to get caught perpetrating fraud – that might put us in jail. It is standards of ethical conduct – where there isn’t necessarily a legal ramification – where the standards of behavior start to go into the gray area. According to the Mortgage Asset Research Institute (MARI), in 2008 78% of all mortgage applications included some misrepresentation. In 2005, the FBI reported that one in ten mortgage applications included some misrepresentation. Mortgage fraud is increasing. While bad checks still account for the majority of suspicious activity reports filed by federal related financial institutions, mortgages have moved up to second position. In 2005 there were over 21,994 suspicious activities reports filed within the real estate industry, yet only three percent were ever investigated. In 2008 the FBI reported 63,173 Mortgage Fraud Suspicious Activity Reports (SARs) with more than $1.5 billion in losses. Through February 2009, there were 28,873 SARs. This compares to only 4,200 SARs during all of 2001. These fraudulent loans often end up in foreclosure creating financial loss to mortgage lenders. Since foreclosure is a cost of doing business, lenders recover financial losses by increasing the cost of loans. We all pay for fraud. Depending on market conditions, losses may be minimized by rapid property appreciation. This can tend to conceal the pervasive influence of fraud damage. When market conditions deteriorate, the problem is exacerbated. In addition, appreciating properties tends to make lenders more aggressive – less close underwriting, riskier guidelines and a reliance on underwriting technology create additional vulnerability to the problem. Technology has also made it easier to perpetrate fraud.

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Geography plays a part as well. The states that the FBI sees as having the most mortgage fraud related problems in 2008 were Florida (1), Nevada (2) Michigan (3), California (4), Utah (5), Georgia (6), Virginia (7), Illinois (8), New York (9), and Minnesota (10).

Types of Fraud Fraud for Housing Fraud for Housing occurs when a borrower misrepresents his/her employment history, credit history, or income to secure a mortgage. He or she may be aided by a mortgage broker or loan officer. Fraud for Profit - Industry Insider Fraud Fraud for Profit occurs when there is conspiratorial use of inflated appraisals, falsified loan documents, and straw buyers to obtain purchase money from lenders. Because the insiders know the business, they can easily skirt the systems in place to avert fraud detection systems. 80% of all reported fraud losses involve collaboration or collusion by industry insiders, according to the FBI. Exigent Fraud This is fraud perpetrated without a financial motive, but is nonetheless fraud. Examples include the loan officer who signs disclosures on behalf of a borrower to satisfy a closing requirement – victimless, for the benefit of the borrower, but nonetheless fraud. Perpetrators It is hard to imagine a normal individual waking up in the morning and saying to him or herself, “I’m going to commit fraud today!” A completed mortgage transaction involves the participation and cooperation of many individuals. Often we remark that there are so many moving parts in a mortgage transaction that it is a miracle any get done. Because a loan file passes through so many hands, there is greater opportunity for fraud without the other contributors’ knowledge. While some are fulfilling a carefully orchestrated scheme, while others are sincerely unaware that their actions could bring fines, loss of licensure, or even jail time. They believe what they're doing is legal and condoned because "so many established people are doing the same thing." Real Estate Brokers Even ethical real estate professionals walk a fine line with respect to fraud. Many daily practices border on fraud because of the diverse interests agents and brokers represent. The motivation is the sale, and while many agents may not actually participate in perpetrating fraud, they may suggest it – such as tricks for getting loans, maneuver cash, or how to sell a distressed property. For agents the lure is particularly strong because there is no vested financial interest in protecting those beyond their defined agency relationship. Agents and brokers are industry insiders, so are educated on the tricks of the trade.

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Real Estate Attorney Real Estate Attorneys are the final gatekeepers to the sanctity of a transaction. They hold the purse strings by disbursing funds. A simple act of omission can conceal an entire fraud scheme. Even if an appraiser fails to list recent sales of a property, the real estate attorney or the entity responsible for the title search should identify changes of ownership. For most elaborate fraud schemes to succeed, the real estate attorney may be responsible for failing to properly to establish ownership and chain of title. Appraisers Appraisers had their own licensing to be concerned with. They, too, are faced with tremendous pressure to provide results. Their business is dependent on referrals from lenders, and appraisers report being pressured to deliver a result. The Appraisal Intelligence National Appraisal Survey of 2003 showed data that 89 percent of respondents felt pressure to hit a number from a mortgage broker in the last year. In addition, the same 89 percent of respondents indicated that they had felt pressure to hit a number from a mortgage broker, 66 percent reported such pressure from a loan officer. The survey choice “anyone else” drew no affirmative responses. As a consequence, the Appraiser Independence Rule was made law in 2009, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Borrowers Borrowers become perpetrators when they work to circumvent guidelines by intentionally providing false information. They may use a false identity, provide misleading documentation as to their qualification, or misrepresent their motivation in a transaction. Most borrowers, however, are outsiders and amateurs. A complicit borrower or buyer is usually working under the direction of an industry insider. Too often it is a naïve or desperate borrower who ultimately pays the price by losing a home, ruining a credit history, or becoming subject to prosecution. Loan Officer "You can't con an honest person." A mortgage professional’s best defense against becoming an unwilling participant in a mortgage fraud scheme is a solid commitment to ethical business practices and a system of accountability to hold them to that commitment. Being aware of the types of fraud schemes being perpetrated by others in the industry will arm you with information to help steer you away from being seduced into or inadvertently becoming a participant in mortgage fraud. When the gatekeeper - the mortgage professional - becomes involved, he or she knows the tactics used by fraud detection specialists and it becomes more difficult to say whether the borrower or the originator first introduced false documentation into a mortgage file.

