Lenders review and adjust several factors in an effort to control and/or limit their risk on each loan.
When making mortgage loans, risk stems from two main sources, homeowner's (borrower's) risk, and market risk.
Market risk includes such factors as the origination interest rate, and potential increase/decrease in subsequent months due to a variable rate tied to an index.
For example, if a rate is locked at 6% for a period of months and could be loaned out during the course of the rate lock, for 8%, the bank is losing 2%.
Another factor to be considered is the value of real estate (security for the loan).
There's not much the lender can do, nor borrower for that matter, to predict or influence real estate values.
If the property value goes up, the security for the loan looks better and better.
However, if the value declines, the security for the loan goes down.
Other factors include both the local and national economy.
For example, loans made in the rust belt in Ohio during the peak of the automobile industry looked very secure.
When the plants began to lay off workers and people had to move out of the neighborhoods, the value on the security for the loans went down.
There are real risks associated with borrowers.
The bank has a definite interest in the financial success of their borrowers.
Banks try to limit their exposure.
However, at the end of the day (or month!), the borrower must make their payments on time, in order for the bank to remain profitable.
Borrowers that do not, or cannot, make their payments force the bank to take a hard look at late payments, collection models, foreclosure litigation, attorney's fees, and eventual REO.
Lenders can seek to mitigate any potential risk or loss in various areas.
The most obvious variable is the interest rate.
Riskier borrowers pay a higher interest rate.
Less risky borrowers pay a higher interest rate.
Believe it or not, different types of property are defined as more (investment) or less (owner-occupied) risky.
I've always felt that lenders in general, charge a higher rate of interest to less qualified and needier borrowers.
This might explain how interest rates exceeding 20% are lawfully charged on credit card debt.
Another item lenders use to control risk is the down payment.
In the early 1980s, a borrower, unless they obtained an FHA loan, had to provide a minimum of 10% of the purchase price as a down payment.
And, if a borrower only had the minimum 10% down payment, principal mortgage insurance (PMI) was mandatory.
The only way to eliminate the lender required PMI, was to increase the down payment to a minimum of 20%.
PMI is mortgage insurance, paid for by the borrower, which protects the lender in the event of a loss.
"Creative Financing" was alive and well between 2002 and 2005.
Many lenders came up with programs that allowed borrowers to purchase homes with little or no money down.
The risk potential of these loans has been realized and the real estate market, the lenders and the borrowers are all in the soup.
The fall out will be felt for many years to come.
Lenders also seek to mitigate or control risk by adjusting the borrower's term, preferring to loan the money with an adjustable rate mortgage, and inserting a prepayment penalty for early payoffs.
The interest rate and the terms of repayment are the most telling differences when analyzing existing loans.
These two factors are derived by the originating mortgagee after assessing risk.
We, as mortgage purchasers, measure risk in essentially the same manner as those who originate loans.
We both, originators and purchasers must look to the subject property in its "as- is" condition, as it relates to both wholesale value for short money and retail value for long money.
Local real estate market conditions must also be a consideration.
In the case of short money, what is the spread on the floor of the foreclosure auction in the county which the property is located? Will the investors on the floor of the sale take short money or will a lack of competition require us to take possession in order to realize a profit? Will substantial rehab be necessary? Is there a bankruptcy of record that would reduce or eliminate the ability to collect or perhaps undermine the security of this loan? How much of the total payoff amount can be recovered? Unlike the originating lender, we do not need to consider the borrowers credit score or debt to income ratio with regard to the original loan terms (does the borrower make enough money to repay the loan?).
Institutional lenders do not own real estate, because they do not wish to.
They are in the business of loaning money for a profit.
Their primary goal is to loan money safely and to get repaid in a timely manner, while collecting the interest spread for their trouble.
The "loan to value" is another consideration that allows the bank to control or mitigate risk.
If a loan appears to be somewhat risky, and the underwriter can't put their finger on the reason, they have the option of making a counteroffer.
Rather than turn a loan down flat, a lender may counteroffer requesting a change in loan to value.
For instance, instead of lending 90% of the purchase price, they may approve the loan providing the buyer add to the down payment resulting in an 80% or 85% loan to value.
This increases security for the loan, minimizes risk a little more, and puts the lender in a better comfort zone.
During the "creative financing" period of 2002 through 2005, there were loan programs offered (and accepted) with repayment terms that were either interest only or negatively amortized.
A typical 30 year fixed rate mortgage is for a term of 30 years, amortized over 30 years, and results in a zero balance.
In other words, if a borrower makes all their payments, on time, the result will be a total pay off of the original debt.
If a loan is non-amortizing or negative amortizing, it means the debt will not be repaid because none of the payment amount is going towards reducing the principal.
With negative amortization loans the principal amount actually increases each month.
Some of these loans were offered with teaser rates such as one half percent or 2% interest for the first two years.
This enabled borrowers to obtain a higher mortgage than they were actually qualified to obtain.
In an effort to entice even more borrowers to the market, lenders created programs that were "no-doc" loans, or "stated" loans.
What this meant was, the methods used to measure the financial stability of a borrower, i.
e.
employment history, income verification; savings deposit verification, etc.
were not done.
What the borrower "stated" was believed to be true.
Other programs came along that were a hybrid between a no dock and a full doc.
This type of loan is known throughout the industry as ALT A loans.
Remember, the more risky a loan position is, the higher the interest rate and the tighter the repayment terms.
With this in mind, the days of stated-income-loans and zero down payment mortgages have gone the way of the dinosaur.
Lenders in the future will be forced to more completely investigate their borrowers as the age of easy credit for all abruptly ends as quickly as it began.
But, and remember that you read it here first, the market for borrowers with less than perfect credit is still a major force in the market.
The new gold will go to the lender that's the first to introduce a safe (to the investor) mortgage instrument that can reach those potential buyers firmly situated at the outer edges of mortgage approval.