Mortgage Industry Basics

TABLE OF CONTENTS
ORIGINATION .................................................................................................... 1
The Role of the Originator....................................................................................................1
Types of Loan Programs.......................................................................................................2
Other Players in the Mortgage Market................................................................................3
Common Financing Tools.....................................................................................................4
Regulatory Compliance ........................................................................................................5
The most encompassing statutes that affect loan production and loan origination............5
THE LOAN APPLICATION ................................................................................ 8
Borrower information...........................................................................................................8
Property information ............................................................................................................8
Loan and transaction information........................................................................................8
PROCESSING ...................................................................................................... 9
The Processor's Responsibilities...........................................................................................9
UNDERWRITING...............................................................................................10
Character.............................................................................................................................10
Capacity...............................................................................................................................10
Capital .................................................................................................................................11
Collateral .............................................................................................................................11
Approving the Loan ............................................................................................................11
CLOSING ............................................................................................................12
Closing Documents..............................................................................................................12
Closing Agents.....................................................................................................................14
Recording the Documents...................................................................................................14
THE SECONDARY MARKET ............................................................................15
Role of the Secondary Market in the Economy .................................................................15
Players in the Secondary Market .......................................................................................16
Pricing and Interest Rates ..................................................................................................18
REVIEW QUIZ....................................................................................................20
MORTGAGE INDUSTRY TERMS .....................................................................24
Course Objectives
By the end of this course, students will be familiar with:

• Loan Origination

• Different types of loan programs

• URLA

• Loan Processing

• Underwriting (four Cs)

• Closing

• Secondary Market
 Preface
Mortgage bankers are in business to originate, sell, and service residential and commercial loan
packages. They are financial intermediaries.

During loan production, mortgage bankers solicit mortgage loan applications from borrowers,
process and underwrite applications, and close mortgage loans.

The closed loans are either retained and serviced or sold to investors in the secondary market.
Secondary marketing involves developing and pricing loan types, selling closed loans to
secondary market investors, and shipping and delivering the sold loans to the respective
investors.

Components of Loan Production

Loan production is the set of functions through which a mortgage loan is brought into existence.

• Origination
• Processing
• Underwriting
• Closing
ORIGINATION

THE ROLE OF THE ORIGINATOR

The loan originator/ loan officer begins the mortgage lending cycle by soliciting customers for
loan applications. He or she plays a key role in mortgage banking by bringing in investment
quality loans. Successful loan originators must first develop a viable and well-organized
marketing plan. They begin by:

• Establishing their geographic locations

• Familiarizing themselves with the number, types, and physical conditions of
housing units available in their market
• Researching and developing demographic information
• Developing relationships in order to solicit referrals (such as real estate agents,
builders, developers, associations, and family members)
• Being aware and knowing the competition

After collecting and analyzing this data, the loan originator is then able to develop a marketing
plan. The loan originator continually strives to be visible and approachable to potential loan
candidates.
A vital ingredient to the success of a loan originator is knowledge. This person should have an
in-depth knowledge of both the loan production process and the mortgage lending cycle.
In addition, the he or she needs to be proficient in the following areas:

• Variety of loan programs on the market, especially products offered by his or her
company.
• Major players in the mortgage industry
• Common financing tools
• Laws and statues that affect mortgage banking (regulatory compliance)

Mortgage Industry Basics 1

TYPES OF LOAN PROGRAMS
• FHA
• VA
• FmHA
• Conventional
• Jumbo Nonconforming
• ABCD Nonconforming

FHA (Federal Housing Administration)

FHA loans are loans insured by the Federal Housing Administration against foreclosure loss.
The Federal Housing Administration is part of the Department of Housing and Urban
Development (HUD).
FHA maintains its self-support by charging borrowers a mortgage insurance premium (MIP) that
is paid in both up-front and monthly installments, or financed in the maximum mortgage amount
depending on the loan program, terms, and conditions.

VA (Veterans Affairs)
The VA loan program offers veterans mortgage loans with little or no down payment and
guarantees against foreclosure loss by the Department of Veterans Affairs (funding fee is
included).

FmHA (Farmers Home Administration)

FmHA loans are federally guaranteed loans, similar to FHA and VA loans. FmHA loans are
guaranteed by the Farmers Home Administration. These mortgage loans must be secured by
residential properties located in rural areas.

Conventional
Conventional loans are mortgage loans that are not guaranteed or insured by the federal
government or its agencies. These loans may require private mortgage insurance (MI) if the
mortgage loan amount exceeds 80% of the value of the mortgaged property.

Jumbo Nonconforming
These are large loans (over $252,700 as of 2000) that exceed the maximum mortgage limits of
Fannie Mae or Freddie Mac, the two largest investors.

ABCD Nonconforming
These are high-risk loans where the borrower usually has a history of late payments. ABCD’ is
actually four categories. A-paper borrowers have good credit history while D-paper borrowers
may be up to six months delinquent in paying their mortgage.