Fraud Schemes

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New Schemes – Short Sale Fraud The meteoric rise in the number of foreclosures and borrowers with negative home equity precipitated an environment that encourages “Short Sale Fraud.” Short sale fraud takes advantage of lenders who are simply besieged with adverse properties and unable to pursue due diligence of property valuation when a borrower begins to default on a mortgage. The Short Sale Fraud scenario occurs like this:    

A property owner is approached by a Short Sale conspirator to who tells the owner that he or she can capitalize on market by defaulting on the mortgage and buying the property back at a below market price. The property owner withholds payments on the mortgage – defaulting The conspirator contacts the lender and offers to purchase the property for less than the amount owed – in a short sale. The lender does not know that the borrower intentionally is defaulting. The lender agrees to a short sale and the borrower and conspirator purchase the property at a below market value pocketing the profit.

This scheme can also be combined with a straw-buyer scheme, where the property is purchased with the sole intent of defaulting and re-purchasing the property at a discount. New Schemes – Foreclosure “Rescue” The Financial Crisis and its concomitant wave of troubled mortgagors provided fuel for a plague of foreclosure rescue schemes. These schemes center around borrowers facing foreclosure and the conspirator normally promises one of three types of relief.

The “Rent Back” – the owner deeds the property to the conspirator. The conspirator allows the former owner to stay in the property at market rent, with the promise that some of the rent can be applied to re-purchase the home later. There are two potential frauds in this scenario: 1.) The terms are so impossible that the former owner can never reclaim the property or 2.) The conspirator keeps the rent money and never addresses the delinquent mortgage, resulting in a foreclosure and eviction to the unsuspecting victim. The “Consultant” – the owner pays a fee to a conspirator who represents that he or she can negotiate on the owner’s behalf to mitigate the foreclosure. In reality, the consultant can do no more than the owner can in this effort. The conspirator keeps the fee and disappears, leaving the victim in worse condition than before. The “Rescue Refinance” – the owner accepts a refinance of the delinquent mortgage to escape the foreclosure. The onerous terms of the refinance reflect the owner’s desperation. The owner cannot maintain the new terms any more than the previous terms, except now the equity has been stripped from the property (see “equity stripping”) and the borrower again becomes delinquent and subject to the foreclosure. Appraisal Fraud

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The appraisal is an independent estimate of a property's market value. Lenders rely on appraisers to ensure the investment in the property's mortgage is secure and has equity. Appraisal fraud occurs when a property value is falsely inflated. The fraud can happen in a number of ways.    

an official-looking appraisal document – electronic appraisals that are digitally signed can be modified Inappropriate comparables to support a home's value – perhaps the appraiser selected comparables that were further away from the subject. Reviews of faulty appraisals indicate appraisers ignore comparable sales closer in proximity to achieve a value conclusion erroneous data intentionally or unintentionally used failure to list recent sale or listing of the property

Mortgage personnel are not insulated from implication in these issues. Courts have found that brokers and lenders may be liable for defective appraisals. For this reason, lenders maintain lists of appraisers to track performance, and verify current licenses. Deceptive appraisals are at the root of many fraudulent lending transactions. HUD has passed two rules that specifically address appraisals. One seeks to control faulty appraisals by making lenders accountable for the quality of appraisals on properties securing FHA-insured mortgages. The FHA “Appraiser Qualification Rule” seeks to ensure that appraisers have strong professional credentials. Scenario 1 A borrower wants to sell his property to buy a more cost efficient home with a lower monthly payment and pay off debts. The borrower owes $170,000 on his first mortgage and owes $30,000 in other debts. The property is listed for $206,900. A properly motivated buyer isn’t likely to pay much more than the property's sales price. The borrower will not net enough after the sale, commissions, and repairs to pay off debts. The borrower is unable to dispose of the property and payoff debts

Scenario 2 A borrower owes $170,000 on a first mortgage and wants to take out a second mortgage for $30,000 to consolidate debt. The lender won't lend more than 95% LTV and the property appraisal indicates a $206,900. If the home value can be coaxed up to $210,600, the problem goes away. The borrower is able to achieve the goal, but the appraisal is inflated

While grossly inflated appraisals are normally at play in a flipping scheme, the pressure to inflate appraisals occurs on a daily basis. For purchase transactions, the agent presses the lender to support the transaction – after all, the borrower is willing to pay the price. Can’t you just get the appraiser to support it? Often, a property value that doesn’t support the proposed transaction can create the pressure to inflate appraised value. Turning the Tables- Appraisers Reporting Lenders It is the responsibility of the appraiser to act ethically and report an unbiased opinion of value. Appraisers can report instances of this type of pressure to state banking regulators or to any of the five federal financial regulators when it involves officials within a lending institution, such as a loan officer. However, the appraiser must report the instance in writing and it must be ad-

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dressed to the correct regulatory agency. Determining which agency to report the instance of client pressure can be a daunting task, because of the sheer number of federal and state regulators. In addition, a large portion of the actors applying pressure on appraisers are generally unregulated by federal and state agencies. APPRAISAL FRAUD RED FLAGS Ordered by a party to the transaction (seller, buyer, broker, etc.) Comps are not verified as recorded or submitted by potentially biased party (seller, real estate broker) Tenant shown to be contact on owner-occupied property Income approach not used on tenant-occupied SFR Appraiser uses FNMA number as sole credential (discontinued program) Market approach substantially exceeds replacement cost approach "For Sale" sign on the photos of the subject (in refinance loans) HUD-1 or grant deed on original purchase is less than two years old (for refinance loans) Year Purchased/Original Purchase Price – Property value increase > 50%

Appraisal Review A factual review of an appraisal focuses on comparable sales. more closely reviewed when LTV’s are high.                  

