The mortgage business is a complicated and ever-changing industry. It is important that you understand how the mortgage market works and how the lenders make their profit. In doing so, you will gain an appreciation of loan programs and why certain loans are offered by certain lenders. There are several categories of lenders that are discussed in this article, and many lenders will fit in more than one category. In addition, some categories of lending are more of a lending “style” than a lender category; this concept will make more sense after you finish reading this article.

Institutional Lenders The first broad category of distinction is institutional versus private. Institutional lenders include commercial banks, savings and loans or thrifts, credit unions, mortgage banking companies, pension funds, and insurance companies. These lenders generally make loans based on the income and credit of the borrower, and they generally follow standard lending guidelines. Private lenders are individuals or small companies that do not have insured depositors and are generally not regulated by the federal government.

Primary versus Secondary Mortgage Markets

First, these markets should not be confused with first and second mortgages, which were discussed in Article 2. Primary mortgage lenders deal directly with the public. They originate loans, that is, they lend money directly to the borrower. Often referred to as the “retail” side of the business, lenders make a profit from loan processing fees, not from the interest paid on the loan. Primary mortgage lenders generally lend money to consumers, then sell the mortgage notes (together in large packages, not one at a time) to investors on the secondary mortgage market to replenish their cash reserves. Portfolio lenders don’t sell their loans to the secondary market, but rather they keep the loans as part of their portfolio (some lenders sell part of their loans and keep others as part of their portfolio). As such, they don’t necessarily need to conform their loans to guidelines established by the Federal National Mortgage Association (FNMA) or the Federal Home Loan Corporation (FHLMC). Small, local banks that portfolio their loans can be an investor’s best friend, because they can bend the rules to suit that investor’s needs. Larger portfolio lenders can handle more loans, because they have more funds, but they are not as f lexible as the small banks. Larger portfolio lenders can also give you an unlimited amount of loans, whereas FNMA/FHLMC lenders have limits on the number of loans they can give you (currently loans for nine properties, but these limits often change). The nation’s larger portfolio lenders include World Savings and Washington Mutual.

The largest buyers on the secondary market are FNMA (or “Fannie Mae”), the Government National Mortgage Association (GNMA, or “Ginnie Mae”), and the FHLMC (or “Freddie Mac”). Private financial institutions such as banks, life insurance companies, private investors, and thrift associations also buy notes. FNMA is a quasi-governmental agency (controlled by the government but owned by private shareholders) that buys pools of mortgage loans in exchange for mortgage-backed securities. GNMA is a division of the Department of Housing and Urban Development (HUD), a governmental agency. Because most loans are sold on the secondary mortgage market to FNMA, GNMA, or FHLMC, most primary mortgage lenders conform their loan documentation to these agencies’ guidelines (known as a “conforming” loan). Although primary lenders sell the loans on the secondary mortgage market, many of the primary lenders will continue to collect payments and deal with the borrower, a process called servicing.

Mortgage Bankers versus Mortgage Brokers

Many consumers assume that “mortgage companies” are banks that lend their own money. In fact, a company that you deal with may be either a mortgage banker or a mortgage broker. A mortgage banker is a direct lender; it lends you its own money, although it often sells the loan to the secondary market. Mortgage bankers (also known as “direct lenders”) sometimes retain servicing rights as well. A mortgage broker is a middleman who does the loan shopping and analysis for the borrower and puts the lender and borrower together. Many of the lenders through which the broker finds loans do not deal directly with the public (hence the expression “wholesale lender”). Using a mortgage banker can save the fees of a middleman and can make the loan process easier. A mortgage banker can give you direct loan approval, whereas a broker gives you information secondhand. However, many mortgage banks are limited in what they can offer, which is essentially their own product. In addition, if you present your loan application in a poor light, you’ve already made a bad impression. I am not suggesting you lie or mislead a lender, but understand that presenting a loan to a lender is like presenting your taxes to the IRS. There are many ways to do it, all of which are valid and legal. Using a mortgage broker allows you to present a loan application to a different lender in a different light (and you are a “fresh” face). A mortgage broker charges a fee for his or her service but has access to a wide variety of loan programs. He or she also may have knowledge of how to present your loan application to different lenders for approval. Some mortgage bankers also broker loans. As an investor, it is wise to have both a mortgage broker and a mortgage banker on your team.

