Finance_11 Instructor Materials.docx

11. FHA-Insured Loans Learning Objectives After completing this lesson, students should be able to… Discuss the purpose of the FHA-insured loan program Identify key rules governing FHA-insured loans List the different types of FHA loan programs Understand the role of maximum loan amounts, and how they vary by location Discuss how a borrower can meet the minimum cash investment requirement Calculate upfront and annual mortgage insurance premiums Identify when secondary financing may be used in the context of an FHA loan Explain when an FHA loan may be assumed Describe the underwriting requirements for an FHA loan, including the income ratios Suggested Lesson Plan 1. Give students Exercise 11.1 to review the previous chapter, “Conventional Financing.” 2. Provide a brief overview of Chapter 11, “FHA-Insured Loans,” and review the learning objectives for the chapter. 3. Present lesson content: FHA Mortgage Insurance FHA Loan Programs Rules for FHA-Financed Transactions – Owner-occupancy – Maximum loan amounts EXERCISE 11.2 Maximum loan amounts – Minimum cash investment and LTV – Loan charges and closing costs – Sales concessions – Secondary financing EXERCISE 11.3 Sales concessions and secondary financing – Property flipping prevention – Assumption EXERCISE 11.4 Rules for FHA-financed transactions FHA Insurance Premiums – Upfront premium – Annual premiums FHA Underwriting Standards – Credit reputation – Income analysis – Assets for closing EXERCISE 11.5 FHA underwriting standards FHA Rehabilitation Loans and Reverse Mortgages 4. End lesson with Chapter 11 Quiz. Chapter 11 Outline: FHA-Insured Loans I. FHA Mortgage Insurance A. The Federal Housing Administration (FHA) is part of the Department of Housing and Urban Development (HUD); the purpose of the FHA is to promote the financing, improvement, and sale of residential real estate B. The primary function of the FHA is insuring mortgage loans; it does not build homes or provide mortgage loans 1. A borrower applies to an FHA-approved lender who either underwrites the loan application directly or submits it to the FHA for approval 2. The borrower is liable to the federal government for any compensation the FHA must pay a lender as a result of the borrower’s default C. FHA loans are designed to help people with low and moderate incomes buy homes II. FHA Loan Programs A. Section 203(b) is the standard FHA loan program. It provides insurance for loans used to purchase or refinance one- to four-unit properties B. Section 203(k) insures loans used for the purchase (or refinance) and rehabilitation of owner-occupied properties of up to four units C. Section 234(c) insures loans used to purchase or refinance individual units in condominiums D. Section 251 insures 30-year adjustable-rate mortgages (ARMs) used to purchase or refinance owner-occupied properties with up to four units E. Section 255 insures reverse mortgages (HECMs), which are loans that allow homeowners to create an income stream using their home’s equity III. Rules for FHA-Financed Transactions A. A home purchased with an FHA loan is generally required to be an owner-occupied principal residence B. The FHA’s local maximum loan amounts are based on median housing costs in the area; there are different maximums for one-, two-, three-, and four-unit residences 1. The FHA’s maximum loan amounts are tied to the conforming loan limits set by Fannie Mae and Freddie Mac 2. Local maximums may be adjusted annually to reflect changes in housing costs EXERCISE 11.2 Maximum loan amounts C. An FHA borrower must make a minimum cash investment of 3.5% of the appraised value or sales price, whichever is less D. Loan charges and closing costs 1. Loan terms are negotiable and can vary from one lender to the next, but cannot be more than what is “reasonable and customary” in the area 2. FHA loans cannot have a prepayment penalty E. The FHA restricts sales concessions from the seller or other interested parties, to prevent circumvention of the FHA’s LTV rules; sales concessions are classified as seller contributions or as inducements to purchase 1. Seller contributions include payments toward the borrower’s closing costs, prepaid expenses, mortgage interest, UFMIP, discount points, or a buydown a. Seller contributions are limited to 6% of sales price b. Contributions in excess of 6% are considered inducements to purchase 2. Inducements to purchase are deducted from the property’s sales price before the LTV is applied, lowering the allowable maximum loan amount a. In addition to seller contributions in excess of 6%, inducements to purchase include funds given to the buyer for decorating, repairs, moving expenses, and buyer’s agent fees, as well as personal property F. Secondary financing may be used with an FHA loan, if the primary and