Nontraditional Mortgage Products

Chapter 8
Nontraditional
Mortgage Products
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 1

Chapter 8: Nontraditional Mortgage Products
Overview
• Nontraditional is defined by SAFE Act as anything

other than a 30-year fixed rate mortgage
• Financing options for buyers who require assistance
• Help buyers achieve goals:
– Qualifying for a loan
– Getting a lower interest rate
– Buying a bigger house
– Or having a lower monthly payment.
• Most popular financing tools:
– Buydowns (discounts)
– ARMs
Overview
• Other financing products include:
–Subprime loans
–Structured mortgages
–Homebuyer assistance programs
–Seller financing (including land contracts)
• Other resourceful programs:
–Lease/options
–Lease/purchases
–Equity exchanges
–Participation plans

Nontraditional
Mortgage Products
Chapter 8 covers:
• Ways lenders and brokers make money on loans
• Calculating points on a mortgage loan
• Advantages and disadvantages of buydown plans
• Elements that make up an ARM
• Factors that define a subprime loan
• Agency guidelines on lending and subprime loans
• Various types of alternative financing

Key Terms
• Adjustable Rate • Estoppel Letter

Mortgage (ARM) • Index
• Buydown • Land Contract
• Caps • Lease/Option
• Discount Points • Lease/Purchase
• Equity Exchange

Key Terms
• Lender’s Yield • Rate Adjustment

• Margin Period
• Option • Reverse Mortgage
• Participation Plan • Subprime Loan
• Points • Teaser Rate
• Yield Spread
Premium

Nontraditional
Mortgage Products
• Achieve lower interest rate or lower
payments through:
– Additional payments to lender at beginning
of loan
– Loan structured to defer higher interest
rates or payments until later in loan
• Both types of financing tools fall under
general category of buydowns, which
involve discounts and payment of points to
lender
Adjustable Rate Mortgage (ARM)
• Borrower can decrease initial interest rate if

he assumes part of the lender's interest
rate risk:
– Borrower can allow lender to change interest
rate as cost of money changes
– Lender not locked into rate for 30 years, so will
give borrower a lower rate

Subprime Loan
• A borrower with less-than-perfect credit or
other risk factor that prevents him from
qualifying for a conventional loan
• Borrower allows lender to charge an interest
rate above that for typical conventional
mortgages to achieve goal of home
ownership

Lender’s Return
• Also known as lender’s yield

• The total amount of money a lender
can earn from a loan in relation to the
amount invested
• Most often as a result of fees collected

Discount Points
• A point is 1% of the loan amount

• Additional funds paid to a lender at the
beginning of a loan to lower interest rate
that would otherwise be offered
• Allows borrower to lower monthly
payments
• Allows lender to make up required rate of
return lost by lower interest rate

Discount Points
• Seller may be willing to pay discount points as a

way of reducing the interest rate paid by the buyer
to make seller’s property more marketable
• It’s far easier to sell property if interest rate to be
paid is lower and more buyers can qualify
• Borrowers should determine how long they need
to keep a loan for the savings from the lower
interest rate to equal the extra money paid up front
in discount points

Loan Origination Fees

• Cover lender’s administrative costs in
processing a loan
• Also called loan fees, service fees, or
administrative fees
• While these are sometimes called points, loan
fees are not discount points

• Base loan fees on actual costs and also on what

the market will bear
• A mortgage broker must set the fees to offset the
actual costs and expenses incurred in the
origination of the loan
• If not, they can be fined for upcharging the
borrower
– profiting from a third party or lender fee


• Lender considers sale of the loan on the
secondary market
• In a competitive environment, some of those
fees may even be waived

Yield Spread Premium
• Tool that lowers the upfront closing costs for

a borrower
• Allows borrower to accept slightly higher
interest rate in exchange for lowering fees
• YSP must be disclosed on GFE within 3
business days of application
• Shows as a credit to the borrower on the
GFE

YSP paid to a mortgage broker is not considered to

be a violation of RESPA’s Section 8 anti-kickback
provisions as long as:
• The broker is providing a service to the borrower,
• The fees charged are reasonable, and
• The YSP is disclosed to the borrower on the Good
Faith Estimate (GFE) within three days of applying
for the loan and on the HUD-1 Settlement
Statement at closing.