Mortgage Industry Basics 2

OTHER PLAYERS IN THE MORTGAGE MARKET
Mortgage Insurance Companies (MIs)
MIs are privately owned companies who insure mortgage loans against foreclosure loss.
Mortgage insurers usually charge the borrower a premium for insuring the loan. (MI usually
applies to loans with less than 20% down)

Secondary Market Investors:

• Fannie Mae (Federal National Mortgage Association)

• Freddie Mac (Federal Home Loan Mortgage Corporation)
• Ginnie Mae (Government National Mortgage Association)
• Private Investors

- Fannie Mae (Federal National Mortgage Association)

Fannie Mae is a federally chartered, private corporation that purchases specific loans from
mortgage lenders, groups similar purchased loans together, and sells them to investors as
securities backed by mortgage loans. Often associated with the term “mortgage-backed
securities”.

- Freddie Mac (Federal Home Loan Mortgage Corporation)

The Federal Home Loan Mortgage Corporation is a federally chartered, private corporation that
purchases primarily conventional loans from mortgage lenders. Freddie Mac’s operations are
similar to Fannie Mae’s in that purchased loans are grouped together and sold to investors as
mortgage-backed securities.

- Ginnie Mae (Government National Mortgage Association)

The Government National Mortgage Association is an agency within the Department of Housing
and Urban Development (HUD). Ginnie Mae securities are backed by the full faith and credit of
the United States government.

- Private Investors
Private investors purchase mortgage loans as investments. These private investors could be
commercial banks, financial institutions, pension funds, savings and loan associations, etc.

Mortgage Industry Basics 3

COMMON FINANCING TOOLS
Financing tools deal with the loan type, term and conditions in that they specify loan
amortization. The loan originator assists the applicant in selecting the best financing tool
available while originating an investment quality loan for the mortgage lender.

Fixed Rate Mortgage (FRM)

A mortgage loan in which the interest rate and payments remain the same
for the life of the loan.

Adjustable Rate Mortgage (ARM)

A mortgage with an interest rate that increases or decreases over the life of
the loan based on market conditions. Also called a variable rate mortgage
(VRM).

Balloon Mortgage
A mortgage with a series of equal monthly payments and a large final
payment due at a specified date. Usually offered to the applicant who
expects to sell or refinance the property within a specified period of time.

Graduated Payment Mortgage (GPM)

A mortgage with payments that increase based on a set schedule over a
period of years and then level off. This is designed for the applicant who
expects a higher income in the near future.

Buydown
A mortgage with a below-market interest rate that results in lower monthly
payments for the first few years or the entire term of the mortgage. A
buydown is made by a lender in return for money received from a builder,
seller, or homebuyer.

Mortgage Industry Basics 4

REGULATORY COMPLIANCE
The originator must also follow the guidelines of the agency who is the potential investor and
insurer (or guarantor) of the loan. If guidelines are not followed, the process can be delayed.
However, if a loan is approved without following the guidelines, the insurer or guarantor might
not pay the insurance claim if the loan goes into default and the property is foreclosed. In this
case the investor might force the mortgage banker to buy back the loan.

The loan originator should:

• Explain the process and timelines involved in the loan approval

• Secure up front any additional documents necessary to expedite the approval
• Provide a realistic estimate of closing costs and loan fees
• Disclose the estimated annual percentage rate (APR)

THE MOST ENCOMPASSING STATUTES THAT AFFECT LOAN

PRODUCTION AND LOAN ORIGINATION
• Equal Credit Opportunity Act (Regulation B or ECOA)
• Fair Housing Act
• Truth-in-Lending Act (Regulation Z or TILA)
• Real Estate Settlement Procedures Act (RESPA)
• Home Mortgage Disclosure Act (HMDA)

Equal Credit Opportunity Act (ECOA)

ECOA disallows discrimination based on nine prohibited bases in any aspect of the credit
transaction. The ECOA prohibits discrimination based on:

• Sex
• Marital status
• Age
• Race
• Color
• Religion
• National origin
• Receipt of public assistance benefits
• Applicant’s exercise of any of his or her rights under the Consumer Credit
Protection Act

Mortgage Industry Basics 5

Fair Housing Act
The Fair Housing Act applies to mortgage and home improvement loans and protects the
applicant from discrimination based on:

• Race
• Color
• Handicap
• National origin
• Sex
• Religion
• Familial status

Truth in Lending Act (TILA; Regulation Z)

The Truth in Lending Act requires lenders to inform their customers of all terms and conditions
of their credit arrangement. This includes disclosure of the costs imposed by a creditor and the
terms of a credit obligation. The law requires the disclosure of two terms thought to be key in
aiding consumers in comparison-shopping for credit -- the finance charge and the annual
percentage rate (APR). TILA also requires the disclosure of a payment schedule, whether a
creditor will impose a penalty if a loan is prepaid, whether a loan may be assumed, and the fee
for a late payment.
Overall, the Act attempts to give the applicant information to better compare and understand the
lender’s loan programs. The lender is obliged to provide the borrower with the Truth-in-
Lending (TIL) disclosure within three business days of receiving the loan application.