secondary loans don’t add up to more than the maximum loan amount for the transaction and the borrower qualifies for the combined payment 1. As a general rule, secondary financing can’t be used for the borrower’s minimum cash investment, but there are significant exceptions a. Secondary financing provided by a close family member or a government agency may be used to cover the minimum cash investment, if the total financing doesn’t exceed the property’s value or sales price plus closing costs, prepaid expenses, and discount points EXERCISE 11.3 Sales concessions and secondary financing G. Property Flipping Prevention Rules 1. For FHA financed transactions, there are several rules that apply to the seller, to lessen the risk of abusive property flipping H. Assumption of FHA Loans 1. Generally, an FHA loan can only be assumed by a creditworthy buyer who intends to occupy the property as a primary residence 2. If the buyer assuming the loan is creditworthy, the lender must release the original borrower from liability automatically EXERCISE 11.4 Rules for FHA-financed transactions IV. FHA Insurance Premiums A. The mortgage insurance premiums (MIP) for most FHA programs include an upfront premium (UFMIP) and annual renewal premiums B. The UFMIP is 1.75% of the base loan amount, and may be paid in cash at closing, by buyer or seller, or it may be financed 1. A financed UFMIP is not included in the base loan amount used to calculate the maximum loan amount and loan origination fee C. The annual MIP ranges from 0.45% to 1.05% of the loan balance, depending on the base loan amount, loan term, and LTV 1. For loans closed after June 2, 2013, the annual MIP is paid for the entire loan term if the LTV is over 90%; for 90% or lower LTV loans, the annual MIP will be canceled after 11 years V. FHA Underwriting Standards A. FHA underwriting standards are less strict than Fannie Mae and Freddie Mac standards for conventional loans B. Credit reputation: FHA requires lenders to consider a loan applicant’s credit report and credit scores when available 1. Mediocre score won’t rule out loan approval, but score cannot be lower than 500 2. Borrowers with a credit score between 500 and 579 are limited to a maximum loan-to-value ratio of 90% 3. If there’s more than one score available, underwriter must use middle of three (or lower of two) 4. If two or more people are applying for a loan, the lowest credit score is used 5. FHA allows manual underwriting for applicants with little or no available credit reputation C. Income analysis: In FHA loan underwriting, the applicant’s monthly effective income is measured against the applicant’s fixed payments and proposed housing expense 1. Effective income is the total amount of income from all sources that can be expected to continue for the first three years of the loan term 2. Fixed payments include the proposed monthly housing expense (principal, interest, property taxes, hazard insurance, one-twelfth of the annual MIP, and any homeowners association dues), plus recurring charges (monthly payment on any debt with ten or more payments remaining) 3. A borrower’s debt to income ratio should not exceed 43%, and the housing expense to income ratio should not exceed 31% 4. An applicant whose income ratios exceed these limits may still qualify for an FHA loan if compensating factors reduce the risk of default 5. Compensating factors include no discretionary debt, substantial reserves, a minimal increase over previous housing expense, adequate residual income, and significant additional income that doesn’t count as effective income D. Assets required for closing 1. At closing, an FHA borrower must have enough cash to cover the minimum cash investment, prepaid expenses, any borrower-paid discount points, the upfront MIP (if it isn’t being financed), and any other closing costs that aren’t being financed or paid for by the seller 2. Allowable sources for the cash required for closing include: a. gift funds from an employer, labor union, family member, close friend, charitable organization, or government agency b. secondary financing (secured by a lien against the home being purchased) in compliance with certain rules c. an unsecured loan from a family member d. a loan from any independent third party (not the seller or a real estate agent involved in the transaction), as long as it is not secured by the home being purchased with the FHA loan EXERCISE 11.5 FHA underwriting standards VI. FHA Rehabilitation Loans and Reverse Mortgages A. Section 203(k) insures mortgages used to purchase (or refinance) and rehabilitate one- to four-unit properties 1. All loan proceeds used for the upgrade work must be put into an escrow account and released as the work progresses 2. Rehabilitation work must meet HUD standards; the work cannot include temporary