Chapter 43
The Adjustable Rate Loan, the Graduated Payment Loan, and Other Loan Arrangements
INTRODUCTION
When interest rates are generally stable from year to year, the fixed-rate amortized loan works well for both the borrower and the lender. For the borrower, the fixed-rate loan is easy to budget since each monthly payment is the same for the life of the loan –usually 30 years. For the lender, the fixed-rate, level payment mortgage results in few cases of default and foreclosure and a good margin of profit.
During times of high inflation and rising interest rates it is harder for purchasers to qualify for fixed-rate loans and more difficult for lending institutions to rely on their portfolio of fixed-rate loans to generate an adequate income stream. When interest rates go up and stay up for an extended period, lenders face a unique problem. The income from their fixed-rate loan portfolio stays the same; but to obtain new funds to lend, they have to pay their depositors or investors more interest because investment alternatives, such as money market funds, are available at much higher returns. This financial problem for the lender is an “asset/liability mismatch.” Inflation also causes lenders to increase interest rates on traditional, fixed-rate loans, pricing many home buyers out of the market. New ways of financing can make homes more affordable for the buyer while shifting the risk of interest rate increases from the lender to the borrower.
Such conditions motivated the real estate lending industry to create alternative loan agreements during the late 1970’s and early 1980’s, a time of high inflation and rising interest rates. That period led lenders to become more flexible in the construction of payment schedules and in the methods of qualifying prospective buyers. Two of the principal payment methods they created to fill the need for flexibility are the adjustable rate loan and the graduated payment loan. Other payment forms are the shared appreciation, buydown, and growing equity loans.
Some of the alternative financing programs developed during periods of high rates of interest and inflation are applicable under any market conditions. Others may be useful only in periods of high rates of inflation. Although the fixed‑rate loan has served home buyers and lenders well over the last 50 years and will continue to do so in the foreseeable future, it is no longer the exclusive residential financing arrangement.
LEGAL ADVICE AND THE LICENSEE IN THE ALTERNATIVE LOAN AGREEMENT PROCESS
If a licensee represents the seller, the licensee’s role is simply to offer assistance to the purchaser in his or her efforts to finance the purchase. If a licensee represents the purchaser, his or her role may be more active. Nevertheless, using alternative financing techniques to solve affordability problems for the buyer does not entitle a licensee to practice law. It only allows the licensee to perform his or her duties more effectively. Because of the legal relationships involved and the potential liability involved for licensees, the attorney is a vital part of every alternative financing transaction. Failure of the broker to involve a knowledgeable attorney can result in many serious problems. An unexpected increase in monthly payments, a buyer’s mistaken belief that he or she owns the property when he or she really does not, a loan balance that is more than the original loan amount, or a purchaser’s finding out the monthly payments did not go toward paying off the mortgage loan — each may result in untold legal problems for the sales associate, the broker, and the client or customer.
The primary purpose of this section is to acquaint licensees with some of the alternative financing solutions that can solve affordability problems that fixed-rate loans cannot. Yet, there are pitfalls to avoid when using these methods. This material does not cover all there is to know about alternative financing. Practitioners constantly revise these techniques to meet the demands of an ever changing economy. Since the home buying public looks to brokers and sales associates for assistance in overcoming affordability problems, licensees must stay constantly abreast of what is happening in the local mortgage market. For instance, well-prepared licensees will always know the types of loans currently available from traditional and special sources; the current interest rates, downpayment requirements, closing costs, and discount points; the basic requirements for qualifying; and the sources for second or junior loans.
ADJUSTABLE RATE MORTGAGES (ARM)
An adjustable rate loan, more commonly known as the adjustable rate mortgage (ARM), has a very important basic feature, a rate of interest that changes periodically with market conditions. This feature allows lenders to reduce some of the financial risks associated with the asset-liability mismatch that is inherent for them in fixed-rate loans. If a borrower has a fixed-rate loan at a low interest rate, he or she may stay in his or her present house and enjoy payments that are below the market rate. Only if the lender could get the money back (if the owner sold the house or refinanced and paid off the old loan) could the lender obtain a higher rate of interest on the money. However, if the loan is an ARM, the interest rate on the borrower’s loan would change periodically to reflect market conditions; and the lender would not be in the position of holding a low interest rate loan in the portfolio of assets. Because the lender takes less interest rate risk on an ARM, the interest rate is typically lower than a borrower could obtain with a fixed-rate loan. While there are several different types of ARM loans, they share several features in common.