Mortgage Industry Basics 6

Real Estate Settlement Procedures Act (RESPA; Regulation X)
The Real Estate Settlement Procedures Act is administered by the Department of Housing and
Urban Development (HUD). RESPA:

• Promotes consumer notification in a timely manner on the nature and costs of the
settlement process.
• Offers consumers protection from unnecessarily high settlement charges caused
by certain abusive practices, for example referral fees.
One of the disclosures under RESPA is the Good Faith Estimate (GFE). The GFE is a list of
the charges a borrower is likely to pay at the time of settlement (closing). It is only an estimate
and the actual charges may differ. The lender is obliged to provide the borrower with the GFE
disclosure within three business days of receiving the loan application.

The Home Mortgage Disclosure Act (HMDA)

The Home Mortgage Disclosure Act requires covered institutions to compile and disclose data
about applications they receive and the home purchase and home improvement loans they
originate or purchase during each calendar year. The purpose of HMDA is to:

• Make available to the public information that helps to show whether financial
institutions are serving the housing credit needs of their neighborhoods and
communities
• Help identify possible discriminatory lending patterns, and assist regulatory
agencies in enforcing compliance with anti-discrimination statutes

These are some of the major regulatory laws the loan originator and the loan production and
mortgage banking personnel need to know. By complying, the lender not only protects the
consumer’s rights, but also protects itself against fines and charges for non-compliance.

Mortgage Industry Basics 7

THE LOAN APPLICATION
Lenders generally use the Fannie Mae or Freddie Mac Uniform Residential Loan Application
(URLA) that is also known as the 1003 (FNMA’s Form Number). The URLA contains three
major types of information:

• Borrower
• Property
• Loan and transaction

BORROWER INFORMATION
• Basic information such as name of applicant, current address, Social Security
number
• Employment history, salary, and income information
• Borrower’s assets and liabilities
• Whether the borrower has any public records such as judgments, foreclosures, and
bankruptcies
• The borrower’s current housing expenses
• Rent or mortgage payment information

PROPERTY INFORMATION
• Address of property
• Legal description of property
• Number of units
• Age of the property
• Whether property will be primary or secondary residence (vacation home), or an
investment property.

LOAN AND TRANSACTION INFORMATION

• Loan type and program
• Loan amount and interest rate
• Proposed housing expenses
• Purpose of the loan
• Details of the transaction

This was a brief description of the information contained in the mortgage loan application
URLA. The processor is responsible for thoroughly reviewing the information in the application
for completeness, accuracy, and consistency.
Then, based on the information supplied in the application, the processor sends out verification.

Mortgage Industry Basics 8

PROCESSING

THE PROCESSOR'S RESPONSIBILITIES

• Confirming all necessary documents are included in the application
• Reviewing the application and supporting documents to for
completeness and consistency of information
• Verifying credit information, and examining the documents for
completeness
• Obtaining an appraisal on the property and ensuring its completeness
• Submitting the loan application, documentation, verifications, and reports to the
underwriter

Verifications
- Verification of Deposit
Verification of deposit confirms the applicant has sufficient cash to meet settlement needs. The
processor prepares them and sends them to financial institutions to verify assets such as checking
accounts, savings accounts, or stocks and bonds.

- Verification of Employment
The processor verifies employment in order to illustrate:

• Employment information supplied in the mortgage loan application

• The stability of the applicant’s source of income
• The applicant’s ability to repay the mortgage loan

- Verification of Credit Standing

A credit report provides a full credit history on the borrower, including any credit cards,
installment loans, mortgage loans, student loans, automobile loans, etc, and lists the payment
history as well as any outstanding balances.

This information allows the lender to review the applicant’s character and willingness in
repaying the loan.

Appraisal Review

• Supportable estimate of market value

• Enables the underwriter to decide whether the property offers sufficient
collateral for the loan amount being requested

Mortgage Industry Basics 9

UNDERWRITING
Underwriting is a detailed evaluation that involves credit and property reviews in order to satisfy
a loan program. The underwriter analyzes the risk of a loan and matches it to needs of investors,
such as Fannie Mae or Freddie Mac.

The analysis comprises the four Cs of underwriting

CHARACTER
The credit report and other information in the loan package are reviewed to confirm good credit
history.

CAPACITY
The applicant’s monthly income and debt (terms with six to twelve months remaining) are
reviewed to verify ability to meet monthly payment requirements. This is determined by
qualification ratios.
Secondary market investors and government agencies each have different criteria in evaluating
these ratios, and the underwriter should apply the specific agency’s underwriting guidelines in
arriving at these percentages.