• Changes to RESPA reclassified YSP
income earned by mortgage bankers
who use their own funds as a service
release premium (SRP)
• SRP allows mortgage bankers to
recognize value for the servicing of
mortgage loan
• When that loan is transferred (sold), the
acquiring lender will pay this premium

Buydown Plans
• When discount points are paid to buy down the
interest rate and lower mortgage payments
• Could make it easier for borrower to qualify
• Two main advantages to a buydown plan:
1. Buyer's monthly payment is lower than
normal
2. Lender evaluates and lets buyer qualify for
the loan on basis of reduced payment after
the buydown

Buydown Plans
• Even with the lower interest rate from the
buydown, payments would increase because
of the increased amount of money financed
• Seller could also pay discount points to buy
down the interest rate for the buyer

Permanent Buydown
• When points paid to lender reduce interest
rate and loan payments for entire life of the
loan
– When buyer's interest rate is
permanently bought down for life of loan,
lender will write that interest rate into the
promissory note
• Nominal rate (or coupon rate) stated in the
note will be the actual reduced interest rate

Temporary Buydown
• Points paid to lender reduce interest rate (prepay
interest) early in a loan
• Reduces loan payments early in the loan
• Interest rates/payments rise at a predetermined
point in loan term
• Popular when interest rates are high
• Plans can take two forms:
1. Level payment
2. Graduated payment

Level Payment Buydown

• A plan with interest rate reduction constant
throughout the buydown period
– Constant interest rate keeps payments
the same during buydown period

Graduated Payment Buydown

• Has payment subsidies in early years that
keep payments low
– Payments go up each year until they're
sufficient to fully amortize the loan

Graduated Payment
Buydown Plans
Two most common types are often
referred to as:
– 2-1 buydowns
– 3-2-1 buydowns

Limits on Seller-Paid Points

and Other Considerations
• Fannie Mae/Freddie Mac guidelines impose
limits on:
– Discounts
– Buydowns
– Other forms of seller contributions to help buyers
get into homes
• Other contributions include:
– Finance costs, such as prepaid interest
– Escrows for property taxes, hazard insurance,
and mortgage insurance
FHA and VA
• FHA guidelines also impose limits
• FHA allows a maximum seller contribution of
6%
• If the contribution is more than 6%, the FHA, like
Fannie Mae and Freddie Mac, deducts the
excess from the maximum loan amount

Adjustable Rate Mortgages (ARMS)
• Permit lender to periodically adjust interest rates

to reflect fluctuations in the cost of money
• Made primarily by banks and mortgage
companies
• S & Ls make a similar type of loan called an
adjustable mortgage loan (AML)

Elements of an ARM
1. Index
2. Margin
3. Rate adjustment period
4. Mortgage payment adjustment period
5. Interest rate cap (if any)
6. Mortgage Payment cap (if any)
7. Negative amortization cap (if any)
8. Conversion option (if any)

How ARMs Work

• Borrower’s interest rate determined initially by
cost of money when the loan is made
• Once initial interest rate for loan is set, rate of
loan is tied to a widely recognized and
published index
• Future interest rate adjustments for ARM
loans are based on the up and down
movements of the index

Prime Rate and Margin

• Prime rate is the lowest rate banks charge
their best commercial customers
• A margin is the difference between the index
value and the interest rate charged on an
ARM
– Also known as spread

Index
• At the time a loan is made, the index
preferred by the lender is selected
• Thereafter the loan interest rate will rise and
fall with the rates reported by that index

Commonly Used
Indexes for ARMs
1. Average One-Year Treasury Constant
Maturity Index (TCM)
2. Cost of Funds Index (COFI)
3. London Interbank Offering Rate (LIBOR)

Margin
• Lender adds a margin to the index to ensure
sufficient income for administrative expenses
and profit
• Lender’s margin generally remains fixed for
the duration of the loan
• Not impacted by the movement of interest
rates or other factors in the financial markets

Rate Adjustment Period

• Interval at which a borrower's interest rate
changes with ARMs
– Can range from a few months up to 7 years
– Most common rate adjustment periods are
every 6 months or 1 year
– After checking movement in the selected index,
lender will notify borrower, in writing, of any
increase or decrease in the rate

Mortgage Payment
Adjustment Period
• The interval at which a borrower’s
mortgage payment changes with ARMs
• Borrower’s actual principal and interest
payments are changed
• Like the rate adjustment period, this
payment adjustment interval can range
from a period of months up to 7 years

Handling Rate and

Payment Adjustments
1. Lender can adjust rate periodically, as
called for in loan agreement, and then
adjust mortgage payment to reflect rate
change
2. Lender can adjust rate more frequently
than the mortgage payment is adjusted

Handling Rate and

Payment Adjustments
• When this happens, the difference in the
amount of interest due is subtracted from or
added to the loan balance
• A loan balance increases, rather than
decreases, because deferred interest
creates negative amortization

Interest Rate Cap

• Lenders typically offer a lower initial interest
rate (start rate) to make ARMs more attractive
to borrowers
• ARMs with lower start rates usually will have a
larger margin, and therefore, a much higher
first payment adjustment
• Interest rate caps are used with ARMs

Interest Rate Cap

• Discounted rates and teaser rates required to
have caps; as do most ARMs
• The government has imposed regulations on
interest rate disclosure and the true costs of
ARMs
• Usually shown as two numbers, e.g., 2/6
– 2=maximum amount the interest rate can
increase in one year
– 6=maximum amount the interest rate can
increase during the life of the loan

Interest Rate Caps

• Fannie Mae and Freddie Mac Interest Rate
Caps:
– Fannie Mae limit rate increases to 2% per
year and 6% over the life of the loan (2/6)
– Freddie Mac limit rate increases to 2% per
year and 5% over the life of the loan (2/5)
• FHA Interest Rate Caps
– Limited to 1% per year and 5% over the life
of the loan (1/5)