The comparable sales will be

Location Area types - (urban, suburban and rural) and built-up percentage. Room count Square footage Property type and design Predominant price range Ownership rights Age – actual and effective Distance of comparables – Comps outside a one mile radius should be addressed. All sales within 6 months in the same subdivision should be addressed. Key line adjustments Lot size Topography Land value Design and appeal, view, condition, age and quality of construction are very difficult to confirm and should be supported by other documentation. Across-the-board adjustments indicate that the comparables are dissimilar Square footage adjustments. Type of financing. Sales concessions, seller contributions, special financing considerations.

Adjustments An explanation for excessive adjustments is required if they exceed certain percentages.

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 

Total net adjustments exceed 15% Total gross adjustments exceed 25%

Builder Bailout Scheme Tract home builders are speculating that they can sell homes in an incomplete neighborhood. They receive construction financing and begin to construct residences, hoping that buyers will purchase them. There are many reasons why a properly motivated buyer will not buy – interest rates rise, the neighborhood lacks appeal, the property is a poor product. A builder who cannot sell property has a huge liability and faces certain bankruptcy. The motivation for desperate action is present. Since the builder controls all sales in his subdivision, he or she can transfer properties creating substantiation of supporting sales. To begin the extrication, the builder finds a buyer to purchase the model. The builder promises to credit the buyer back for down payment funds, and to rent the model from the buyer’s in an amount sufficient to cover the mortgage payment. BUILDER BAIL OUT RED FLAGS Straw Borrowers Multiple Loans to the Same Borrower Initial Payments Made by Entities Other than the Borrower Borrowers Appear to have been Employed by the Builder or a Related Entity

Occupancy Fraud Occupancy fraud is one of the most common types of mortgage fraud. This is an area growing concern and one faced by many mortgage professionals. The fraud scheme is to get a lower rate, down-payment, or closing cost package buyers by falsifying their primary residence claim. They state the property is owner occupied instead of a vacation property or investment property which represents more risk to lenders than a primary residence. More than half—about 53%—of claims filed with The Prieston Group contained some type of occupancy misrepresentation. Occupancy fraud occurs when borrowers—or someone acting on behalf of borrowers—misrepresents whether they plan to live at the property. Following behind occupancy fraud were schemes involving hidden debt (found in 31.6% of all claims), employment fraud (found in 30.3% of all claims) and straw borrowers (found in 12.9% of all claims). In fact, occupancy fraud was the No. 1 type of fraud reported in four of the top five mortgage fraud hot spot states. In Georgia, which led the list in number of claims filed during the first half of the year, occupancy fraud was found in 48% of the files. The average FICO score of claims filed in Georgia was 633 and the average loan-to-value ratio was 86%. APPLICATION FRAUD PREVENTION TIPS Invalid social Security number Significant or contradictory changes from handwritten to typed loan application Contradictory Address Information on asset/income documentation A significant increase or unrealistic change in commuting distance New housing is not large enough to accommodate all occupants

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The appraisal shows a tenant as the contact on an owner-occupied loan.

Flips Property flipping occurs when a property is bought and resold within a very short period of time. Some property flips occur within the same week, and even on the same day. The resale usually involves the use of an inflated appraisal of the property’s value. Transactions involving real property sold at highly inflated values are suspect. A property’s purchase price should not be disproportionate to the tax valuation unless there have been substantial improvements made to the property. Flipping schemes involve the multiple transfers of property in a brief period to artificially inflate the value in order to obtain larger loans, skim equity off the property or conceal the identity of the true buyer or seller. Typically a seller, appraiser and real estate broker are involved. Flips are usually concealed by a settlement agent’s documentation.    

Inaccurate HUD-1 failing to show the exact origins and payees of funds can facilitate an illegal land flip. Commitments erroneously showing the "middle man" in title instead of the actual owner. Schedule A of a title insurance commitment should be a true reflection of ownership. Performing two closings and using the money from the second closing's buyer to pay the seller in the first closing without full disclosure to the buyer and new lender on the HUD-1 Inaccurately indicating the actual equity position of the borrower who is purchasing with borrowed funds from another closing, yet reflecting on the HUD that the borrower is coming to the closing with cash.

PROPERTY FLIPPING RED FLAGS Inflated Sales Price – Substantial Appreciation Since Transfer Two or more simultaneous closings Seller not on title or owned for a short time Reference to double escrow on HUD-1 form Transaction parties are affiliated The preliminary title report reveals delinquent taxes on the property. The homeowner's insurance policy is listed in the name of someone other than the borrower.