Qualification ratios:

• Housing-to-income ratio
• Total debt-to-income ratio

- Housing-to-Income Ratio (front-end ratio)

This ratio is used to analyze a prospective borrower’s ability to maintain the fixed monthly
mortgage expenses of PITI (Principal, Interest, Taxes, and hazard Insurance). Plus when
applicable: special assessments such as sewage assessment, homeowner’s association fees, and
mortgage insurance.

A simple calculation for this ratio is:

Mortgage Industry Basics 10

 - Debt-to-Income Ratio (back-end ratio)
Evaluates an applicant’s ability to cover the housing AND living expenses during the month.

A simple calculation for this ratio is:

Compensating Factors
All agencies have criteria for qualifying ratios; however, there can be compensating factors
(exceptions). Higher than normal qualifying ratios can be accepted if the underwriter evaluates
and documents the existence of compensating factors. Some compensating factors that can
justify higher qualifying ratios include:

• Applicant makes a large down payment

• Applicant has demonstrated the ability to save
• Applicant has significant liquid assets and reserves for contingencies
• Applicant has demonstrated excellent long-term credit use

CAPITAL
Capital is the liquid assets the applicant has available for closing costs and down payment. This
is determined by the verifications of deposit.

COLLATERAL
An analysis completed to ensure the property value substantiates the loan is called the loan-to-
value (LTV) ratio.
The loan amount divided by the appraised value or sales price, whichever is less.

The lower the loan-to-value ratio, the less risk there is to the lender, and the fewer underwriting
requirements the underwriter makes. This is because:

• the applicant has put down a larger down payment and therefore has higher
equity in the property and is more apt to protect his or her investment in the
property
• the more equity the applicant has in the property, the less risk the
lender/investor is exposed to in the event it has to foreclose on the loan

APPROVING THE LOAN

The last step in the underwriting process is to determine whether to approve the loan or decline it
based on a reconciliation of the character, capacity, capital, and collateral analyses.

Mortgage Industry Basics 11

CLOSING
Closing is the process of preparing, assembling, and reviewing the legal documents involved in
the completion of the mortgage lending transaction. The mortgage lending cycle continues
through servicing the loan until the loan is paid off, refinanced, or foreclosed.
The basic documents required to complete a residential mortgage file vary depending on:

• State requirements
• Mortgage company
• Loan program/financing tool (fixed-rate mortgage, ARM, buydown)
• Loan type (FHA, VA, FmHA, or conventional)

* Any requirements or regulations are subject to change.

CLOSING DOCUMENTS
• Promissory note
• Security instrument
• Deed
• Truth in Lending Disclosure Statement
• Uniform Settlement Statement (HUD-1)
• Title insurance policy
• Hazard insurance policy

Promissory Note
Referred to as the "note”, it should contain information on the terms of the loan, the lender, and
the borrower. The note creates the borrower's legal obligation to repay the loan and is generally
secured by a security instrument.

Security Instrument

• Mortgage
• Deed of trust

A mortgage has two parties: the lender and the borrower. In a mortgage, the borrower pledges
the property as security for repayment of the note.

A deed of trust has three parties: the lender, the borrower, and the trustee. The property is
pledged or conveyed to the trustee for the benefit of the lender to secure repayment of the note.
An advantage of the deed of trust over a mortgage is that in many states, in case of default, the
deed of trust can be foreclosed by a trustee’s sale without a court proceeding.

Mortgage Industry Basics 12

Deed
The deed is the document that conveys title to the property from the seller to the buyer.

Uniform Settlement Statement

The Real Estate Settlement Procedures Act (RESPA) of 1974 requires the Uniform Settlement
Statement, also known as HUD-1, for almost every residential loan. The HUD-1 provides the
borrower and the seller with a full disclosure of the closing and settlement costs. It includes all
payments made by all parties to the transaction.

Truth in Lending Disclosure Statement

The Truth in Lending Disclosure Statement discloses the actual cost of financing, including the
annual percentage rate and the total finance charge which could include interest, service,
transaction, activity and carrying charges, points paid by borrower, assumption fees, etc.
This information has to be supplied to the borrower three business days after application for a
mortgage loan. It is safe to re-disclose at closing to ensure accuracy. The mortgage banker must
retain proof that the Truth in Lending statement was provided to the borrower.

Title Insurance Policy

The closer hires a title company to examine public records that disclose the past and current facts
regarding ownership of the property. A title search identifies who has rights to the property and
therefore must sign the mortgage to secure the property, and it discloses any prior encumbrances,
tax liens, or other interest on the property. Upon completion of this examination, the title
company issues a title insurance policy. A title insurance policy guards the lender’s lien
position.

Hazard Insurance Policy

Hazard insurance (also called "property insurance") is coverage that provides compensation to
the insured in case of property loss or damage.

* Depending on the loan program, there might be additional documents required for closing.