Mortgage Payment Cap

• Used ARMs to protect a borrower from
large payment increases
• Without limits on the amount mortgage
payments can be increased, borrowers
are vulnerable to extreme changes in
the cost of money
• Lenders usually set the cap at about
7 1/2% annually

Negative Amortization Cap

• When a loan balance grows from deferred
interest, because payments don’t cover the
interest on the loan
• Negative amortization caps limit the growth of
a loan balance beyond a predetermined LTV
• Caps do not stop negative amortization
• Note usually calls for lender to adjust the
monthly payment at some point to prevent
further negative amortization

Periodic Payment Readjustment
• Some ARMs provide for regularly scheduled,

periodic readjustment of payment
• This can be instead of, or in addition to, any
negative amortization caps, payment caps,
or rate caps
• Payment caps are usually not taken into
account when a loan payments are
readjusted
• Readjustment reduces the chance of large
build-up of debt
44
Conversion Option
• Gives the borrower the right to convert
from an adjustable rate loan to a fixed rate
loan
• ARMs with a conversion option normally
include:
– Higher interest rate
– Limited time to convert
– Conversion fee

ARM Standardization
• Estimation: More than 200 different adjustable rate plans
• Sharp criticism from confused customers:
– Threats of government regulation
– Increased dangers of foreclosure
– Refusal of secondary markets to buy ARMs
• Led lenders to standardize most ARM programs
• Now, lenders usually follow secondary market guidelines
so they can sell ARMs just as they do fixed rate loans

Loan-to-Value Ratios
• 80%, 90%, and 95% are available

• Loan-to-value ratios may not exceed 95% for
ARMs purchased by Fannie Mae and Freddie
Mac
• Requirements are based on the potential risk
from higher payments when the interest rate is
adjusted
• Fannie Mae and Freddie Mac also require
owner occupancy for all ARMs
Appraisals on ARM Properties

• Appraisal guidelines followed more strictly by
lenders when underwriting ARM loans
• Lender concerned about validity of appraisal
• Lenders insist that appraisal report
accurately reflects an estimate of true value
of the property
• Terms of the sale must be clearly
communicated to appraiser
• Terms must be clearly identified—preferably
in the appraisal report
Underwriting ARMs
• Underwriter will:
– Carefully review the appraisal report to determine if
the appraiser has performed this analysis
satisfactorily
• If not found to be performed satisfactorily:
– Appraisal will be considered deficient because
underwriters try to subtract the value of any
favorable financing from the appraised value in
determining the maximum loan for a given LTV

ARM Qualifying
• Lenders are often stricter in qualifying borrowers
to be sure they have sufficient income in the event
their payments increase
– They take the income that a borrower has and
multiply it by certain percentages to determine
how much debt the borrower should be able to
afford
• Certain ARMs have features that increase the
likelihood of mortgage payments increasing to
dangerous levels after the first rate adjustment

Freddie Mac Guidelines
Freddie Mac recommends borrowers be allowed

to qualify:
• For a mortgage payment up to 25% of their
gross monthly income for total housing
expense ratio (as opposed to 28%)
• With total payments for all debts (including
mortgage payment) up to 33% of their gross
monthly income as a total debt service expense
ratio (as opposed to 36%)

Freddie Mac Guidelines

These recommendations are for ARM loans with any of
the following features:
• Rate or payment cap outside Freddie Mac guidelines
(2% per year, 5% per loan), or no caps
• Discounts or buydowns that exceed 2%
• Rate cap over 1% or payment cap over 7 1/2 %
• Difference between rate and payment adjustment
periods exceeds three years
• Payment cap does not meet Freddie Mac guidelines

FHA Guidelines
• Borrowers who are utilizing the one-year
ARM with an LTV of 95% or higher must
qualify at the initial rate plus 1%
– Which is the anticipated maximum 2nd
year rate
• FHA Hybrid ARMs are underwritten at the
initial interest rate

ARM Discounts and Buydowns

• ARMs with discounts or buydowns almost
always have payment increases after the first
adjustment period
• If the index goes up during the first period, the
payment shock would be even greater

ARM Discounts and Buydowns

• Potential problem—initial rate discounts and
buydowns often make ARMs more attractive for
borrowers who have trouble qualifying for
financing at higher rates
– These loans inherently riskier than most other
loans
– Lenders are beginning to underwrite them
more conservatively

ARM Disclosures
• Lenders offering residential financing must
comply with federal guidelines under
Regulation Z of the Truth-in-Lending Act
• Disclosures must be provided to the borrower
when the loan application is made or before
payment of any non-refundable fee

ARM Disclosures
The following disclosures must be made, if
appropriate:
• Index used to determine the interest rate
• Location where the borrower may find the
index
• Explanation of how the interest rate and
payment are determined
• Suggestion that the borrower asks the lender
about the current margin and interest rate
Continued on next slide 