One flipping scheme starts with a seller with a difficult to sell property. Advertising a “turnkey” investment opportunity, they lure a buyer into purchasing the property by providing fraudulent rental income documentation. They allow the buyer to purchase with no money down by inflating the sales price and creating an artificial deposit or credit for down payment. The buyer provides income documentation and applies for a loan. Depending on how sophisticated the fraud is, there are several junctions here. Obviously, if the property is overvalued, they are not going to get a legitimate appraiser to support the appraisal. Option 1 - Negotiate an inflated appraisal with a conspiring appraiser. Nearby subdivisions are selling at higher levels than the subject subdivision. This is a more difficult scheme to support long term because a review appraisal will reveal the falsified information. In sophisticated flipping schemes a more intricate approach is required.

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Option 2 – Create inflated comparables for the appraiser to utilize. This is an approach utilized by builder flipping schemes. By transferring properties between individuals, perpetrators create a record of higher and higher sales prices. A legitimate appraiser is able to use these comparable sales to unknowingly support an inflated sales price. In this way the buyer, seller, and lender are all unaware of the fraud. The settlement agent, however, is conspiring with the agent or broker. First, the title insurance binder has to show the agent or broker as the seller. The lender, thinking this is a legitimate transaction, disburses the inflated loan proceeds to the settlement agent. The settlement agent now conducts two settlements simultaneously – one from the seller to the agent at the market sales price and one from the agent to the buyer at the inflated price. The broker keeps the difference in proceeds. The conspirators set some funds aside to keep the buyers rental income going for a while. The next transaction will be even further inflated because there is now an additional comparable to support a higher sales price. Flipping Tra nsa ction Fina ncia l Ana lysis Property Value Seller Owes Contract Buyer offers seller Flipper Sells to Turn Key Buyer New Buyer's Mortgage Proceeds of Flip

$ $ $ $ $ $

100,000 100,000 110,000 200,000 190,000 80,000

Actual Rent $ Fictitious Rent $ Shortfall $ Seller Gets Flipper Gets

$ $

600 1,400 (800) 10,000 80,000

Figure 25 - This example shows how property is re-sold - "flipped" - and the false equity stripped.

Foreclosure or Deed-in-Lieu Sometimes, when a homeowner knows he or she is going to file bankruptcy, the owner will transfer the home to a 3rd party so the equity cannot be counted in the bankruptcy. Most states have adopted the Uniform Fraudulent Conveyance Act or its replacement, the Uniform Fraudulent Transfer Act. Section 548 of the Bankruptcy Code defines fraudulent conveyances for the purposes of bankruptcy proceedings. Transfers for less than equivalent value made under such circumstances deprive unsecured creditors of assets which they could otherwise look to for satisfaction of a judgment. Such transfers are by statute constructively fraudulent. The fraudulent conveyance law makes the insolvent debtor's charity start with unsecured creditors. Fraudulent Legal Documentation Attorneys are officers of the court, and would not easily commit fraud without substantial pressure or incentive. However, many closings are conducted by “settlement officers” acting in the capacity of a facilitator. In this way legal documentation can easily be prepared to conceal the true nature of a transaction.  

Changing the dates on deeds so that the land flippers could conceal the fact that they were selling properties prior to their actually having acquired them Notarizing the signatures of purported property buyers on several documents, when those persons did not actually appear to sign the documents

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   

Preparing fictitious leases Preparing false closing documents, HUD-1 statements, Preparing false second mortgages that were not recorded Creating false escrow letters

CLOSING/ESCROW/TITLE REPORT RED FLAGS Income tax or similar liens against borrower on refinances Delinquent property taxes Notice of default recorded Seller not on title (double escrow) Modification agreement on existing loan (s) Seller owned property for a short time with cash-out on the sale Buyer has preexisting financial interest in property Cash paid outside of escrow to seller Down payment paid into escrow upon opening Reference to another (double) escrow/closing Related parties involved in the transaction Unusual credits with no economic substance (see HUD-1 settlement statement) Right of assignment (who is the actual borrower?) Power of attorney used (why can’t borrower execute document?) Business entity acting as the seller may be controlled or related to borrower Change of sales price to "fit" the appraisal No amendments to escrow "Fill in the blank" escrow instructions Purchase not subject to inspection Unusual amendments to the original transaction Demands paid off to undisclosed third parties (potential obligation) No real estate commission (possibly related parties) Actual settlement charges exceed "Good Faith Estimate" by 10% Recently recorded deeds or satisfactions may be recorded by a defrauder to get record title into his/her name, or clear an unpaid mortgage as an encumbrance Insufficient tax stamps/fees paid on previous transfer indicating lower value Recently recorded quit claim deeds – why warranty deed not used? Intra-family instruments – less than Arm’s Length Transaction, sale(s) to relative, related, or interested party Recorded instruments to returnable to a title company or attorney No borrower credit history developed Contract assigned, names added, or no agent Indication of default by the property seller

Always confirm changes in lender's written closing instructions in writing via fax or mail. The settlement agent should not rely on verbal changes from a loan processor or mortgage broker. Rushed deals from new customers should be treated with caution. This applies to all entities in the process. Straw Buyers A straw buyer is an individual who accepts a fee, to provide his/her name, social security number, and other personal information for use on a mortgage application. A straw buyer may not be aware of his or her complicity in a fraud. The buyer serves as a purchaser of a property sold at an inflated price. The property may be a rental property, although the buyer states he or she will

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be living in the property. Straw buyers naively expect to make money on these transactions, but they soon learn there is no rent and the property is not worth what he or she paid for it. Stuck with the property and unable to support the loan without rental income, the borrower defaults on the loan. Straw Sellers A straw seller is an individual who falsely claims ownership to a property. Falsified or fabricated title documents, including sham warranty deeds, are created to support the fraudulent claim that the straw seller is the owner of the property. Straw sellers may appear at closings where the property which they claim to own is transferred to straw buyers. In a situation where the agent has become a “contract owner”, that agent is a straw buyer to the real seller and a straw seller to the real buyer.