Mortgage Industry Basics 13

CLOSING AGENTS
Once completed, the closing documents are reviewed and sent to the closing agent who is
generally one of the following:

• an outside attorney
• a title insurance company
• an escrow agent
• the closing staff of the mortgage banker

The mortgage banker is responsible for the accuracy of closing documents regardless of who
closes the loan. The closer is responsible for specifying how funds will be delivered to the
settlement agent. The settlement agent could be the mortgage lender’s accounting department,
the investor who has bought the mortgage loan, or a financial institution that provides a line of
credit to the lender.

RECORDING THE DOCUMENTS

The final stage of closing is recording the necessary mortgage documents and releasing any prior
liens on the property. The mortgage lender places a public record of the deed and note in the
files at a local courthouse or public building. This serves as a public notice of ownership.

Recording the deed protects the borrower and the lender from competing claims against the
property.

Mortgage Industry Basics 14

THE SECONDARY MARKET
In the mortgage banking process, there are two types of marketing:

1. Primary marketing is the portion of the mortgage market in which the lender
originates loans directly from homeowners for its own portfolio or for sale to
another investor.
2. Secondary marketing is that portion of the mortgage market in which lenders and
investors buy, sell, and trade mortgages.

Investors are part of the secondary market. Normally an investor is not one person, but a
company. One loan may be sold several times from investor to investor.
Investors include other mortgage lenders and large banks that often resell groups of mortgages
to:

• Fannie Mae or Freddie Mac, who package and sell pools of mortgages as mortgage-
backed securities
• Private conduits that sell groups of mortgages as mortgage-backed securities
• Life insurance companies looking for safe investments to place their clients’
premiums
The secondary market makes funds and an array of financing alternatives available. For the
lender, it can increase profits and help reduce the risks involved in mortgage lending.

ROLE OF THE SECONDARY MARKET IN THE ECONOMY

• Making additional funds available for new mortgages
• Moderating the negative effects of periods of capital shortage
• Facilitating the movement of capital from surplus regions to low-capital regions
• Moderating regional differences in interest rates and lessens the local effects of
natural disasters and regional economic downturns

Why is it important to the national economy?

1. New investors - such as pension funds, trust accounts, and credit unions make more
money available for new mortgages. For many years, several institutions have
helped attract new investors to the secondary market. Government-guaranteed or
insured loans and private mortgage insurance (PMI) guarantee repayment, making
the loans safer investments. The introduction of the mortgage-backed security has
increased the liquidity of mortgages, making them easy to buy and sell.

2. The secondary market moderates the negative effects of periods of capital shortage.
Real estate activity slows down during periods of capital shortage because funds for
mortgages are scarce. By encouraging other investors to purchase mortgages from
primary mortgage lenders, however, the secondary market provides funds for new
mortgages.

Mortgage Industry Basics 15

 3. The secondary market facilitates the movement of capital from surplus regions to
low-capital regions. The secondary market provides a national network enabling
those in capital-surplus areas to invest in mortgages originated in low-capital areas.

4. The secondary market moderates regional differences in interest rates and lessens
the local effects of natural disasters and regional economic downturns.

The mobility of capital and the diversity of investors created by the secondary market lessens
regional disparities. As monies move to investors in areas where interest rates and yields are
highest, the rates are pushed downward. And, by spreading the risk among many investors, the
effects of regional downturns, such as a major industry shutting down, are lessened.

PLAYERS IN THE SECONDARY MARKET

The major players in the secondary market are the three federally chartered institutions, which
were created by Congress to develop the secondary market for residential mortgages.

• Fannie Mae (The Federal National Mortgage Association)

• The Government National Mortgage Association (Ginnie Mae)
• The Federal Home Loan Mortgage Corporation (Freddie Mac)

Fannie Mae (Federal National Mortgage Association)

Fannie Mae, formerly The Federal National Mortgage Association, is the oldest of the three
institutions. It was created by Congress in 1938 as a wholly owned government corporation. Its
purpose was to provide a secondary market for FHA-insured and later VA-guaranteed loans. In
1968, it was partitioned into Fannie Mae and Ginnie Mae. Fannie Mae is now owned by private
shareholders and deals mostly with conventional mortgages.
Fannie Mae has the nation’s largest mortgage portfolio. In 1981, it began issuing pass-through
securities. The underlying mortgages are usually fixed-rate or adjustable-rate loans. Fannie Mae
guarantees the timely repayment of principal and interest regardless of whether the payments
have been collected from the borrower.

Mortgage Industry Basics 16

Government National Mortgage Association (Ginnie Mae)
The Government National Mortgage Association, commonly known as "Ginnie Mae," was
created in 1968 during the partitioning of Fannie Mae. As a part of the Department of Housing
and Urban Development (HUD), Ginnie Mae guarantees mortgage-backed securities consisting
of FHA and VA loans.
The Ginnie Mae security, which is backed by a federal government guaranty, enables mortgage
bankers to sell large quantities of mortgages to new investors who lack the staff and expertise to
evaluate the purchase of whole loan packages.
Ginnie Mae guarantees single family and multi-family mortgage pools. The largest number of
Ginnie Mae securities is backed by pools of long-term fixed-rate mortgages on single-family
residential properties.