ARM Disclosures
• Disclosure of the fact that the initial rate is
discounted and a suggestion that the borrower
inquire as to the amount of the discount
• Rate and payment adjustment periods
• Rate and payment caps
• Statement that rate or payment caps may result in
negative amortization
• Statement that the loan has a demand or call
provision
Continued on next slide 

ARM Disclosures
• Description of the information that will be
contained in the adjustment notice and when
such notices will be provided
• Statement that disclosure forms are available
for lender’s other ARM loans
• Maximum interest rate and payment
• Initial interest rate and payment
• Conversion option details

ARM Disclosures
• Lender must give borrower advance

notice of:
– Any change in payment
– Interest rate
– Index
– Loan balance
• Such disclosures must be given at least
25 days, but not more than 120, before a
new payment level takes effect
Annual Percentage
Rate (APR)
• The relationship between the cost of borrowing
money and the total amount financed,
represented as a percentage
• Cannot be made based solely on an ARM’s initial
rate
• The disclosure of the APR in the federal box on
the Truth-in-Lending Statement (TIL) must be
based on the lender’s margin
• Composite annual percentage rate

Payment Option ARMs
The options typically include:

– A traditional payment of principal
and interest
– An interest-only payment
– A minimum (or limited) payment

Hybrid ARMs
• May be used as a “band-aid”

• Get borrowers into a home at a lower rate
and payment upfront
– Once a borrower has had a chance to
establish more credit or repair their credit,
they can look into qualifying for a mortgage
with a better fixed rate
• 2/28 adjustable rate mortgage
• 3/27 adjustable rate mortgage

Subprime Loans
• Prime loans are ones made to borrowers with

good credit
• Subprime loans have more risks
– AKA B-C loans or B-C credit
– Allow those with less than perfect credit to
own a home
• To underwrite a subprime loan, lender examines
where the borrower belongs on the risk scale
• Credit scoring helpful in making this determination

Subprime Loans
• Regulation C of the Home Mortgage

Disclosure Act (HMDA)
• Lenders willing to make these riskier loans
because they can get:
– Higher interest rates
– Fees

Assessing Risk
• Subprime borrower matched to a series of risk
profiles
• Sometimes larger down payments or
secondary financing are required by lenders
• Many subprime lenders offer borrowers a
chance to refinance their loans at lower interest
rates after they pay their mortgage on time for
a given period of time

Interagency Guidelines
Jointly published by:

• The Office of the Comptroller of the Currency
(OCC)
• The Board of Governors of the Federal Reserve
System (Board)
• The Federal Deposit Insurance Corporation
(FDIC)
• The Office of Thrift Supervision (OTS)
• The National Credit Union Administration (NCUA)

Guidance on Nontraditional
Mortgage Products
• Interagency Guidance on Nontraditional
Mortgage Products
• The Guidance applies to nontraditional
mortgage products (NMPs)
– Defined as mortgage products that allow
borrowers to defer principal and, sometimes,
interest

Qualification Standards
• Collateral-dependent loans
• Risk layering
• Reduced documentation
• Simultaneous second lien loans
• Introductory interest rates

Underwriting Standards
• Should address the effect of a substantial

payment increase on the borrower’s
capacity to repay a nontraditional
mortgage loan when amortization begins

Statement on Subprime
Mortgage Lending
• Promote consumer protection standards
• The statement includes guidelines for:
– Defining predatory lending
– Underwriting standards
– Establishing control systems
– Consumer protection

Consumer Protection
Consumers should be informed of:

• Payment shock
• Prepayment penalties
• Balloon payments
• Cost of reduced documentation loans
• Responsibility for taxes and insurance

Predatory Lending
A loan involving at least one of the following:

• Making loans based mostly on the foreclosure or
liquidation value of a borrower’s collateral
• Inducing a borrower to repeatedly refinance a loan
in order to charge high points and fees each time
the loan is refinanced (known as “loan flipping” or
“equity skimming”)
• Engaging in fraud or deception to conceal the true
nature of the mortgage loan obligation

Structured Mortgages
• Variable Balance Mortgage (VBM)

• Bi-Weekly Mortgage
• Growth Equity Mortgage (GEM)
• Reduction Option Mortgage
• Reverse Mortgage
• Shared Appreciation Mortgage (SAM)

Seller Financing
• When a seller extends credit to a buyer to

finance the purchase of the property
• Mortgage money from traditional lenders
may be too costly in terms of interest
rates or it may be simply unavailable
• Seller must address the possibility of a
due on sale clause in existing mortgage

Purchase Money Mortgage

• A mortgage given by the buyer to the seller as partial
payment of the purchase of real estate
• AKA seller held mortgage
• Contains all of elements and follows all rules and
procedures for any type of mortgage
• Central advantage of this arrangement: Sellers are not
bound by institutional policies regarding:
– Loan ratios
– Interest rates
– Qualifying standards

Unencumbered Property
• Property with the title owned free and

clear
• Simplest form of purchase money
financing
• The buyer and seller can simply negotiate
the amount and terms of their financing
arrangement and draw up the appropriate
documents