Mortgage Application Documentation Fraud Beware of “Rush” transactions from individuals you don’t know. Beware of borrowers whom you didn’t solicit. Come on – how many people really walk in to a loan officer’s business and ask for a loan?... unsolicited? PURCHASES New housing expense exceeds 150% of current housing expense Escrow closing check drawn on different depository from VOD Escrow receipt used as verification (may be a personal check or NSF) Fund paid outside of escrow (pre-existing trust relationship) Borrower lives with parents or relatives Borrower pays no rent at current residence Is the source of the down payment consistent with assets available? All recent increases in the bank accounts, as verified on a bank statement or VOD, must be explained. Sources of closings funds such as gifts, sale of assets, and stock liquidation must be verified with a "paper trail". The source of the funds (gift letter and copy of check) and the receipt of funds (copy of deposit slip and verified new balance) must be documented. Purchaser on contract?

Falsified Applications and Documentation A review of the statistics reveals that the number one source of fraudulent loan activity revolves around the loan application. Approximately 35 percent of all “red flags” on mortgage applications are due to blatant inconsistencies on the loan application. The mortgage professional should constantly be asking “Do the facts on this application make sense?”

Borrower Identity Fraud IDENTITY FRAUD RED FLAGS - CREDIT / CREDIT REPORTS No credit (possible use of alias) High income borrower with little or no cash (undisclosed liabilities) Variance in employment or residence data from other sources Recent inquiries from other mortgage lenders Invalid social security number AKA or DBA indicated

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Round dollar amounts (especially on interest-bearing accounts) Borrower cannot be reached at place of business Borrower cites cell phone as work or home number High income borrower with no "prestige" credit cards

A prevalent scheme is identity fraud. In the lending business our primary source of verification of a borrower’s identity is the use of the Social Security number. Social security number misuse occurs in a number of different ways. A borrower may present    

invalid social security numbers numbers that have been retired because they were issued to people who have died numbers that were issued to someone else or reported stolen numbers issued prior to the borrower's birth year numbers that didn't match the borrower's age

Social Security Numbers A Social Security Number (SSN) consists of nine digits, commonly written as three fields separated by hyphens: AAA-GG-SSSS. The first three-digit field is called the "area number". The central, two-digit field is called the "group number". The final, four-digit field is called the "serial number". With some exceptions, the Area is determined by where the individual APPLIED for the SSN (before 1972) or RESIDED at time of application (after 1972). The area assignments are provided in the supplemental information. Any SSN conforming to one of the following criteria is an invalid number: 1) 2)

Any field all zeroes (no field of zeroes is ever assigned) First three digits above 770

Social Security Number Area Prefix 001-003 NH 004-007 ME 008-009 VT 010-034 MA 035-039 RI 040-049 CT 050-134 NY 135-158 NJ 159-211 PA 212-220 MD 221-222 DE 223-231 VA 232-236 WV

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400-407 KY 408-415 TN 416-424 AL 425-428 MS 429-432 AR 433-439 LA 440-448 OK 449-467 TX 468-477 MN 478-485 IA 486-500 MO 501-502 ND 503-504 SD

530 NV 531-539 WA 540-544 OR 545-573 CA 574 AK 575-576 HI 577-579 DC 580 VI Virgin Islands 581-584 PR Puerto Rico 585 NM 586 PI Pacific Islands* 587-588 MS 589-595 FL


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237-246 NC 247-251 SC 252-260 GA 261-267 FL 268-302 OH 303-317 IN 318-361 IL 362-386 MI

505-508 NE 596-599 PR Puerto Rico 509-515 KS 600-601 AZ 516-517 MT 602-626 CA 518-519 ID *Guam, American Samoa 520 WY Northern Mariana Islands 521-524 CO Philippine Islands 525 NM 526-527 AZ

Credit Score Improvement Scheme A growing scheme for increasing credit scores comes from exercising the “named account holder” feature many credit card companies offer. A borrower with a low score is added to the account of a holder with an excellent record. The excellent account’s presence on the impaired borrower’s credit report drives the score up. Identity Theft Identity theft occurs when a perpetrator uses another individual’s name, social security number, driver’s license number, or other personal information to secure credit or make purchases. The use of the information is made without the knowledge of the individual whose personal information is included in fraudulent loan applications or other documents. File Segregation A popular credit repair scheme is called “file segregation.” In this scheme, borrowers are promised a chance to hide unfavorable credit information by establishing a new credit identity using a Federal Tax ID number instead of a Social Security number. “File segregation” is illegal. Credit Repair Organizations often promote this as a legitimate process by stating that borrowers cannot be legally required to provide a social security number. This is not untrue, but it does not endorse the process of substituting a Federal Tax ID number for a social security number. This is fraud. Unsuspecting borrowers can face fines and prison sentences. Income Documentation Fraud Once a borrower has made false claims on an application he or she must produce supporting documentation. Technology has permitted the production and submission of high quality authentic looking but fraudulent documents INCOME / EMPLOYMENT / EMPLOYMENT VERIFICATION RED FLAGS Employee is paid monthly Curiously “even” or rounded income numbers on documentation No prior year earnings on VOE Gross earnings per VOE for commission-only employees should not be used (see IRS Form 1040 Schedule C) Borrower is a business professional (may be self-employed) Answering machine or service at place of business (may be self-employed) Prior employer "out of business" Seller has same address as employer