Federal Home Loan Mortgage Corporation (Freddie Mac)

The third federally chartered secondary market institution is the Federal Home Loan Mortgage
Corporation, or "Freddie Mac." Freddie Mac was created by Congress in 1970 primarily as a
secondary market for savings and loan associations. However, it now buys loans from many
types of originators. Although Freddie Mac is authorized to purchase FHA and VA loans, it
usually deals only with conventional loans.
Though Freddie Mac holds a few loans in portfolio, it finances its operations chiefly through its
participation certificate (PC) program. Under this program, Freddie Mac purchases and packages
mortgages that meet its requirements into participation certificates. "Participation certificate" is a
different name for a mortgage-backed security.
In addition to participation certificates, Freddie Mac (as well as Fannie Mae) offers collateralized
mortgage obligations (CMOs). CMOs are mortgage-backed securities combining aspects of the
pass-through security and the bond. Each CMO is divided into three or more classes; each class
is called a "tranche." Each tranche pays interest and principal regularly to its holder, but each has
a different rate, maturity or payment type.
Most borrowers refinance or pay off their mortgage before the due date. This pre-payment
affects the yield of mortgage-backed securities, and the stability of regular interest payments to
the investor. This is one of the risks assumed by investors in mortgage-backed securities. With
CMOs, principal prepayments are made to one class at a time until the class is retired. In this
way, prepayments to investors become more predictable and less risky.

Mortgage Industry Basics 17

PRICING AND INTEREST RATES
Investors supply lenders with pricing quotes that show the lender what they will pay for a loan
with a given interest rate, for delivery by a given date.

Interest Rate Pricing Example

8.5% 98% - Below The investor will

Par pay the lender
Discount $98,000 for a
$100,000 loan.

9.00% 100% Par The investor will

pay the lender
$100,000 for a
$100,000 loan.

9.50% 102% Above The investor will

Par pay the lender
Premium $102,000 for a
$100,000 loan.

The price the investor will pay for a loan depends on the loan’s interest rate. A higher interest
rate will make the investor more money. Therefore, the investor will pay more for a loan that
yields more than current market rates.
Borrowers who want a below market interest rate pay an extra fee called "points" to the lender.
The points charged are based upon the price the lender gets from the investor. For example, a
price of 98 requires 2 additional discount points from the borrower.
Pricing can be risky to a lender. Lenders often commit to giving the borrower a specific interest
rate without making a commitment with an investor. If the lender thinks interest rates will
decline, the lender will wait before making a commitment to the investor, hoping to get better
pricing. However, if interest rates go up, the lender will have to sell the loan at a loss. Risk
management is the process of reducing this price risk while maximizing the potential for profit.
Each company’s strategy is different.

Mortgage Industry Basics 18

Mortgage Industry Basics 19
REVIEW QUIZ

Question 1

One of the functions of the loan originator is to:

A. Bring in investment quality loans

B. Help the applicant find a house
C. Order the credit report
D. Obtain an appraisal on the property

Question 2

Jumbo nonconforming loans:

A. Are for high-risk borrowers

B. Exceed the maximum mortgage limits of Fannie Mae and Freddie Mac
C. Allow little to no downpayment
D. Are federally guaranteed

Question 3

Mortgage insurance companies insure against loss due to:

A. Property loss or damage

B. Foreclosure
C. Job loss
D. Defects of title

Question 4

With an adjustable-rate mortgage, payments over the life of the loan:

A. Increase periodically at rates determined by the lender

B. Increase periodically at rates agreed upon at the inception of the loan
C. Increase at regularly set intervals, then level off
D. Either increase or decrease periodically, depending on market conditions

Question 5

One purpose of the Home Mortgage Disclosure Act is to:

A. Identify possible discriminatory lending patterns

B. Make it possible for applicants to compare lenders' loan programs
C. Protect applicants from high settlement charges caused by abusive practices
D. Protect applicants from abusive penalties for late payments

Mortgage Industry Basics 20

Question 6

One of the loan processor's responsibilities is:

A. Determining the housing-to-income and debt-to-income ratios

B. Ensuring consistency and accuracy of application information
C. Closing the loan
D. Reporting in detail on the property and its condition

Question 7

The three major categories of information on the Uniform Residential Loan Application are:

A. Borrower, Co-borrower, and Property

B. Borrower, Property, and Loan and Transaction
C. Assets and Liabilities, Public Records, and Housing Expenses
D. Credit, Capacity, and Collateral

Question 8

One way a loan processor typically verifies information on a loan application is to:

A. Obtain a credit report

B. Research public records for foreclosures, repossessions, bankruptcies, etc.
C. Obtain an appraisal
D. Interview the applicant's supervisor

Question 9

The appraisal helps protect the lender from heavy losses in case of:

A. Property loss or damage

B. Foreclosure
C. Delinquency
D. Unstable market conditions

Question 10

The Cost Approach to appraisal:

A. Is based on the theory that no property has greater value than the cost of replacing it
B. Is the most prevalent method used to appraise residential single-family properties
C. Is estimated based on the amount of income it can be expected to generate
D. Determines value by selecting three comparable properties which have sold recently and
analyzing their cost

Mortgage Industry Basics 21

Question 11

Underwriters evaluate four "C"s: character, capacity, capital, and collateral. Capacity
refers primarily to:

A. The size of the loan for which an applicant can qualify

B. The applicant's ability to meet total monthly housing expenses
C. Assets available for closing costs and down payment
D. The property value in relation to the loan amount

Question 12

The debt-to-income ratio analyzes an applicant's ability to:

A. Maintain housing and living expenses

B. Meet down payment and closing costs
C. Maintain fixed monthly mortgage expenses
D. Pay homeowner dues and real estate taxes

Question 13

An applicant's total monthly income is $2000 and housing expenses are $500. What is the
applicant's housing-to-income ratio?

A. 2.5%
B. 4%
C. 25%
D. 40%

Question 14

An applicant's total monthly income is $2500 and monthly expenses are $1000. What is the
applicant's debt-to-income ratio?

A. 2.5%
B. 4%
C. 25%
D. 40%

Question 15

What is the loan-to-value ratio if the property is valued at $100,000, the sales contract price is
$112,000, and the loan amount is $87,000?

A. 11.49%
B. 77.7%
C. 87%
D. 89.3%

Mortgage Industry Basics 22

Question 16

Lower LTV ratios represent less risk to the lender because they mean that the applicants:

A. Have a better credit history

B. Have smaller mortgage payments
C. Can more easily afford to pay housing and living expenses
D. Have more equity in the property

Question 17

The promissory note:

A. Creates the borrower's legal obligation to repay the loan

B. Conveys title to the property from the seller to the buyer
C. Guards the lender's lien position
D. Provides the borrower with a full disclosure of the closing and settlement costs

Question 18

The loan closer:

A. Solicits referrals from real estate agents

B. Obtains verifications and credit information
C. Prepares, assembles, and reviews documents for closing
D. Obtains and reviews the appraisal for closing

Question 19

The last stage of the loan production cycle is:

A. The signing of the promissory note

B. The disbursing of funds by the settlement agent
C. Securing a closing letter from the closing agent
D. Recording the mortgage documents at a local courthouse or public building

Mortgage Industry Basics 23

MORTGAGE INDUSTRY TERMS
Adjustable rate mortgage (ARM)
A mortgage on which the interest rate, after an initial period, can be changed by the lender. While ARMs in many
countries abroad allow rate changes at the lender's discretion ("discretionary ARMs"), in the US most ARMs base
rate changes on a preselected interest rate index over which the lender has no control. These are "indexed ARMs".
There is no discretion associated with rate changes on indexed ARMs.
Alternative documentation
Expedited and simpler documentation requirements designed to speed up the loan approval process. The
documentation modifications can range from the modest, such as substituting payroll stubs for tax returns, to no
documentation whatever. Borrowers looking for the latter should expect to pay at least 30%, and more likely 40%
down.
Amortization
The repayment of principal from mortgage payments that exceed the interest due. The payment less the interest
equals amortization -- which is the same as the reduction in the loan balance. If the payment is less than the interest
due, the balance rises, which is negative amortization.
Amortization schedule
A table showing the mortgage payment, broken down by interest and amortization, the loan balance, and perhaps
other data.
Application
Solicitation of a loan by a borrower through the provision of a written request that includes information about the
borrower, the property and the requested loan. In a narrower sense, the application refers to a standardized
application form called the "1003" which the borrower is obliged to fill out.
Application fee
A fee that some lenders charge to accept an application. It may or may not be refundable if the lender declines the
loan.
APR
The Annual Percentage Rate, which must be reported by lenders under Truth in Lending regulations. It is a
comprehensive measure of credit cost to the borrower that takes account of the interest rate, points, and flat dollar
charges. It is also adjusted for the time value of money, so that dollars paid by the borrower up-front carry a heavier
weight than dollars paid ten years down the road. However, the APR is calculated on the assumption that the loan
runs to term, and is therefore potentially deceptive for borrowers with short time horizons.
Approval
Acceptance of the borrower's loan application. Approval means that the borrower meets the lender's qualification
requirements and also its underwriting requirements. In some cases, especially where approval is provided quickly
as with automated underwriting systems, the approval may be conditional on further verification of information
provided by the borrower.
Assumable mortgage
A mortgage contract that allows, or does not prohibit, a creditworthy buyer from assuming the mortgage contract of
the seller. Assuming a loan will save the buyer money if the rate on the existing loan is below the current market
rate, and closing costs are avoided as well. A loan with a "due-on-sale" clause stipulating that the mortgage must be
repaid upon sale of the property, is not assumable.
Automated underwriting
A computer-driven process for informing the loan applicant very quickly, sometimes within a few minutes, whether
the applicant will be approved, rejected, or asked for additional information. The quick decision is based on
information provided by the applicant, which is subject to later verification, and other information retrieved
electronically including information about the borrower's credit history and the subject property.