or luxury improvements B. Section 255 insures home equity conversion mortgages (HECMs), also known as reverse mortgages 1. Allows older homeowners to convert their equity into either a source of monthly income or a line of credit 2. Repayment isn’t required as long as the property remains the owner’s principal residence 3. The homeowner must be at least 62 years old 4. The property may have up to four units or be a condominium 5. The property must be owned free and clear, or have only a small balance remaining on the existing mortgage 6. The loan amount depends on the FHA ceiling for high-cost areas, the home’s appraised value, the current interest rate, and the age of the borrower 7. The lender recovers the amount borrowed, plus interest, when the property is sold; the FHA will make up any shortfall in the sale proceeds 8. The proceeds from the FHA HECM can be used to purchase a one- to four-unit principal residence Exercises EXERCISE 11.1 Review exercise To review Chapter 10, “Conventional Financing,” have the students answer the following questions. 1. What is a nonconforming loan? 2. When is private mortgage insurance generally required? 3. What are the standard maximum income ratios for conventional loans? 4. Fannie Mae’s comprehensive risk assessment approach uses primary risk factors and contributory risk factors. What are the two primary risk factors an underwriter considers when evaluating an application for a manually underwritten loan that is going to be sold to Fannie Mae? 5. Juan is buying a $400,000 house with a $340,000 85% LTV conventional loan. His parents want to give him as much money toward the downpayment as the lender will allow. If the lender is following the usual Fannie Mae/Freddie Mac rules concerning gift funds, how much can Juan’s parents contribute? Answers: 1. A nonconforming loan is a conventional residential mortgage loan that doesn’t comply with Fannie Mae or Freddie Mac underwriting guidelines. It can’t be sold to those entities except by special arrangement, and it’s also likely to be more difficult to sell to other secondary market investors as a result. 2. Fannie Mae and Freddie Mac require PMI on any conventional loan with an LTV over 80%. 3. For a conventional loan, the borrower’s housing expense to income ratio generally shouldn’t exceed 28%, and his total debt to income ratio generally shouldn’t exceed 36%. Higher ratios are acceptable when the loan application presents significant compensating factors or the loan will be underwritten by an AUS. 4. Fannie Mae’s two primary risk factors are credit reputation and loan-to-value ratio. These determine the level of underwriting review that the application must receive. 5. For a conventional loan, a borrower is generally required to provide at least 5% of the sales price from his own resources, unless the LTV is 80% or less. The LTV for Juan’s loan is 85% ($340,000 ÷ $400,000 =.85). Juan must come up with 5% of $400,000, or $20,000, out of his own pocket. His parents can give him the other $40,000 he needs for the downpayment. EXERCISE 11.2 Maximum loan amounts Discussion Prompt: With FHA financing, what are the three main factors that can limit the loan amount for a particular transaction? Explain the basic purpose of each factor. Analysis: The first limitation on the loan amount in an FHA transaction is the loan ceiling that applies in the local area. The second is the loan-to-value rules. The third is the minimum cash investment requirement. The purpose of the local loan ceiling, which is based on median housing prices in the area, is to target FHA loans at low- and moderate-income borrowers. An FHA loan generally isn’t big enough to buy a fancy home. The loan-to-value rules serve the same purpose that they do with any type of financing: they reduce the risk of loss in the event of default. Basing the loan amount on the property’s value makes it more likely that the proceeds of a foreclosure sale will be enough to pay off the loan balance. The minimum cash investment requirement is supposed to help reduce the risk of default. If a borrower has invested at least a small amount of her own money in the property, she’s a little less likely to fall behind on her payments. EXERCISE 11.3 Sales concessions and secondary financing Read the following True/False questions aloud to students and have them jot their answers down on a piece of paper; discuss the answers together. 1. In a transaction financed with an FHA loan, if the seller pays two discount points on behalf of the buyer, it’s considered a seller contribution. 2. If the seller pays for the buyer’s moving expenses or pays the real estate agent’s commission on the sale of the buyer’s current home, that’s considered an inducement to purchase in an FHA transaction. 