| (a) | THE INTEREST RATE OR PAYMENT ADJUSTMENT PERIOD: THE FREQUENCY OF THE RATE OR PAYMENT CHANGE – The interest rate or the payment amount on an ARM can change as often as the lender and borrower agree for them to change in the loan agreement. However, six months to five years has become the generally acceptable range in the market, with a one year change period being most common for ARM’s on residential property loans. | ||
| (b) | INTEREST RATE INDEX – A financial index determines the initial interest rate and the periodic change in the interest rate on the ARM. At the time of loan approval, the index plus an add-on component known as a margin or a spread establishes the interest rate in effect until the first adjustment. This financial index is an indicator of current interest rate conditions in the market. With an ARM, regulations allow a lender to adjust the interest rate on a loan to reflect the current economy. However, this adjustment cannot be arbitrary. For this reason, the lender and the borrower must agree on a market indicator (or index). The requirements for this index are that: | ||
| (1) | the index cannot be under the control of the lender, and | ||
| (2) | information about the index must be readily verifiable by the public. | ||
| If the index goes up at the adjustment interval, the lender may increase the interest rate. If the index goes down at the adjustment interval, the lender must decrease the interest rate. Indexes used by lenders include the rate on one year Treasury Bills or on three or five year Treasury Notes; the Federal Reserve Discount Rate; the London Interbank Offering Rate (LIBOR), and the Eleventh District Cost of Funds Index. At this writing, the two most common indexes used in Georgia are the One Year Treasury Bill rate and the LIBOR. Many lenders offer first year interest rates on the ARM that are below the prevailing market level of interest rates on ARM’s. Borrowers need to be aware that these “teaser” rates are a one time, first year reduction and must be prepared for larger monthly payments in the second year. At that time, the contract interest rate will increase back to the market level; and loan payments can increase by a large amount if there is a significant gap between the size of the “teaser rate” and market rates. |
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| (c) | MARGIN OR SPREAD – The margin or spread is the percentage added to the index to derive the interest rate for the ARM. The lender usually states the margin in basis points which equate to a percentage rate. For example, 200 basis points are equivalent to 2%. The margin serves the purpose of covering the lender’s administrative costs of servicing the loan. While the interest rate from the index represents the cost of money at the time of the loan, it does not compensate the lender for the administrative costs. The level of the margin or spread is a point of agreement when the borrower and the lender discuss the specifics of the loan agreement. In practice the lender will simply inform the borrower of the amount of the margin. In most cases, the margin is constant over the term of the loan; but it can change in a predetermined and mutually agreeable fashion. If the index on an ARM loan has a current market rate of 7 percent and the margin is 250 basis points (2.5%), the interest rate on the ARM will be 9.5% per year. If, at the next adjustment, the index is 7.25% and the margin is constant, the new rate would be 9.75%. If at the time of the next adjustment interval the index dropped, the new interest rate on the loan could also drop. |
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| (d) | CAPS OR RESTRICTIONS ON THE SIZE OF THE INTEREST RATE OR PAYMENT ADJUSTMENT – Caps restrict the size of the interest rate or payment adjustment. There are “caps” that restrict the change in the interest rate or the payment from one adjustment period to another, and there are “caps” that restrict the total change in the interest rate over the term of the loan. | ||
| (1) | THE ADJUSTMENT PERIOD CAP – The adjustment period cap limits the amount of the adjustment in the interest rate from one period to another. For instance, if a borrower receives a 2% annual cap on a one year ARM, regardless of the increase in the index, the interest rate on the loan cannot increase more than 2% per year. The cap also limits any decrease in the interest rate when the index declines from one adjustment period to another. | ||
| (2) | LIFETIME CAP – A lifetime cap sets a maximum that the interest rate can increase over the entire term of the loan. For instance, a “6% lifetime cap” means that over the life of the loan, the interest rate can only increase from its original level to a level that is 600 basis points (6% ) higher regardless of the movement of the index. For example, assume a one year ARM with caps of 2% and 6% on a contract (or initial) rate of 8%. The first year rate would be 8%. The second year rate could not exceed 10% (8% + 2%, assuming a maximum adjustment the first year), the third year rate could not exceed 12% (10% + 2%), and the rate may never exceed 14% (8% + 6%). It is quite common for ARM’s to feature both a periodic and a lifetime cap. | ||
| (3) | PAYMENT CAP – While not as common as an interest rate cap, a lender and borrower may agree upon a maximum amount the payment may adjust at each interval, such as 7.5%. Therefore, if the payment were $1,000.00, the payment would not change more than $75 ($1,000.00 X 7.5%) at the next adjustment interval, regardless of the interest rate change. | ||