Encumbered Property
• Has mortgages, liens, or other restrictions

against it which prevent or restrict its
transfer
• Can complicate a seller financing deal
because there are other parties whose
interests must be considered

Assumption
• One party agrees to take over payments of

another party’s debt, with terms of the note
staying unchanged
• FHA and VA loans permit assumptions
• Some conventional mortgages also allow
assumptions

Assumption and Release

• Assumption might be an agreement strictly
between buyer and seller
• The buyer assumes responsibility for the
loan, but the seller is not completely released
from liability
• A release is a document in which a legal right
is given up

Alienation Clause
• Gives the lender the right to exercise certain

rights upon transfer of the property
– Such as declare the entire loan balance
immediately due and payable
– Due on sale clause or acceleration clause
• Designed to restrict the seller’s right to
transfer the property

Seller-Sponsored
Wraparound Financing
• When seller offers the wraparound mortgage,
retaining an existing loan on the property while
the lender (or in this case, seller) gives the
buyer another larger loan
• Seller can extend the benefit of an existing
loan at lower-than-market interest rates

Purchase Money
Second Mortgage
• A purchase money mortgage in a second
lien position
• If the seller is financing only part of the
purchase price, then the seller would be in a
junior lien position with the institutional
lender taking the first lien position

Land Contract
• Real estate installment agreement where the

buyer makes payments to the seller in exchange
for the right to occupy and use the property,
– No deed or title is transferred until all, or a
specified portion, of the payments have been
made
• Equitable title is an interest in real property
created with the execution of a valid sales contract

Land Contract Subject to

an Existing Mortgage
• Possession of property is transferred to
buyer
• Seller retains liability for mortgage
• If seller defaults, buyer may be forced to
file suit to recover
• Land contract could allow buyer to make
payments directly to lender

Contract Escrow
• Ensures that a seller makes the payments

on the existing mortgage
• Sets up an escrow account or servicing
agreement for the contract payments

Estoppel Letter
• Legal doctrine that prevents a person (or

artificial person such as a lender or
company) from asserting rights or facts
inconsistent with earlier actions or
statements, when he or she failed to object
(or attempt to stop) another person’s
actions

Land Contract with Assumption

of an Existing Mortgage
• The mortgage must not contain any alienation
clauses
• Seller must get a release or remain
secondarily liable
• Buyer becomes personally liable for:
– Payment of the mortgage debt
– Making one payment to the mortgagee
– Another payment to the seller for the land
contract

Other Forms of
Creative Financing
• Lease/Option
• Lease
• Option

Option
Instances in which an option might be used:

• Profit
• Speculation
• Investment
• Comparison
• Time to Acquire Cash
• Qualifying
• Rent Credit

Consideration for an Option
• Anything of value given to induce another

to enter into a contract
• Usually a sum of money (called option
money), but it can be anything of value

How Does a Lease/Option Work?
• The seller/lessor leases the property to the

buyer/tenant for a specific term
• Includes provision that part of the rental
payments may be applied to the purchase
price if the tenant decides to buy before the
lease expires

Lease Contract Separate

from the Option Contract
• Problem: Too often the optionee/lessee
does not exercise the right to purchase
• Two problematic characteristics:
1. Prospective buyer’s minimal cash
investment
2. Prospective buyer’s extended
occupancy of property before
commitment

Lease/Purchases
• When a seller leases property to someone

for a specific term, with the tenant agreeing
to buy the property at a set price during or
following the lease term
• Equivalent of a sale

Lease/Purchase
• Instances in which a lease/purchase might be

used:
– Time to Acquire Cash
– Qualifying
– Rent Credit
• How does a lease/purchase work?
– The seller/lessor leases the property to the
buyer/tenant for a specific term with the
provision that part of the rental payments may
be applied to the purchase price

Equity Exchanges
• Value in one property being traded for value in

another property
• This is also called:
– Tax-deferred exchange
– Tax-free exchange
– Like-kind exchange, or Section 1031 (from the
section number of IRS law)

Equity Exchange General Rules
1. The properties must be exchanged, or

qualify as delayed exchange
2. The properties must be like-kind property
(real estate for real estate)
3. The properties must be held for use in a
trade or business, or held by the party as
an investment

Participation Plans
• AKA equity participation mortgage
• When a buyer and another investor enter
into a partnership, with the buyer paying an
equity share in a deal in lieu of interest (also
called a shared equity plan)
• Buyer enters into a form of partnership with
an investor who provides cash for the
purchase
• The investor may be the seller, a bank, or
any private investor

Important Questions to Consider
• How will the loan be applied?

• How will the equity be calculated?
• What percentage of the equity will the investor
receive?
• When will the investor be repaid?
• How will improvements be handled?
• Who will be responsible for payment of taxes
and insurance?

