Conventional Loan

Conventional mortgage loans are loans that do not have any special government involvement.  Conforming conventional mortgage loans do not exceed the Fannie Mae / Freddie Mac loan limits, see chart, and are underwritten according to the specific guidelines.

Conventional Conforming Loan Maximum Original Principal Balance for 2012 Contiguous States, District of Columbia, and Puerto Rico, left side.

Alaska, Guam, Hawaii, the U.S. Virgin Islands, right side. (1 thru 4 units).

        General             High-Cost*              /          General                       High-Cost*

    1.  $417,000            $729,750                 /          $625,500                      $938,250

    2.  $533,850             $934,200                 /          $800,775                     $1,201,150

    3.  $645,300             $1,129,250              /          $967,950                     $1,451,925

    4.  $801,950             $1,403,400              /          $1,202,925                  $1,804,375

Conventional loans can be either uninsured, if the borrower paid a down payment sufficient to bring the loan amount down to 80% of value or purchase price, whichever is less; or insured, using PMI (private mortgage insurance) when the down payment is less than 20% of the purchase price.

Underwriting guidelines for uninsured and insured conventional loans are the same and use the same loan pricing matrix. The difference is in the cost of PMI that has its’ own pricing template that declines from a maximum fee for maximum LTV (loan-to-value ratio) to a minimum fee for LTV’s between 80% and 85%.

The charges for PMI change from time to time and from market to market. Your lender cannot charge an amount greater than the PMI provider charges them for the coverage. The PMI companies are regulated by State insurance regulatory departments, and must register their rates in each State where they do business. Whatever amount is published will be the rate charged. So having to pay for PMI boils down to a simple “IF /THEN” scenario. IF your loan is greater than 80% of value (or price whichever is less) THEN you will pay the fee.

From a borrower’s perspective, if you have sufficient liquid assets to pay  20% down payment without cutting your reserves uncomfortably short, you can save money.

What Is Private Mortgage Insurance?  Private Mortgage Insurance (PMI), like FHA insurance, protects the mortgage lender in the event that a homebuyer is unable, or unwilling to pay their monthly mortgage payments. Many studies have concluded that the less money the borrower uses for down payment on their home, the more likely that home loan will end in foreclosure.  Lenders prefer that borrowers put at least 20 percent down on a house. If the borrower doesn’t make that much of a down payment, the lender faces a greater risk of losing their investment (your agreed monthly loan payments, paid on time). By requiring a borrower to obtain private mortgage insurance, the home loan payment will include the cost of that private mortgage insurance.

With private mortgage insurance, if the borrower defaults on their mortgage, the lender receives a payout from the title insurance provider, capped to cover a pre-agreed specified portion of the loss caused by the foreclosure.  For example, let’s say you want to purchase a home for $140,000. Your lender wants you to put down 20 percent of the purchase price, or $28,000, but you only have $7,000, or 5 percent.  The lender then, agrees to loan 95 percent of the purchase price, provided that you pay for the private mortgage insurance for the increased loan percentage. You then mortgage the additional amount, $133,000. (95% of $140,000).

Typically, for a 95% conventional loan, PMI covers the top 30% of the lender’s exposure and the PMI insurance cost for a fixed rate loan is about .94% of the loan amount (less than 1% if the loan amount) and it is broken into 12 equal payments and included in your monthly mortgage payment. (NOTE:  PMI FEES ARE NOW TRENDING TO FICO SCORE PRICING… do you remember what you learned about tweaking your credit?)   Using the above example,  your mortgage insurance payment would be $1,250.20 a year. Mortgage insurance is paid monthly in your mortgage payment, so your payment would include an additional $104.18 ($1,250.20 divided by 12) to cover the mortgage insurance costs on the loan.

The good news is that this extra payment doesn’t last forever.  After you’ve paid your mortgage down to a certain amount, (currently 80% LTV) or your home appreciates, you can have your PMI cancelled, and the $104.18 in your monthly payment goes away.

In assessing the risk of the borrower, PMI companies evaluate both the ability and the willingness of the borrower to repay the mortgage loan.  In determining the borrower’s ability to repay, insurers examine sources of income, debt-to-income ratios, asset holdings, employment history, and prospects for income growth.

Insurers gauge willingness to repay primarily by reviewing the borrower’s credit history, including rent and utility payment records in some cases. They will also look closely at the property securing the mortgage. For example, because insurers generally perceive condominiums, manufactured homes, and properties with two, three, or four units as riskier sources of collateral than single-family detached dwellings, they usually underwrite them more stringently.

In addition, insurers consider the use of the property securing the mortgage. Dwellings to be used as vacation homes, second homes, or investment properties are generally underwritten to stricter standards than those for owner-occupied, primary residences. For example, the maximum loan-to-value ratio allowed for second homes is often lower than that for primary residences. In the extreme, some PMI companies have chosen not to offer insurance for particular uses of property, such as investment.