| (e) | NEGATIVE AMORTIZATION – Because the index can change by more than the interest rate cap over one adjustment period, the ARM loan can create a situation in which the lender receives an interest payment based on the index and the margin that is less than the lender’s cost of money plus administrative costs for the loan. To avoid this situation the lender may ask to allow “negative amortization” of the ARM loan. The term negative amortization refers to a situation when the unpaid balance of the loan increases from one period to the next. Positive amortization, which always exists in a fixed-rate loan, means that the loan balance drops with each loan payment. Negative amortization is the reverse. Lenders rarely make ARM loans that include negative amortization, but when they do, the loan agreement must be specific in giving the lender the ability to amortize a loan negatively. In the event that a negative amortization provision exists, the extent of negative amortization can be “capped” at a mutually agreeable level such as 125 percent of the original loan amount. | ||
OTHER FEATURES OF ARM LOANS
While the index, margin, adjustment interval, and caps are common to the ARM, most ARM’s include other provisions, some of which are also common to the fixed-rate loan.
| (a) | MORTGAGE INSURANCE – As in the case of fixed-rate loans, if the LTV exceeds 80%, the ARM lender will most likely require mortgage default insurance. It also is not uncommon for the premium to be slightly higher than for a fixed-rate loan, reflecting the potentially higher risk for the lender of an ARM in the event the payments increase and the borrower defaults. | |
| (b) | PREPAYMENT OPTION – With an ARM, a borrower may prepay, all or in part, without penalty. A unique result of this option with an ARM is that if the borrower pays a substantial amount of principal, this prepayment lowers the borrower’s monthly payment at the next adjustment since the lender computes the payment at the intervals based on the new interest rate, the term remaining, and the current principal balance. | |
| (c) | DUE ON SALE CLAUSE – Some ARM’s contain a due on sale clause allowing the lender to call the loan due upon the sale or transfer of the property. If a subsequent purchaser wishes to assume the debt as part of the purchase price, the lender will use this provision to require the new borrower to qualify financially and/or increase the interest rate to the market rate, if the lender will allow the assumption at all. | |
| (d) | CONVERSION OPTION – Many borrowers like having the ability to change from the ARM to a fixed-rate loan. If the lender agrees to the borrower’s request, the loan agreement will contain a clause that fully identifies the borrower’s right to exercise the conversion option and any associated conditions and fees. For example, the lender may wish to specify that upon conversion, the interest rate for the fixed-rate loan will be at or above the current rate for new fixed-rate loans. The lender may also limit the time during which the borrower has the right to convert and set a fee for the conversion to cover the administrative costs of making the change. | |
| (e) | MODIFICATION TO THE APPLICATION OF THE INTEREST RATE CAP – The loan agreement can carry the provision that an increase in the market interest rate not obtained by the lender due to the 2 percent cap on the interest rate change could be recouped in a subsequent year. For example, if the contract rate in year 4 is 7 percent and if the index rate increased from 5 percent to 8 percent between years 4 and 5 of the loan, the contract rate in year five will be 9 percent. Even though the index increased 3 percent, the 2 percent cap would hold the increase in the contract rate to 9 percent from the previous year’s 7 percent. If in year six the index rate declined from 8 to 6 percent, a corresponding decrease in the contract rate from 9 percent to 7 percent would normally occur. However, by agreement in this case, the lender could recoup all or part of the one percent increase that the lender had to forego in year five. So, the contract rate could be 7, 9 and 8 percent respectively for years 4, 5 and 6 instead of 7, 9 and 7 as might be expected. The specific language of the loan agreement determines whether the lender has the right to recoup past interest increases which the interest rate caps precluded. |
TRUTH IN LENDING ACT DISCLOSURE REQUIREMENTS FOR THE ARM
Federal regulations in the Truth in Lending Act require a lender to disclose to a borrower, at or before the time of application, the financial features of the ARM including the interest rate adjustment, the index, the margin, the adjustment period and caps, and any negative amortization and conversion options. The lender must provide an APR for the ARM using the initial contract interest rate that exists at the time of the closing. The lender must also provide a historical example that shows the monthly payments on a $10,000.00 ARM using the actual interest changes over the last fifteen years. When the loan is in effect, any change in the payment level requires an advance notice. This disclosure must come at least 25 days prior to the change but not more than 120 days before the change in payment.