Application of the Loan
• An investor may simply put up cash for

the down payment
• The primary lender may reduce the
interest rate in exchange for a share of
the equity

Calculation of Equity
• Equity is the difference between the

value of the property and the outstanding
indebtedness secured by the property
• Buyer and investor must agree at the
outset to the method of valuing the
property

Investors
• Investor’s Percentage of Equity

– Negotiable
– Provide at least a market rate of return to
investors
• Repayment of Investor
– The investor may cash out his share of equity
at a pre-agreed time, or when the property is
sold

Handling Improvements
• Handling Improvements
– The agreement should specify how improvements will
be paid for
– if the investor will share in any changes in equity
resulting from improvements to the property
• Responsibility for Taxes and Insurance
– Usually the buyer will pay the property taxes and
homeowners insurance premiums
– but this point may be negotiable with some private
investors

Responsibilities for
Taxes and Insurance
• Usually the buyer will pay the property
taxes and homeowners insurance
premiums
• But this point may be negotiable with
some private investors

Homebuyer Assistance Programs
• Can be:
– Down payment assistance programs (AKA DAP
programs)
– Subsidized mortgage interest rates
– Help with closing costs
– Combination
• May be offered by:
– Government or non-profit organizations
– Lenders as part of their obligation under the
Community Reinvestment Act

Exercise 8-1
A borrower wants to buy a $150,000 home,

and is going to make a $15,000 down payment.
The borrower is seeking a conventional loan,
but doesn’t want to pay more than 6 1/2%
interest. The lender agrees to 6 1/2% interest if
the loan has three discount points and the loan
origination fee is 2%.

Exercise 8-1
1. What’s the total amount of points (in

dollars and percentage) that the lender
will receive for making this loan?
Points are based on the loan amount, in this
case, $135,000 ($150,000 - $15,000 down).
The lender is charging a total of 5 points, or
5% of the loan. Discount points total $4,050
($135,000 x .03) and the loan origination fee
is $2,700 ($135,000 x .02). The total the lender
will receive in points is $6,750 ($4,050 +
$2,700).
Exercise 8-1
2. If the seller agrees to pay the discount

points, how much will the seller net from
the transaction? (Assume the seller pays
no other costs.)
The seller net is the sale price minus any

seller-paid points, so the seller will net
$145,950 ($150,000 - $4,050).

Mortgage Exercises
3. What will the borrower’s note state as the

interest rate on the loan? What dollar
amount will the note say was borrowed?
The loan note rate will be 6.500% since this is

not a temporary buydown. The amount on the
note equals the loan amount, not the sale
price, so it’s $135,000 ($150,000 - $15,000).
The note amount does not reflect the seller-
paid points.

Exercise 8-1
4. Can the lender sell this loan to Fannie

Mae or Freddie Mac on the secondary
market? Why or why not?
Yes, the lender should be able to sell this loan to

Fannie Mae/Freddie Mac on the secondary
market because it has less than the 6% seller
assistance limit that the programs allow with a
90% LTV.

Exercise 8-2
A borrower just received a 30-year ARM

mortgage loan for $120,000. The start rate is
3.50% and the loan adjusts every 12 months
for the life of the mortgage. The index used
for this mortgage is the LIBOR (for this
exercise, let’s say it’s currently at 5.00%).
The margin on the loan is 3.00%. Rate caps
are 2.00% per year, 6.00% over life of the
loan with a first adjustment cap of 3.00%.

Exercise 8-2
1. What is the initial rate and what is the

interest rate after the first year?
The initial and start rate are the same, 3.50%.
The rate after the first year based on the
current LIBOR is 5.00% + margin of 3.00% =
8.00%. BUT, the maximum rates caps have to
taken in consideration also. In this mortgage,
the maximum rate increase the first year is
3.00% (2.00% in all other years). So 3.50% +
3.00% = 6.50%, which will be the interest rate
after the first adjustment.

Exercise 8-2
2. What is the fully indexed rate? Is this a

teaser rate?
The fully indexed rate is 8.00%: Current
LIBOR Rate (5.00%) + Margin (3.00%)
When you subtract the start rate of 3.50%
from the fully indexed rate of 8.00%, you find
a difference of 4.50%, or 450 basis points.
Since the rate spread is more than 300 basis
points (or 3%) this is a teaser rate.
Exercise 8-2
3. What is the interest rate after the second year

using the information provided?
The current LIBOR of 5.00% + the margin of

3.00% is 8.000%. The rate after the first
adjustment period is 6.50%. Adding the
maximum adjustment cap of 2.00% = 8.50%.
Using the lower of the two interest rates
makes the actual rate 8.00% after the second
adjustment.
Exercise 8-2
4. What is the maximum interest rate this loan

could have? What would the LIBOR have to
be to obtain that interest rate?
The maximum interest rate equals the start rate of
3.50% + the life of the loan maximum of 6.00%, so
the maximum interest rate this loan could have is
9.50%. In order for this loan to get to that rate,
however, the LIBOR would have to increase 1.50%
from its current rate of 5.00%:
9.50% (Maximum Lifetime Rate) – 3.00% (Margin) =
6.50% (LIBOR)
Summary
1. Nontraditional mortgage products could include
real estate that is financed with terms or
concessions other than those typical for
conventional loans. Such products can help
buyers qualify for larger loans, or help them
reach other financial goals. The most popular
alternative financing tools are buydowns and
adjustable rate mortgages (ARMs). Other types
include structured mortgages, subprime loans,
and homebuyer assistance programs.