Borrowers, advised by their Realtors, often choose home loans backed by the FHA or the VA instead of mortgages backed by private insurers because the agencies will insure mortgages that require a considerably smaller amount of cash at closing and will use more liberal underwriting guidelines when evaluating the credit-worthiness of the applicant.

For example, the FHA insures mortgages that require smaller down payments.  FHA allows the borrower to finance the mortgage insurance premium.  In addition, the FHA allows borrowers to use gifts from others for the entire down payment. Generally, insurers backing conventional low-down payment home loans limit the proportion of the down payment that may be paid from gifts. Moreover, the FHA allows borrowers to carry relatively more debt and still qualify for a home loan, an underwriting practice that is often important to lower-income and first-time homebuyers.

Comparison of Costs

Comparing the costs of purchasing a home with an FHA-insured mortgage relative to the costs of a mortgage backed by PMI can be difficult.  The initial fee for government insurance is higher than for PMI, but government agencies allow the borrower to finance this fee as part of the mortgage.  Furthermore, the FHA refunds part of the initial premium when the borrower prepays the mortgage within a specified period of time.

On the other hand, PMI in some circumstances can be dropped once the household has accumulated at least a 20 percent equity position in the property, whereas the household must prepay the mortgage to drop FHA insurance.  The price of FHA insurance also does not vary by the size of the borrower’s down payment, whereas the premium rate for PMI is lower for borrowers making larger down payments.

Overall, borrowers that have low debt payments relative to income, good credit scores and that are taking out mortgages with loan-to-value ratios between 80 percent and 95 percent are more likely to choose a mortgage backed by PMI.  A calculation of the expenses incurred by a borrower purchasing a $100,000 home with the minimum required down payment shows that the cash required at closing would be substantially greater for a mortgage with PMI ($8,250) than for one with FHA insurance ($615).

The lower cash outlays associated with the FHA-insured mortgage mainly reflect the FHA’s willingness to allow the borrower to finance the FHA insurance premium.  As described in the following example, an FHA-insured mortgage will be more attractive to households with fewer assets.

The difference in the minimum down payments made under the two programs is relatively small, but financing the mortgage insurance premium means that the FHA borrower has less equity relative to the value of the home.  In addition, the borrower’s monthly housing expenses are higher for the FHA mortgage.  The higher loan-to-value ratio and monthly housing expenses suggest that FHA borrowers may be more prone to default if they encounter financial difficulties.  If you find yourself leaning towards conventional financing, but are very close on the required amount of liquidity, ask your lender if they offer any lender paid Mortgage Insurance.

The reason many borrowers used to request lender paid MI is that the lender would “self-insure” the loan by charging a marginally higher interest rate (usually about equal to the normal MI payments).  Borrowers liked the idea of having a bigger tax deduction, MI payments are not tax deductible on your residence, but interest is.  On the other hand, the primary reason lenders liked that scenario is because the interest rate would not be adjusted downward based on the LTV, like when the MI policy would automatically drop off.  The lender would be enjoying the additional interest rate for the life of the loan.

Under the FHA insurance program, the borrower’s initial cash outlays are lower, but the monthly payments are higher.  If the borrower is constrained by the amount of available cash at closing, the FHA may be the only alternative.  On the other hand, if the borrower has good mortgage credit scores, sufficient cash on hand and is concerned about the amount of debt to be carried and the higher monthly payment, then PMI may be a better choice.  Be sure to look at your mortgage credit scores BEFORE selecting your mortgage product.  FHA “hits” are currently far lower than those on conventional loans (thanks Fannie and Freddie!).

Conventional Ratio Qualifications

The HOUSING ONLY RATIO is benchmarked at 28% of the borrower’s gross monthly taxable income.  (The total monthly payment for the loan that you are applying for, which includes P&I, taxes, insurance and the private mortgage insurance, if any, divided by the borrower’s gross monthly taxable income)

TOTAL MAXIMUM RATIO is benchmarked at 36% of the borrower’s gross monthly taxable income.  (Include the total proposed house payment and add all monthly debts divided by monthly gross taxable income)

Just like the ratio guidelines with FHA (refer back to FHA qualification Guidelines), conventional ratio guidelines are also “elastic”.  They can exceed the stated limits if your Loan Originator can make written justification for them to do so.  Underwriters will consider strengths of your file and approve loans that exceed the guidelines with sufficient reason to believe that the risk of making your expanded ratio loan still falls within an acceptable range of risk according to the flavor of the guidelines.

For manually underwritten loans, Fannie Mae’s benchmark total debt-to-income ratio is 36% of the borrower’s stable monthly income. The benchmark can be exceeded up to a maximum of 45% with strong compensating factors.

HOWEVER, for loan case files underwritten through DU (an electronic underwriting platform), DU determines the maximum allowable debt-to-income ratio based on the overall risk assessment of the loan case file.  DU will apply a maximum allowable total expense ratio of 45%, with flexibilities offered up to 50% for certain loan case files with strong compensating factors.  WITH THIS IN MIND, ALWAYS CHOOSE A LENDER WHO WILL USE THE DU UNDERWRITING METHOD.

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