QUALIFYING THE BORROWER FOR THE CONVENTIONAL ARM
In qualifying a borrower for a conventional ARM, lenders generally use the 28% housing expense ratio and the 36% total obligations ratio as they do for fixed-rate conventional loans. Chapter 42 in section 42.20 presents these ratios and discusses several compensating factors that allow borrowers to exceed these ratios and still qualify. However, the size of the principal and interest payments in these two ratios depends on the interest rate in the calculation. Since the initial interest rate on an ARM is lower than that of a fixed-rate loan, the lender will estimate the level of interest and principal using the maximum interest rate that will be in effect at the end of the first adjustment period. (The lenders in the secondary mortgage market set this requirement.)
THE FHA SECTION 251 ARM PROGRAM
A borrower can use the FHA Section 251 ARM program to purchase or to refinance a single family to four family property. While the rules governing the loan amount and the loan-to-value ratio are the same as those for the FHA section 203(b) plan, the contract rate, the discount points, and the margin are items for negotiation between the lender and the borrower. The index is the one-year Treasury securities index. Other requirements for the FHA’s ARM are a 30-year term, an annual interest rate cap of 1%, a 5% lifetime cap, and no negative amortization. The lender must also provide a loan scenario using the annual cap and the life time cap and figuring the interest at the maximum rate for the duration of the loan term.
GRADUATED PAYMENT MORTGAGE (GPM)
Federal agencies designed the graduated payment mortgage, GPM, to overcome the negative effect on first-time homebuyers caused by rising interest rates and rising house prices. In a GPM loan, the payments are lower in the early years of the loan. The size of the payments increase periodically, typically yearly, according to a fixed schedule. Eventually (usually after five years) the payments level off to a fixed amount, but at a higher level than the payment would have been on an equal payment loan. The loan then amortizes down to zero, just as an equal payment loan would.
Several important features are unique to the GPM.
| (a) | LOAN PAYMENT CALCULATION – The calculation of the loan payment begins with the selection of a number called the loan constant. This number is derived from the interest rate on the loan; the term of the loan, typically 30 years; the gradation period or the length of time between the beginning of the loan term and the time when the monthly payment reaches the maximum level; and the annual rate at which the monthly payments increase. (A discussion of the calculation of the loan constant is beyond the scope of this reference text.) Multiplying the loan constant times the amount of the loan determines the loan payment for the first year. For example, if the market interest rate is 10%, the loan term is 30 years, the gradation period is five years and the annual growth rate for the loan payment is 7.5%, the GPM loan constant is 0.00667. For a loan of $90,000.00 the monthly payment in the first year of the loan is $600.30 (.00667 x $90,000.00). In the second year the payment increases by 7.5% to $645.32. For the third, fourth and fifth years the payments become $693.72, $745.75 and $801.68 respectively. At the start of the sixth year which is at the end of the gradation period, the monthly loan payment becomes $861.81 and remains at this level for years six through thirty. In contrast, the monthly loan payment for a fixed-rate, equal payment loan of $90,000.00 at 10% per year for 30 years is $789.81. Thus while the GPM loan payments for first four years are less than for the fixed-rate, level payment loan, the GPM monthly payments in the fifth and subsequent years are higher. |
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| (b) | NEGATIVE AMORTIZATION AND THE LOAN BALANCE – Negative amortization is a basic feature of the GPM. In the first year of the loan, the GPM returns a payment of $600.30 per month to the lender. But, at an interest rate of 10%, the lender expects to receive an interest payment of $9000.00 per annum or $750.00 per month. The lender and the borrower agree to add the difference between $750.00 and $600.30 to the loan balance. So, after the first month the loan balance increases from $90,000.00 to $90,149.70. The borrower borrows the $149.70 difference between the payment and the interest due at the contract rate for the term of the loan. As monthly payments increase, the differential declines although the amount of interest on the growing unpaid balance increases. The differential disappears when positive amortization occurs at the end of the fifth year. This process continues for the first five years. At the end of the fifth year the loan payment for the GPM exceeds the required interest payment for the accumulated loan balance and positive amortization starts in the sixth year (the year after the gradation period). At the end of the gradation period the loan balance for this loan example is $94,839.80. Negative amortization is $4,839.80. |
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| (c) | THE GPM BECOMES A LEVEL PAYMENT LOAN AFTER THE GRADATION PERIOD – After the gradation period when the loan incurs negative amortization and the loan balance increases to $94,839.80, the GPM becomes a level payment 10% loan for the 25 remaining years. The monthly payment of $861.81 pays off the loan. |
THE GPM COMPARED TO THE LEVEL PAYMENT LOAN
There are three major differences between a GPM and a level payment fixed-rate loan.