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Employer signs VOE prior to date it was mailed by the lender Borrower uses employer’s letterhead for letters of explanation Employment verified by someone other than personnel department Pay stubs are not preprinted for a large employer Pay stubs are handwritten for a large employer Current and prior employment overlap Date of hire is weekend or holiday Income is primarily commissions or consulting fees (Self-employment) Employer uses mail drop or post office box for conducting business Change in profession from previous to current employer Borrower is a professional employee not registered/licensed (doctor, lawyer, architect, real estate broker, etc) Illegible employer signature with no further identification Inappropriate verification source (secretary, relative, etc.) Document is not folded (never mailed) Evidence of ink eradicator (whiteout) or other alterations Verification "returned to sender" for any reason Inappropriate salary with respect to amount of loan Check number sequence wrong - date changes but the check sequence does not match

Verbal Verifications When income documentation is presented, verbally verify the information.   

Independently verify business address (post office boxes can be a clue). Use directory assistance to verify business phone number. Contact the corporate office directly to avert the possibility of borrower “coaching” beepers, home answering machines or answering services

Self-Employed Borrowers Tax returns are complex documents and it can prove difficult to the untrained eye to detect fraud or misrepresentation. There are some common mistakes made by providers of fraudulent income tax returns. SELF EMPLOYED (Some "red flags" are indicators that someone may be self employed, these are important if a borrower has not revealed themselves to be self employed) Business entity not registered or in good standing with the applicable regulatory agencies Address and/or profession does not agree with other information submitted on the loan application Tax computation does not agree with tax tables No estimated tax payments made by self-employed borrower (Schedule SE required) No FICA taxes paid by self-employed borrower (Schedule SE required) Self employment income shown as wages and salaries Income or deductions in even dollar amounts High bracket taxpayer with few or no deductions or tax shelters High bracket taxpayer does not use a professional tax preparer Paid preparer signs taxpayer’s copy Paid preparer hand-writes tax return TAX RETURNS Schedule A – Real estate taxes paid but no property owned Schedule A – No interest expense paid when borrower shows ownership of property (or vice versa)

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Schedule A – Employee who deducts business expenses (check against Form 2106) Schedule B – Amount or source of income doesn’t agree with information submitted on loan application Schedule B – No dividends earned on stock owned (may be closely held) Schedule B – Borrower with substantial cash in bank shows little or no related interest income Schedule C – Gross income does not agree with total income per Form 1099 Schedule C – Borrower shows interest expense but no related loan (business loans with personal liability) Schedule C – Borrower takes a depreciation deduction for real estate not disclosed (or vice versa) Schedule C – No IRA or Keogh deduction Schedule C – No salaries paid on non-service companies Schedule C – No "cost of goods sold" on retail or similar operations Schedule C – No schedule SE filed (computation of self-employed tax) Schedule C – Net Income does not match page 1 1040 Schedule E – Net income from rents plus depreciation does not equal cash flow as submitted by borrower. Schedule E – Additional properties listed by not on loan application Schedule E – Borrower shows partnership income (may be liable as a general partner for partnership’s debts) Form W-2 – Invalid employer identification number Form W2 – FICA and local taxes withheld (where applicable) exceed ceilings Form W2 – Copy submitted is not "Employee’s Copy" (Copy C) Form W2 – Large employer has handwritten or typed W-2

Tax Return Authenticity Verification Most lenders require all borrowers to complete and sign some for of Tax Return verification authorization for the lenders use in the event should of a discrepancy.  

Request for Copy of Transcript (4506) – provides line summaries of tax return entries for comparison. Tax Information Authorization (8821) – provides complete forms for comparison, more substantive of fraud

The use of a tax verification service to verify tax information from the I.R.S. can produce verification within 24-48 hours. Asset Documentation Fraud Source of funds issues tend to be the greatest opportunity to discover fraud activity. This is because most lenders verify the ownership and source of funds. A straw seller is unlikely to give a stranger a large sum of cash to cover a large deposit. Borrowers who list a substantial securities investment but who have failed to save any other money, warrant a second review for clarification. Underwriters verify cash to assure that borrowers are not assuming other obligations in addition to the mortgage. VERIFICATION OF ASSETS /DEPOSIT / BANK STATEMENT Regular deposits (payroll) significantly at odds with reported income Earnest Money Deposit not debited to checking account NSF items require explanation. Large withdrawals may indicate undisclosed financial obligations or investments Lower income borrower with recent large accumulation of cash Bank account is not in borrower’s name (business entity, trust funds, etc.)