Conventional versus Nonconventional Loans

Conventional financing, by definition, is not insured or guaranteed by the federal government (see discussion of government loans later in this article). Conventional loans are generally broken into two categories: conforming and nonconforming. A conforming loan is one that conforms or adheres to strict Fannie Mae/Freddie Mac loan underwriting guidelines.

Conforming Loans

Conforming loans are a low risk to the lender, so they offer the lowest interest rates. Conforming loans also have the strictest underwriting guidelines. Conforming loans have the following three basic requirements: 1. Borrower must have a minimum of debt. Lenders look at the ratio of your monthly debt to income. Your regular monthly expenses (including mortgage payments, property taxes, insurance) should total no more than 25 percent to 28 percent of your gross monthly income (called “front-end ratio”). Further-more, your monthly expenses plus other long-term debt payments (e.g., student loan, automobile, alimony, child support) should total no more than 36 percent of your gross monthly income (called “back-end ratio”). These ratios can sometimes be increased if the borrower has excellent credit or puts up a larger down payment. 2. Good credit rating. You must be current on payments. Lenders will also require a certain minimum credit score (discussed in Article 4). 3. Funds to close. You must have the requisite down payment (generally 20 percent of the purchase price, although lenders often bend this rule), proof of where it came from, and a few months of cash reserves in the bank.

Private mortgage insurance.

Private mortgage insurance (PMI) requirements apply only to first mortgage loans; thus, you can get around PMI requirements by borrowing a first and second mortgage loan. So long as the first mortgage loan is less than 80 percent loan-tovalue, PMI is not required. However, the second mortgage loan may have a high interest rate, so that the blending of the interest rate on the first and second mortgage loans exceeds what you would be paying with a first mortgage and PMI. Use a calculator to figure out which is more profitable for you (the formula for interest rate blending is discussed in Article 5). One way around the large down payment is to purchase PMI. Also known as “mortgage guaranty insurance,” PMI will cover the lender’s additional risk for a high loan-to-value ratio (LTV) program. The insurer will reimburse the lender for its additional risk of the high LTV. PMI should not be confused with mortgage life insurance, which pays the borrower’s loan balance in full when he or she dies (not recommended— regular term life insurance is a better deal for the money). Nonconforming Loans Nonconforming loans have no set guidelines and vary widely from lender to lender. In fact, lenders often change their own nonconforming guidelines from month to month. Nonconforming loans are also known as “subprime” loans, because the target customer (borrower) has credit and/or income verification that is less than perfect. The subprime loans are often rated according to the creditworthiness of the borrower—“A,” “B,” “C,” or “D.” An “A” credit borrower has had few or no credit problems within the past two years, with the exception of a late payment or two with a good explanation. A “C” credit borrower may have a history of several late payments and a bankruptcy. The subprime loan business has grown enormously over the past ten years, particularly in the refinance business and with investor loans. Every lender has its own criteria for subprime loans, so it is impossible to list every loan program available on the market. Suffice it to say, the guidelines for subprime loans are much more lax than they are for conforming loans.

Government Loan Programs

The federal government and state government sponsor loan programs to encourage home ownership. Most of the loan programs are geared towards low-income neighborhoods and first-time homebuyers. If you are dealing in low-income properties, you should be aware of these guidelines if you intend to sell properties to these target homebuyers. Also, some of these programs are geared to investors as well.

Federal Housing Administration Loans HUD is the U.S. Department of Housing and Urban Development, an executive branch of the federal government. The Federal Housing Administration (FHA) is an arm of HUD that administers loan programs. HUD does not lend money but rather insures lenders that make high LTV loans. Because high LTV loans are risky for lenders, the FHAinsured loan programs cover the additional risk. Not all lenders can make FHA-insured loans; they must be approved by HUD. The most common FHA loan program is the 203(b) program, designed for first-time homebuyers. This program allows an owneroccupant to put just 3 percent down and borrow 97 percent loan-tovalue. This program is for owner-occupied (noninvestor) properties, but investors should be familiar with the program because they may wish to sell a property to a buyer who may use the program. The two most common HUD loans available for investors are the Title 1 Loan and the 203(k) loan.