| (a) | The monthly loan payments for a GPM rise for a time rather than remaining fixed for the term of the loan. Over the life of the GPM, however, the borrower makes full payment of principal and interest. | |
| (b) | Monthly payments in the early years of the GPM loan are not sufficient to cover the interest on the loan resulting in negative amortization. | |
| (c) | Negative amortization occurs in the GPM only during the gradation period; positive amortization takes place over the remaining term of the loan. |
THE FHA SECTION 245 A PROGRAM: THE FHA GPM PROGRAM
The most common GPM is the FHA “Section 245 A” program. Only owner‑occupied, proposed or existing, single family homes which meet FHA minimum property standards are eligible. Under the FHA/GPM program, the interest rate is fixed over the full term of the loan, but the borrower selects one of three basic plans to determine how much his or her payments increase and for how long.
On GPM plans, monthly payments increase annually. Starting in the 6th year (for the 5 year plan) or the 11th year (for the 10 year plan), the monthly payments are level for the remaining term.
The table below lists the annual increases for the various plans.
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Plan |
Annual Payment Increase |
| Plan I (Code A) | 2.5% each year for 5 years |
| Plan II (Code B) | 5% each year for 5 years |
| Plan III (Code C) | 7.5% each year for 5 years |
| Plan IV (Code D) | 2% each year for 10 years |
| Plan V (Code E) | 3% each year for 10 years |
The FHA’s GPM allows negative amortization but limits the permissible size of the loan after the negative amortization occurs. The increased principal balance cannot exceed the maximum insurable loan amount that is available through FHA’s standard 203b program for that sales price at the time of closing the GPM. If the maximum FHA insured loan is $70,000.00 under the standard 203b program, a GPM loan must not exceed that amount during its period of negative amortization. It is for this reason that down payment requirements for an FHA/ GPM will generally be more than that required under the standard FHA 203(b) program.
THE BUYDOWN LOAN
A buydown loan is a fixed-rate loan agreement with an additional feature incorporated into the plan. Either the borrower, or more typically the seller, provides front-end funds to the lender to lower the borrower’s monthly payments for a specified period. Withdrawals from the front-end funds supplement the lower payments each month so that the lender receives the full amount of the required monthly payment as in the fixed-rate conventional loan. Buydown loan agreements are most often fixed-rate conventional loans, but they can also be a variety of the ARM or GPM.
The buydown loan is a more attractive loan agreement when interest rates are relatively high. The higher interest rates and resulting reduction in sales volume motivate the seller or builder to provide the buydown funds to facilitate the sale of the property. However, the borrower may choose to use the buydown arrangement to qualify for a higher‑priced home than he or she would otherwise be unable to purchase without the lower monthly payments in the initial years of the loan.