Summary
2. Lender’s yield is the total amount a

lender or broker makes on a loan. This
can come from loan fees, discount
points, or yield spread premium. Points:
1% of loan amount; increase lender’s
yield and are paid for many reasons.

Summary
3. Buydowns are additional money (points) paid to the lender at

the start of a loan to lower interest rate and payments. Discount
points are paid to the lender to make up the difference between
the market interest rate and the rate a buyer gets in the note.
Buydowns may be paid by a seller or builder. A permanent
buydown (for life of loan) has a reduced rate stated in the note.
A temporary buydown (early in loan) can be level payment or
graduated payment (3-2-1, 2-1). With buydowns, the lowest a
buyer can qualify is 2% below market rate. The limit on seller
paid points: Fannie Mae and Freddie Mac—90% or higher LTV
= 3 points, between 90% and 75% LTV = 6 points, 75% or
lower LTV = 9 points; FHA = 6 points. FHA requires buyers to
qualify at the note rate, not the buydown rate.

Summary
4. Adjustable rate mortgages (ARMs) let lenders adjust interest rates.
Lenders pick an index (statistical report reflecting cost of money), add a
margin (profit margin), and this is the rate paid on the loan. Loan
documents must state: Rate, index, margin, and payment adjustment
period; caps (if any) on rate, payments or negative amortization;
conversion option (if any). The rate and payment may not adjust at same
time. Rates that change more frequently than payments create negative
amortization (loan balance grows from deferred interest). Caps keep
loans from growing out of control. Rate caps: Fannie Mae = 2%/year,
6%/life of loan; Freddie Mac = 2%/year, 5%/life of loan; FHA = 1%/year,
5%/life of loan. Payment caps are 7 1/2% to 15% a year. Negative
amortization caps are based on LTV: 110 to 125% of loan or 100% of
appraised value. If loan grows too large, re-amortization occurs. Periodic
re-amortization is when payments are recalculated based on the loan
balance at specific interval. Conversion options allow buyers to convert
to fixed rate (limited).

Summary
5. Other limits on ARMs: Fannie Mae and Freddie Mac
LTVs are limited to 95%, appraisals are more strict, if
there are no (or high) caps, then income ratios are
reduced to 25% and 33%. Freddie Mac requires buyer
to qualify 2% above initial rate. ARM rules under
Regulation Z of Truth in Lending Act include: CHARM
booklet must be given to the buyer, specific
disclosures are made, annual percentage rate (APR)
is disclosed. APR is a composite rate that reflects the
lower rate for certain number of years and the higher
rate for later years. Lenders cannot disclose only initial
low rates.

Summary
6. Structured mortgages help borrowers reach

other financial goals. Variable balance: Variable
rate, constant payments so balance adjusts. Bi-
weekly: Payments every two weeks so balance is
paid faster, saves interest. Growth equity: Fixed
rate, but payments increase to pay off faster.
Reduction option: Buyer can reduce rate one
time, with fewer refinancing costs. Reverse:
People over 62 can get a monthly check from
lender. Shared appreciation: Lender shares
equity in commercial project.

Summary
7. Subprime loans (B-C loans, B-C credit)

have more risk than what is allowed by the
conventional market. Borrower risk factors
determine interest rate and terms.

Summary
8. Seller financing is when seller extends credit to buyer to finance the
purchase of property. Seller can extend all or partial credit. This can
help a buyer who doesn’t have enough cash to buy a property, can’t
qualify for a conventional loan, or wants or needs a lower-than-market
interest rate. Seller gets the benefit of a home that’s easier to sell, and
often a better price by offering terms, as well as a tax deferment on the
gain from the home’s sale. A purchase money mortgage or seller-
held mortgage is given by buyer to the seller to secure part or all of
the money borrowed to purchase property. Unencumbered property
with no liens is best for this transaction; encumbered property with
liens needs assumption or wraparound. Assumption has the buyer
take responsibility for the mortgage, but the seller must get a release
from the lender. (An alienation clause can stop this.) A wraparound
mortgage has the seller retain existing mortgage (the buyer makes
one larger payment; the seller pays the lender and keeps difference,
making good yield.)

Summary
9. A land contract is an installment contract

where a buyer pays a seller for possession
of property, but the seller keeps title until all
(or some) payments are made. If seller
doesn’t own the property free and clear,
the buyer may take a land contract subject
to the existing mortgage or assume the
mortgage. An estoppel letter gives the
lender’s written consent to the deal.