Title 1 loan. The Title 1 loan insures loans of up to $25,000 for light to moderate rehab of single-family properties, or $12,000 per unit for a maximum of $60,000 on multifamily properties. The interest rates on these loans are generally market rate, although local participation by state or municipal agencies may reduce the rate (see below). An interesting note on Title 1 loans is that it is not limited to owners of the property. A lessee or equitable owner under an installment land contract (discussed in Article 9) may qualify for the loan.

FHA 203(k) loan. The 203(k) program is for an investor who wants to live in the home while rehabbing it. It allows the investoroccupant to borrow money for the purchase or refinance of a home as well as for the rehab costs. It is an excellent alternative to the traditional route for these investors, which is to buy a property with a temporary (“bridge”) loan, fix the property, then refinance it (many lenders won’t offer attractive, long-term financing on rehab properties). The 203(k) loan can be for up to the value of the property plus anticipated improvement costs, or 110 percent of the value of the property, whichever is less. The rehab cost must be at least $5,000, but there is no limit to the size of the rehab (although it cannot be used for new construction, that is, the basic foundation of the property must be used, even if the building is razed). The program can be used for condominiums, provided that the condo project is otherwise FHA qualified. Cooperative apartments, popular in New York and California, are not eligible.

The Department of Veterans Affairs The Department of Veterans Affairs (VA) guarantees certain loan programs for eligible veterans. As an occupant, an eligible veteran can borrow up to 100 percent of the purchase price of the property. When a borrower with a VA-guaranteed loan cannot meet the payments, the lender forecloses on the home. The lender next looks to the VA to cover the loss for its guarantee, and the VA takes ownership of the home. The VA then offers the property for sale to the public.

State and Local Loan Programs Many states and localities sponsor programs to help first-time homebuyers qualify for mortgage loans. The programs are aimed at improving low-income neighborhoods by increasing the number of owners versus renters in the area. Most of these programs are for owneroccupants, not investors, but it may also help to know about these programs when you are selling homes. Some state and local programs work in conjunction with HUD programs, such as Title 1 loans. Contact your state or city department of housing for more information on locally sponsored loan programs. A list of links to state programs can be found at <www.hsh.com/pam phlets/state_hfas.html>.

Commercial Lenders Most of the discussion so far has been about financing of singlefamily homes and small multifamily residential homes. What about large multifamily projects and commercial projects, such as shopping centers, strip malls, and office buildings? Many of the same concepts do apply, except for the financing guidelines. Commercial lenders generally do not have industry-wide loan criteria. Instead, each lender has its own criteria and will review loans on a project-by-project basis. Lenders will look at the experience of the investor as well as the income and expenses of the particular collateral. In other words, commercial lenders are more concerned with whether the property will generate enough income to pay the loan, not whether the borrower has good credit (although a borrower with poor credit will generally have a hard time getting any type of loan from an institutional lender).

A commercial appraisal is required, which is more detailed and expensive than a residential appraisal. A commercial loan will require the borrower to have a substantial reserve of cash to handle vacancies. Commercial loans also can be made for residential buildings of five units or more, but there is a minimum loan amount required by each lender (generally a $300,000 to $500,000, depending on the property values in your marketplace). Oddly enough, multimillion dollar loans are often made without recourse to the borrower. In other words, if the project fails, the borrower (often a corporate entity) is not liable for the debt. The lender’s sole recourse is to foreclose against the property. For this reason, the lender is more concerned with the property than the borrower.

Key Points

• Most lenders sell their loans to the secondary market.

• Loans come in three basic categories: conforming, nonconforming, and government.

• The government does not lend money, but rather it guarantees loans.

• Commercial lenders look to the property rather than the borrower.