There are two forms of the buydown loan: the permanent buydown and the temporary buydown. The temporary buydown has two aspects: the level payment buydown and the graduated payment buydown.
| (a) | THE PERMANENT BUYDOWN – In the most typical permanent buydown, a front-end payment in discount points reduce the contract interest rate on the loan. For example, if the current market interest rate is 9%, the borrower would like to have an 8% interest rate. The lender can accommodate the borrower by charging an offsetting number of discount points. In reducing the contract interest rate, lenders typically use a rule of thumb or guideline that six discount points are equivalent to 100 basis points in the interest rate. (Other lenders apply a ratio of eight discount points to 100 basis points.) If in the example, the borrower wants to buydown the contract interest rate from 9% to 8%, he or she would have to pay approximately six discount points. (Chapter 42 also discusses this point in the section on discount points.) | |||||||||||||||||||||||||||||||||||||
| (b) | THE LEVEL PAYMENT TEMPORARY BUYDOWN – A level payment temporary buydown might be a solution to a problem in which a buyer can qualify for a loan based on creditworthiness, but cannot qualify for the size of loan needed to purchase the home at market interest rates. If the borrower can show evidence that his or her annual gross stable income will grow over the next few years, a temporary buydown might work. (Other compensating factors might come into play as well.) For example, if current interest rates are 12% on a 30-year loan for $120,000.00, the monthly payment is $1,234.34, an amount above what the borrower can qualify for. Based upon income, the borrower can qualify for a 30-year loan of $120,000.00 with a monthly payment of $1,097.69, which represents an interest rate of 10.5%. Using this example, the borrower, the builder (seller), and the lender can agree for the lender to receive payments of $1,234.34 a month and the buyer to make payments of $1,097.69 per month for the first three years of the loan. To make up the difference between what the buyer pays and the lender receives monthly for the first three years, the seller deposits a total of $4,919.40 into an account with the lender. Each month the lender withdraws the difference between $1,234.34 and $1,097.69. The following chart illustrates the process. | |||||||||||||||||||||||||||||||||||||
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| If the lender is willing to pay interest on the account compounded monthly and if 4% is the appropriate market interest rate on savings accounts, the builder would only have to deposit $4363.99 which along with the interest earned would cover the monthly payment difference over the three years. The lender and the builder could structure other arrangements to deposit the front-end funds. | ||||||||||||||||||||||||||||||||||||||
| (c) | THE GRADUATED PAYMENT TEMPORARY BUYDOWN – A graduated payment temporary buydown might be another solution to a problem in which a buyer can qualify for a loan based on creditworthiness, but cannot qualify for the needed size of loan at market interest rates. If the borrower can show that his or her annual gross stable income will grow over the next few years, a graduated payment temporary buydown might work. (Other compensating factors might come into play as well.) For example, if current interest rates are 12% on a 30-year loan for $120,000.00, the monthly payment is $1,234.34, an amount that the borrower cannot qualify for. Based upon income, the borrower can qualify for a 30-year loan of $120,000.00 with a monthly payment of $965.55, which represents an interest rate of 9%. Using this example, the borrower, the builder (seller), and the lender can agree upon a graduated payment plan whereby the buyer makes payments calculated at 9% interest the first year, 10% the second year, 11% the third year, and 12% for the remaining life of the loan. In every year the lender receives payments of $1,234.34 a month. The first year the buyer makes monthly payments of $965.55; the second year, $1,053.08; and the third year, $1,142.79. To make up the difference between what the buyer pays and the lender receives monthly for the first three years, the seller deposits a total of $6,499.20 into an account with the lender. Each month the lender withdraws from this account the difference between $1,234.34 and the borrowers monthly payment amount for that year. The chart that follows illustrates a 3-2-1 buydown plan. | |||||||||||||||||||||||||||||||||||||
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| If the lender is willing to pay interest on the account compounded monthly and if 9% is the appropriate market interest rate on savings accounts, the builder would only have to deposit $5,018.57 which along with the interest earned would cover the monthly payment difference over the three years. The lender and the builder could structure other arrangements for the deposit of the front-end funds if they agreed.