3. In an FHA transaction, the value of an inducement to purchase is subtracted from the sales price after the loan-to-value ratio is applied. 4. Seller contributions are limited to 3% of the loan amount in an FHA transaction. Anything in excess of that limit must be refunded to the seller. 5. It isn’t permissible to use secondary financing from an institutional lender along with an FHA-insured first mortgage. 6. Secondary financing provided by an FHA borrower’s parents may be used to cover the minimum cash investment. Answers: 1. TRUE. Any discount points on the buyer’s loan that are paid by the seller are considered a seller contribution. 2. TRUE. It’s an inducement to purchase if the seller pays any part of the buyer’s moving, decorating, or repair expenses, or any part of the sales commission on the sale of the buyer’s current home. 3. FALSE. The value of an inducement to purchase is subtracted from the sales price before the LTV ratio is applied, which reduces the maximum loan amount available to the borrower. 4. FALSE. Seller contributions are limited to 6% of the sales price. Any contributions in excess of that are treated as inducements to purchase and subtracted before the loan-to-value ratio is applied to the sales price. 5. FALSE. A borrower may use secondary financing from anyone in conjunction with an FHA-insured first mortgage, as long as the two mortgages together don’t exceed the maximum base loan amount. 6. TRUE. A close family member may provide secondary financing to cover the borrower’s minimum cash investment. So can a government agency. EXERCISE 11.4 Rules for FHA-financed transactions Fill in the blanks in the sentences below with the correct terms. Investor Primary residence Owner-occupant Second home Single-family home Four-unit apartment building Purchase loans Median home prices Rehabilitation loans Median family incomes Refinancing Insuring 1. The FHA’s main function is _________________ mortgage loans. 2. Because FHA loans are intended to help low- and moderate-income buyers, maximum loan amounts are tied to local _________________. 3. An FHA borrower is required to be a/an _________________, as opposed to a/an _________________. 4. The property purchased with an FHA-insured loan generally must be a/an _________________. 5. There are several different FHA programs for different types of loans. The standard program, 203(b), is used to insure _________________ and _________________. 6. An FHA loan could be used to buy either a/an _________________ or a/an _________________. Answers: 1. Insuring 2. Median home prices 3. Owner-occupant; Investor 4. Primary residence 5. Purchase loans; Refinancing 6. Single-family home; Four-unit apartment building EXERCISE 11.5 FHA underwriting standards Discussion Prompt: The Jablonski family has a monthly income of $6,500. They’re applying for an FHA loan with monthly payments of $2,200. They have student loan payments of $300 per month and a minimum monthly payment of $20 on their credit card balance. Those are their only recurring monthly obligations. Do they qualify for the loan under the standard FHA underwriting rules? If not, what are some compensating factors that would allow a lender to approve the loan anyway, if any of those factors were present in the Jablonskis’ situation? Analysis: The Jablonskis don’t qualify under the standard FHA rules. Their debt to income ratio isn’t a problem, but their housing expense to income ratio exceeds the maximum usually allowed for an FHA loan. $2,200 ÷ $6,500 = 33.8% housing expense ratio (over the 31% limit) $2,520 ÷ $6,500 = 38.8% debt ratio (under the 43% limit) Possible compensating factors that would allow a lender to approve the loan anyway include: having paid at least $2,200 per month in housing expenses for the past several years; substantial reserves left after closing; potential for increased earnings; no debts with outstanding balances other than their current housing expense; significant additional income that doesn’t count as effective income; and residual income that would be adequate for a VA loan. Chapter 11 Quiz 1. Which of the following is NOT a characteristic of FHA loans? A. Maximum loan amount which varies from area to area B. Minimum cash investment requirement C. Mortgage insurance is required D. No downpayment is required 2. The primary function of the Federal Housing Administration is to: A. build homes B. insure loans C. originate loans D. purchase loans 3. An FHA loan would be appropriate financing for a/an: A. commercial space B. vacation home C. investment property D. owner-occupied primary residence 4. An FHA loan can be used to purchase any of the following, except a: A. single-family home B. condominium unit C. six-unit apartment building D. mobile home 5. Recurring charges can include all of the following except: A. alimony B. child support C. security deposit D. car