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Evidence of ink eradicator (whiteout) or other alterations Verification "returned to sender" for any reason High income borrower with little or no cash (undisclosed liabilities) IRA is shown as a liquid asset or a source of down payment Non-depository "depository" (escrow trust account, title company, etc.) Credit union for small employer Borrower’s funds are security for a loan Illegible bank employee signature with no further identification Source of funds consist of (unverified) note, equity exchange or sale of residence Cash in bank not sufficient to close escrow New bank account Gift letters must be carefully reviewed (canceled checks, bank statements) Borrower has no bank accounts (doesn’t believe in banks) Document is not folded (never mailed) Young borrower with large accumulation of unsubstantiated assets Young borrowers with substantial cash in bank

Validating “Cash on Hand” Many borrowers state the source of their funds is cash on hand. Verifying this money has been a time old problem for loan officers. The correct way to verify the asset is to show it in the bank and show the source of those funds, if possible. Some strategies to verify cash on hand are text book examples of money laundering. For instance purchasing products or commodities with cash, and receiving a refund in check form effectively launders those funds. Asset/Deposit Verification Scheme Sometimes referred to as “deposit rental” this scheme involves an institution that adds a borrower’s name to a verified account, and then allows the assets in the account to be verified as the borrower’s. While this scheme was popular momentarily, once it made press underwriters quickly looked for evidence of deposit rental circumstances in their files. Pending Rental Scheme In some cases a borrower buying a new home before selling a current residence may be asked to write a letter stating the pending property will be rented. This fraud is employed by real estate agents and loan officers when the borrower does not need the proceeds of the sale, but cannot qualify for the both the new and old mortgage. There is no renter, but a lease is provided to the underwriter to offset the mortgage payment on the old home. The property may eventually sell, but can create problems for the buyer if it doesn’t.

Punishment Federal Laws that Address Mortgage Fraud

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014 QuickStart Publications

There is not a federal law that specifically addresses mortgage fraud. Complaints filed in federal court against participants in schemes to fraudulently obtain a mortgage may include one or all of the following allegations: • • • • • •

Mail fraud Bank fraud Fraud by wire Making false statements to the government or to a financial institution Money laundering Conspiracy

Other potential charges include racketeering, embezzlement, and misappropriation of funds. Mail Fraud (18 USC Section 1341) Mail fraud is the knowing use of the mails to carry out a fraudulent scheme. In 1994, Congress amended the law to include the use of private or commercial mail carriers, such as Federal Express and the United Parcel Service in addition to the U.S. Postal Service. The statute provides in for fines up to $1,000,000, imprisonment of not more than 30 years, or both. Prosecutors face a relatively light burden in making a case for mail fraud. They must prove the existence of a scheme to defraud, intent to deprive another of money or property, and use of the mail to carry out the scheme. It is not necessary for the defendant to complete the mailing. The simple use of the U.S. mail or a private mail carrier to deliver an appraisal, title documents, or closing documents for the purpose of making a fraudulent mortgage loan is a violation of the law. Frauds by Wire, Radio, and Television (18 USC Section 1343) Wire fraud is the use of interstate wire communications, including the phone, television, radio, or internet to attempt carry out a fraudulent scheme. As with mail fraud, prosecuting a case for wire fraud does not require proof that a fraudulent scheme succeeded or that it created victims. Furthermore, each communication counts as a separate offense. Violations are punishable by fines not more than $1,000,000 or imprisonment not more than 30 years, or both. Bank Fraud (18 USC Section 1344) Whoever knowingly executes, or attempts to execute, a scheme or artifice to defraud a financial institution or to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both. Attempt and Conspiracy (18 USC Section 1349)

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014 QuickStart Publications

The crimes described by federal law as mail fraud, wire fraud, and bank fraud relieve prosecutors of any burden of proving that schemes are successful. The success of the scheme is not relevant to successful prosecution for these crimes. Section 1349 provides that any person who attempts or conspires to commit any offense shall be subject to the same penalties as those prescribed for the offense. Making False Statements to the Government (18 USC Section 1014) Under federal law, knowingly making false statements or overvaluing land or property in order to influence the decision of lending institutions “…shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.” False statements that can lead to fines and imprisonment include inflated appraisals used to secure a mortgage, and false statements in a lending transaction, such as falsely stating that a home will be used as a primary residence. Conspiracy (18 USC Section 371) The general conspiracy statute protects the federal government from fraud and other offenses. The law specifically addresses conspiracies “…to defraud the United States or any agency thereof….” Therefore, the law applies to fraudulent actions against government agencies such as HUD and the Federal Housing Administration. In order to successfully bring an action for conspiracy to defraud the government, prosecutors must show the existence of a scheme to defraud the government, and that the defendant knowingly used deceitful actions, false statements, or false representations to obtain property or funds from the government. Prosecutors are not required to show that the fraudulent statements or actions resulted in any actual loss to the government of money or property. Conspirators shall be fined or imprisoned not more than five years, or both. If the conspiracy is a misdemeanor the punishment shall not exceed the maximum punishment provided for that misdemeanor. Laundering of Monetary Instruments Money laundering is a term that describes financial transactions which are used to distance illegally obtained funds from their original criminal source. It is a common misperception that money laundering laws apply strictly to funds and proceeds from drug trafficking, terrorist activities, and organized crime. The misperception is understandable since the first federal law to define “money laundering” was enacted in 1986 to help fight the “War on Drugs.” However, federal money laundering laws are far-reaching and apply to all types of transactions, including fraudulent lending activities. If charges of money laundering are included in an action to address mortgage fraud, the defendant faces a much greater likelihood of a long prison sentence and large fines. A very aggressive prosecutor can turn almost any standard fraud into a money laundering case, thus increasing the guideline range and the potential jail time for the perpetrator.