Lenders must consider the marketability of their buydown loans in the secondary mortgage market. For this reason, they structure their buydowns to comply with the following guidelines established by the agencies which buy mortgages in the secondary market. |
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| (a) | The term of the buydown period must be for a minimum of one year and a maximum of five years. | |||||||||||||||||||||||||||||||||||||
| (b) | The plan must not reduce the effective interest rate to the borrower by more than 3%. | |||||||||||||||||||||||||||||||||||||
| (c) | If the buydown plan calls for graduated payments during the total term of the plan, then such payments must be constant for each twelvemonth period. | |||||||||||||||||||||||||||||||||||||
| (d) | The borrower’s payment increase from one payment phase to the next should generally not exceed 7.5%. On the level payment buydown plan, the 7.5% guideline may apply on a cumulative basis. For instance, a buydown on a three‑year term which results in the 37th payment being 22.5% higher than the 36th payment would be acceptable. The level payment temporary buydown example given above passes this test. Payments increase from an initial $1097.69 to $1234.34 over the three years. The percentage increase over the three years is 12.45 percent ($136.65/$1097.69) which is less than the 22.5% allowed. The graduated payment temporary buydown plan in the previous example does not meet this criterion. The annual percentage increase is 9 percent, 8.5 percent, and 8 percent respectively for years one, two and three. | |||||||||||||||||||||||||||||||||||||
| (e) | The amount of the buydown is limited to a percentage of the sales price or the appraised value of the property, whichever is lower. The limits apply to any contributions made by an interested party to the transaction — the seller (the builder) or the real estate licensee. If the loan to value ratio is over 90 percent the maximum contribution allowed in the buydown is 3 percent of the sales price or the appraised value, whichever is lower. If the loan to value ratio is 90 percent or less, the maximum contribution allowed in the buydown is 6 percent of the sales price or the appraised value, whichever is lower. The buydown limit does not apply to the funds of third parties or disinterested parties to the buydown transaction. A borrower could receive any sum of money from a parent, a family member or an employer and apply them as a buydown. If the buydown amount actually made by the seller exceeds the limit, the lender must subtract the amount over the limit from the sales price or the appraised value of the property. For example, a seller provided a $7500.00 buydown on a property with a $125,000.00 sales price and a $130,000.00 appraised value. All of the buydown money applies under the rule. But if in this situation the seller gave a $8500.00 buydown, the lender needs to subtract the excess $1000.00 from the sales price to calculate the loan amount. The $125,000.00 sales price less the $1000.00 excess contribution to the buydown equals a $124,000.00 “adjusted sales price.” The $124,000.00 figure times the 80 percent loan to value ratio yields a loan amount of $99,200.00. |
THE BUYDOWN LOAN: QUALIFYING THE BUYER
The standards for qualifying the borrower for a buydown come from the guidelines of the agencies in the secondary mortgage market. For the permanent buydown loan, the guidelines provide that the borrower’s housing expense be calculated at the reduced or “bought down” interest rate.
For the temporary buydowns the two principal agencies in the secondary mortgage market have different standards. FNMA’s standards for qualifying a borrower for an owner-occupied principal residence allow the lender to use the reduced first year interest rate. However, the total obligations ratio must not exceed 33% which is lower than the 36% for conventional fixed-rate loans. The guidelines do not allow the consideration of compensating factors if the borrower is unable to meet the 33% ratio.
FHLMC has its own standards for temporary buydowns. The lender can qualify the borrower at the reduced first year rate, and the standard housing expense ratio and total obligations ratios of 28% and 36% respectively apply. However, the temporary buydown cannot exceed a two-year term and cannot have more than a 200-basis point reduction in the interest rate for the temporary period. So FHLMC standards do not allow the 3-2-1 buydown but do permit a 2-1 buydown.
FIXED‑RATE LOAN WITH BALLOON PAYMENT
A fixed-rate loan with a balloon payment has two primary characteristics. The monthly payment is the same as that for a long term fixed-rate loan, and the borrower and the lender have agreed that the loan will be paid off in the short term. For example, a borrower and a lender may agree to a $100,000.00 loan at 9% per annum for 30 years with a balloon for the unpaid balance at the end of the tenth year. The monthly payment for this loan is the same as it would be for the 30-year fixed-rate loan — $804.62. The balloon payment is the unpaid loan balance at the end of the tenth year — $89,429.74. The payment schedule for this loan agreement is $804.62 for 119 months and a final closeout payment of $90,234.35 ($89,429.74 + $802.64). The borrower and the lender must cover three things about the balloon payment in the loan agreement: (1) when is the payment due, (2) how much the payment will be, and (3) whether the date of the payment is deferrable. The borrower might like the possibility of deferring the balloon payment because of the uncertainty of the future. Perhaps he or she will not have the funds to meet the balloon when it comes due but will have it two years later. The lender might be willing to allow a deferment but will want to assess a financial penalty. For example, the balloon‑payment deferment clause might say that if the borrower does not make the balloon‑payment at the end of the tenth year, the interest rate will increase in some manner for the deferment period. The interest penalty could be set at 150 basis points (1.5% points) over the market rate or over the contract rate whichever is higher. The increased interest would compensate the lender for the additional wait, and it would give the borrower an incentive to repay the loan as early as possible.