Summary
10. A lease/option has the seller lease to a tenant who has
the right (but not the obligation) to buy the property at a set
price within a certain time. An option can be used for profit,
speculation, investment, comparison, or to give buyer time
to acquire cash, to qualify, or credit rent toward purchase
price. A lease/purchase combines a lease with a purchase
contract. An equity exchange (tax-deferred exchange,
Section 1031) is property traded for value in other property.
Properties must be exchanged (or delayed exchange), like
kind, and held for trade, business, or investment. Capital
gains tax is deferred, but boot (unlike property added to
balance value) is taxed. Tax-free exchanges are not
available for residential property. Participation plans have
investors share equity instead of receiving interest.

Summary
11. Homebuyer assistance programs can

be down payment assistance programs
(DAP), subsidized mortgage interest rates,
help with closing costs, or combination.
Programs can be offered by government or
non-profit groups, or by lenders as
obligated under the Community
Reinvestment Act.

Quiz
1. Which is NOT a way for lenders or

brokers to make money at the
beginning of a loan?
a. discount points
b. loan fees
c. prepayment penalties
d. yield spread premium

Quiz
2. On an $80,000 loan, six points equals

a. $800.
b. $2,400.
c. $3,400.
d. $4,800.

Quiz
3. In VA transactions, points are

a. allowed and can be paid by buyer, seller,
or a third party.
b. allowed, but must be paid by the
buyer.
c. allowed, but must be paid by the seller.
d. not allowed.

Quiz
4. A buydown plan can reduce the borrower's
payments
a. early in the loan or for the entire life of the loan.
b. early in the loan only, but then requires a large
balloon payment.
c. for the life of a loan, but with automatic
prepayment penalty.
d. through gradual payment decreases throughout
the life of the loan.

Quiz
5. Which statement is true about interest

rate buydowns on FHA loans?
a. Borrowers may qualify at the buydown
rate.
b. Borrowers must qualify at the note rate.
c. FHA does not allow builder-paid
buydowns.
d. FHA does not allow seller-paid buydowns.

Quiz
6. Which of the following is NOT an

element of an ARM?
a. index
b. margin
c. positive amortization cap
d. rate

Quiz
7. What is the adjustable number used to

compute the interest rate on an ARM
called?
a. cap
b. index
c. margin
d. prepayment

Quiz
8. With an ARM, the margin is added to the

______ to determine the _________ .
a. APR / cost of funds index
b. home value / amount borrowed
c. index / interest rate charged
d. qualifying ratio / maximum monthly
mortgage

Quiz
9. Negative amortization occurs when

a.a borrower suffers payment shock.
b.mortgage payments are adjusted more
frequently than interest rates.
c.the loan balance grows from deferred
interest.
d.all of the above.

Quiz
10. What is the LTV limit that Fannie Mae

and Freddie Mac require for ARMs
they purchase?
a. 80%
b. 85%
c. 90%
d. 95%

Quiz
11. How are subprime loans different from

conforming loans?
a. They allow for lower interest rates.
b. They allow for more risk.
c. They are only offered by banks.
d. They are sold in the secondary market.

Quiz
12. According to HMDA, a first mortgage will

be considered a subprime loan when the
difference between the annual
percentage rate and the rate spread is
greater than
a. 2 percentage points.
b. 3 percentage points.
c. 5 percentage points.
d. 6 percentage points.

Quiz
13. If Bob takes over Sue’s mortgage,

becoming personally liable for the debt,
and he will pay the balance of the purchase
price to Sue under a contract, they have
a. an assumption and release.
b. encumbered property cash out.
c. a land contract subject to an existing
mortgage.
d. a land contract with assumption of an
existing mortgage.

Quiz
14. An equity exchange is treated as a tax-

free exchange when property is
a. for profit and of like kind.
b. held for sale by a dealer only.
c. owner-occupied.
d. rental only.

Nontraditional Mortgage Products

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Chapter 8

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 1

• Nontraditional is defined by SAFE Act as anything

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 3

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 4

• Adjustable Rate • Estoppel Letter

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 5

• Lender’s Yield • Rate Adjustment

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 6

Adjustable Rate Mortgage (ARM)

• Borrower can decrease initial interest rate if

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 8

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 9

• Also known as lender’s yield

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 10

• A point is 1% of the loan amount

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 11

• Seller may be willing to pay discount points as a

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 12

Loan Origination Fees

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 13

Loan Origination Fees

• Base loan fees on actual costs and also on what

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 14

Loan Origination Fees

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 15

Yield Spread Premium

• Tool that lowers the upfront closing costs for

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 16

Yield Spread Premium

YSP paid to a mortgage broker is not considered to

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 17

Yield Spread Premium

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 18

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 19

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 20

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 21

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 22

Level Payment Buydown

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 23

Graduated Payment Buydown

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 24

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 25

Limits on Seller-Paid Points

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 27

Adjustable Rate Mortgages (ARMS)

• Permit lender to periodically adjust interest rates

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 28

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 29

How ARMs Work

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 30

Prime Rate and Margin

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 31

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 32

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 33

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 34

Rate Adjustment Period

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 35

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 36

Handling Rate and

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 37

Handling Rate and

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 38

Interest Rate Cap