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014 QuickStart Publications

Many defendants who face money laundering charges may not realize that they have laundered money. The Office of the Comptroller of the Currency (“OCC”) defines money laundering as “the criminal practice of filtering ill-gotten gains or ‘dirty’ money through a series of transactions so that the funds are ‘cleaned’ to look like proceeds from legal activities.” “Filtering” typically involves “placement”, which is the depositing of funds into a bank account. Then funds are “layered” or moved into a number of different locations, including offshore accounts. Then funds are “integrated” or reentered into the economy through the purchase of real estate or other investments. Although the OCC’s definition describes money laundering as a systemic and deliberate process, it is possible to prosecute a defendant for money laundering without showing his/her intent to launder the money. A defendant may be subject to prosecution after conducting an ordinary monetary transaction with proceeds which he or she knew to be from illegal activities. The criminally-derived funds involved in the transaction must exceed $10,000 and the transaction must be conducted through a financial institution. Federal Sentencing Guidelines Even though the law provides for it, a sentence for a full thirty years is unusual. Federal Sentencing Guidelines ensure that those who perpetrate economic crimes will serve time in prison. In 1984, the Sentencing Reform Act authorized the United States Sentencing Commission (“the Commission”) to create sentencing guidelines. Federal Sentencing Guidelines ensure uniformity in sentencing. The Commission had specific goals regarding the punishment of white collar crimes. Past sentencing practices revealed that sentences for fraud, embezzlement, and tax evasion generally received less severe sentences than did crimes such as larceny or theft, even when the crimes involved similar monetary loss. Many convicted of white collar crimes received sentences of probation served no time in prison. After reform there was a shift away from probation toward intermediate sentences that included some type of confinement. Today judges follow the guidelines carefully. The Feeney Amendment of 2003 requires judges, who impose lesser sentences than the Guidelines prescribe, to report to the Justice Department and to Congress. Industry Actions to Combat Fraud Private industry is actively involved in combating fraud. Because of the fact that fraud schemes tend to multiply from one single event, lender programs, government actions, service providers are developing methods to isolate problems early, before they grow into substantial issues. In 2003, a company called ChoicePoint created a new product known as the Mortgage Fraud Alert System (“MFAS”). MFAS reports nonpublic information on incidents of fraud. Subscribers to the service agree to send information to MFAS regarding incidents of fraud or irregular borrowing patterns. MFAS shares the information with other subscribers in order to alert them to the emergence of new fraudulent schemes.

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014 QuickStart Publications

Guaranty Asset Protection Services (“GAPS”) is a private investigations company that created a database program called AEGIS for use by lending institutions. It collects information on borrowers and industry insiders implicated in fraud. One lender specializing in loans to borrowers with poor credit histories developed its own automated underwriting system to identify fraudulent home loans. Using a scale of 0 to 52, the system evaluates loan applications and those with a score that exceed 30 are subject to investigation for fraud. HUD is using regulatory reforms and monitoring programs to improve its oversight of appraisers, and has adopted automated underwriting systems and consumer education programs to help to control mortgage fraud. HUD now refuses to insure FHA loans on properties that are re-sold within 90 days and require additional appraisals for homes resold within ½ year. The Federal Bureau of Investigation is building a database to get a better handle on property flipping, which comprises a majority of mortgage fraud cases currently under investigation The anti-flipping rule also addresses situations in which unscrupulous investors sell or assign the rights to a sales contract. Under the new rule, only the owner of record may sell a home to an individual who will secure FHA insurance for the mortgage. Lenders must verify compliance with this requirement by submitting documentation which shows that the seller is the owner of record. Acceptable documentation includes a copy of the recorded deed or a property sales history report. Prevention The industry can help protect itself and the broader public by creating a climate and culture that places a premium on quality control. Mortgage companies with effective quality control environments start with the full support and commitment of senior management. The desire to control quality should be reflected in your company's policies and procedures, compensation schemes and marketing efforts. Originators that neglect or downplay quality control do so at their own peril. Common Sense is the Loan Officer’s Best Defense There are no fool-proof methods for preventing fraud. A loan officer is the “field underwriter” and should be aware of issues that don’t seem to match. No specific factor “proves” fraud or misrepresentation but should encourage a deeper investigation into anything questionable or inconsistent.   

Consider the borrower’s level of income compared to current outgoings, savings patterns, and accumulated assets. Consider the borrower’s type of employment or profession compared to income level, job history, and education. Closely review the structure of the transaction.

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Though some may be hesitant to be a “whistle-blower”, everyone in the industry must be aware that the primary responsibility for policing the mortgage industry falls to those inside and those who count on its proper functioning for their livelihood. If the industry fails to properly police itself, the public will demand that the governing bodies become more aggressive in their efforts to do so. As has been shown in the past, any intervention efforts on the part of the government will undoubtedly mean more compliance and fewer options for borrowers.

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The Loan Officer’s Practical Guide to Residential Finance – SAFE Act Version © 2014 QuickStart Publications

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Chapter 16 – Predatory Lending Practices Introduction Predatory lending rules have evolved. Until the CFPB codified the Unfair, Deceptive and Abusiv