THE INTEREST-ONLY LOAN
The interest-only loan is a loan contract in which the lender and the borrower agree that the periodic payment from the borrower to the lender will be a payment only of the interest due. The borrower repays the total loan amount at the end of the loan term. For example, an interest-only loan of $10,000.00 at 10% per annum with quarterly payments for five years has quarterly interest payments of $250.00 for 19 quarters and a final payment at the end of the twentieth quarter of $10,250.00.
THE GROWING EQUITY LOAN
The growing equity loan or growing equity mortgage (GEM) is also a variety of the fixed-rate loan. Although there are several possible arrangements, the simplest form of the GEM requires a payment equal to the fixed-rate level payment amount for the same loan amount, interest rate, and term. The borrower also agrees to make additional monthly payments on the principal. While the basic payment pays the interest due and amortizes the principal according to a standard amortization schedule, the entire additional payment pays down the principal and, in effect, shortens the term of the loan. For example, a borrower and a lender could create a GEM agreement with a $100,000.00 loan at 9% for thirty years with the size of the payment increasing by 5% each year beginning with the second year until the borrower pays off the loan. The monthly loan payment in the first year is $804.62, the amount needed to pay back the $100,000.00 at 9% in 360 payments. The monthly loan payment in the second year is $844.85, 5 percent higher than the first year payment. Since the interest due is already covered by the first year payment, the additional $40.23 per month in the second year payment amount goes entirely to reduce the loan balance.
The GEM starts as a thirty-year loan, but the additional funds work two ways to pay the loan off faster. The additional amounts not only reduce the loan balance faster than would happen in a level payment amortization, but the shrinking principal balance means that less of the basic payment each month goes to pay interest and more goes to pay principal than would be the case in a level payment fixed-rate loan. Therefore the thirty-year loan becomes a twenty-five, twenty, or even fifteen year loan, depending upon how much the payment amounts increase each year. An amortization schedule would show exactly at what point the GEM loan is off. Conventional lenders and the FHA offer GEM loans. The Section 245a insurance program is the FHA GEM loan.
SHARED APPRECIATION MORTGAGES
A shared appreciation mortgage, or SAM, is a loan agreement between the borrower and the lender is which the lender and the borrower split the increase in the value of the property in some agreed upon proportion. For the right to share in the increase in the value of the property, the lender agrees to charge a lower rate on the loan. The borrower and the lender agree that the lender will receive monthly loan payments at the below market rate and a single payment when the property is sold or at a specified date whichever date is the earliest. For example, the lender gives the borrower a loan for $100,000.00 to buy a $120,000.00 property. The lender and borrower agree to a 6 percent interest rate on the loan although current interest rates are 8 percent. For agreeing to forego the 2 percent in interest, the lender will receive 40 percent of the increase in the value of the property upon its sale or on the tenth anniversary of the loan, whichever comes first. If the borrower sells the house for $160, 000.00 nine years later, the lender will receive 40 percent of $40,000.00 or $16,000.00 as his or her share of the value increase.
THE REVERSE-ANNUITY LOAN
A reverse-annuity loan is an agreement between a real property owner and a lender in which the lender makes monthly payments to the property owner for a time; and at the end of that time, the property owner must repay the lender. The property owner can repay the loan by obtaining the funds from any source, but typically the property owner must sell the property to repay the loan. The need for a reverse-annuity loan arises when a homeowner needs a steady income stream (monthly or annual) to meet living expenses during retirement or to provide funds for anticipated additional expenses in the near future such as medical bills.
For example, a property owner has a house valued at $100,000.00; and a lender agrees to a reverse-annuity loan for $50,000.00 at 7 percent interest over a ten year period. The lender is confident the property will be worth at least $100,000.00 in ten years. The lender agrees to a monthly payment to the borrower of $288.88, which at an annual interest of 7 percent will accumulate to $50,000.00 at the end of the tenth year. The property owner gets $288.88 for 120 months, and the lender earns interest on these funds at a rate of 7 percent each year and recovers all the money loaned at the end of the tenth year.