payments 6. An FHA buyer would like to obtain a Section 203(k) loan. She plans to: A. buy a property in an older, declining neighborhood B. purchase and rehabilitate a property C. use a graduated payment mortgage D. use an adjustable-rate mortgage 7. Reverse mortgages: a. convert rental income into equity b. convert home equity into income c. are used when flipping property d. are prohibited by the FHA 8. FHA mortgage insurance: A. remains in effect only until it is canceled B. generally requires a one-time (upfront) premium plus annual premiums C. is paid for by the lender, unless otherwise agreed D. All of the above 9. When the upfront MIP is financed: A. the total amount financed can’t exceed the maximum loan amount B. it is subtracted from the base loan amount C. it doesn’t count as part of the loan amount when the maximum loan amount rules are applied D. it must be paid off within the first five years of the loan term 10. In an FHA transaction, which of the following would be considered an inducement to purchase, if the seller paid for part or all of it? A. Closing costs B. Discount points C. Moving expenses D. Upfront MIP 11. Who may provide secondary financing to cover the minimum cash investment for an FHA borrower? A. The borrower’s parent B. A real estate agent C. An institutional lender D. The seller 12. An FHA loan made last year may be assumed: A. only by a buyer who intends to occupy the property B. only by a buyer who intends to occupy the property as a primary residence C. only by a buyer who has had an FHA loan before D. by any buyer, regardless of whether he intends to occupy the property 13. An FHA borrower’s housing expense to income ratio generally may not exceed _____, and her fixed payment to income ratio may not exceed_____. A. 31%; 43% B. 28%; 43% C. 31%; 36% D. 36%; 38% 14. Which of the following would not be considered a compensating factor which would allow the borrower to exceed maximum income ratios? A. Applicant lives in an area with low median housing prices B. Borrower has no discretionary debt C. Large reserves D. Proposed housing expense is only a small increase over current housing expense 15. Which of the following is not a way for an FHA borrower to cover the minimum cash investment? A. Use a loan secured by collateral other than the home B. Use gift funds from a charitable organization C. Use gift funds from his real estate agent D. Use secondary financing from a parent Answer Key 1. D. FHA loans require at least a small downpayment. 2. B. The Federal Housing Administration’s role is to insure mortgage loans and compensate lenders for losses resulting from borrowers’ default. 3. D. FHA loans are for residential properties; FHA borrowers must intend to occupy the property they’re buying. 4. C. FHA loans can be used to finance the purchase of residential property with up to four dwelling units, including a single-family home, a condo unit, or a mobile home. 5. C. Recurring charges include monthly payments on any debt with ten or more payments remaining; a security deposit is paid once. 6. B. Section 203(k) loans are used for the purchase (or refinancing) and rehabilitation of residential property. 7. B. A reverse mortgage converts a homeowner’s equity into an income stream. The FHA allows this kind of loan, calling it a “home equity conversion mortgage” (HECM). 8. B. FHA insurance is paid for with a one-time premium plus annual premiums. The borrower ordinarily pays the premiums, and the insurance remains in effect for the life of the loan, even if the annual premium payments have been cancelled. 9. C. The financed UFMIP isn’t considered part of the loan amount. The total amount financed can exceed the maximum loan amount for the transaction. 10. C. If a seller pays for a buyer’s moving expenses, that’s considered an inducement to purchase, and it’s subtracted from the sales price before the loan-to-value ratio is applied. 11. A. Secondary financing of the minimum cash investment is allowed if it’s provided by a member of the borrower’s family, a government agency, or an approved nonprofit agency. 12. B. An FHA loan originated since 1991 can be assumed only by a buyer who meets the FHA’s standards and will occupy the property as his primary residence. 13. A. Without compensating factors, an FHA borrower’s housing expense to income ratio should not exceed 31%, and her fixed payment to income ratio should not exceed 43%. 14. A. Living in an area with low housing costs would not be considered a compensating factor. 15. C. Gift funds may be applied toward the minimum cash investment, but they must come from a relative, a close friend with a defined interest in the borrower, a charitable organization, a government agency, or the borrower’s employer or labor union.

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