Mortgage Industry Basics 24

Balance
The amount of the original loan remaining to be paid. It is equal to the loan amount less the sum of all prior
payments of principal.
Balloon mortgage
A mortgage which is payable in full after a period that is shorter than the term. It therefore has a balloon that must
be repaid or refinanced. On a 7-year balloon loan, for example, the payment is usually calculated over a 30-year
period, and the balance at the end of the 7th year must be repaid or refinanced at that time.
Balloon
The loan balance remaining at the time the loan contract calls for full repayment.
Biweekly mortgage
A mortgage on which the borrower pays half the monthly payment every two weeks. Because this results in 26
(rather than 24) payments per year, the biweekly mortgage amortizes before term.
Bridge loan
A short-term loan, usually from a bank, that "bridges" the period between the closing date of a home purchase and
the closing date of a home sale. To qualify for a bridge loan, the borrower must have a contract to sell the existing
house.
Cap
A pricing option exercised by the borrower at the time of the application wherein the rates and points prevailing at
the time cannot rise if market rates rise, but they can decline if market rates decline. A cap costs the borrower more
than a lock because it is more costly to the lender. Caps vary widely in terms of how often the borrower can exercise
(usually only once), and exactly when the borrower can exercise. Do not confuse with interest rate increase caps and
payment increase caps.
Cash-Out refi
Refinancing for an amount in excess of the balance on the old loan plus settlement costs. The borrower takes "cash-
out" of the transaction.
Closing costs
Costs that the borrower must pay at the time of closing, in addition to the down payment and points. Also referred to
as "settlement costs".
Conforming mortgage
A loan eligible for purchase by the two major Federal agencies that buy mortgages, Fannie Mae and Freddie Mac.
Conversion option
The option to convert an ARM to an FRM at some point during its life. These loans are likely to carry a higher rate
or points than ARMs that do not have the option.
Correspondent
A lender who delivers loans to a wholesaler against prior price commitments the wholesaler has made to the
correspondent. The commitment protects the correspondent against pipeline risk.
Credit Report
A report from a credit bureau containing detailed information on an individual's credit history.
Credit Score
A single numerical score, based on an individual's credit history, that measures that individual's credit worthiness.
Credit scores are as good as the algorithm used to derive them.
Cumulative interest
The sum of all interest payments to date or over the life of the loan. This is an incomplete measure of the cost of
credit to the borrower because it does not include up-front cash payments, and it is not adjusted for the time value of
money. See effective rate.
Current index value
The most recently published value of the index used to adjust the interest rate on indexed ARMs.

Mortgage Industry Basics 25

Deferred interest
See negative amortization.
Direct Lender
Same as Lender.
Discount Points
See points.
Downpayment
The difference between the purchase price of the property and the loan amount, expressed in dollars, or as a
percentage of the price. For example, if the house sells for $100,000 and the loan is for $80,000, the down payment
is $20,000 or 20%. The loan amount used in this calculation does not include any prepaid finance charges that are
included in the loan. For example, if the $80,000 loan in the example above includes a $1,000 up-front mortgage
insurance premium, the down payment is $21,000.
Due-on-sale clause
A provision of a loan contract that stipulates that if the property is sold the loan balance must be repaid. This bars
the seller from transferring responsibility for an existing loan to the buyer when the interest rate on the old loan is
below the current market. A mortgage containing a due-on-sale clause is not an assumable mortgage.
Effective rate
A term used in two ways. In one context it refers to a measure of interest cost to the borrower that is identical to the
APR except that it is calculated over the time horizon specified by the borrower. The APR is calculated on the
assumption that the loan runs to term, which most loans do not. (See Interest Cost). QuickenMortgage uses the term
in this way. In most texts on the mathematics of finance, however, the "effective rate" is the quoted rate adjusted for
intra-year compounding. For example, a quoted 6% mortgage rate is actually a rate of .5% per month, and if interest
received in the early months is invested for the balance of the year at .5%, it results in a return of 6.17% over the
year. The 6.17% is called the "effective rate" and 6% is the "nominal" rate.
Equity
The difference between the value of a home and the outstanding loan balance on the home.
Fees
The sum of all upfront cash payments required by the lender as part of the charge for the loan. Origination fees and
points are expressed as a percent of the loan. Junk fees are expressed in dollars.
FHA mortgage
A mortgage on which the lender is insured against loss by the Federal Housing Administration, with the borrower
paying the mortgage insurance premium. The major advantage of an FHA mortgage is that the required down
payment is very low, but the maximum loan amount is also quite low. While it varies from area to area depending on
local prices, in many areas the maximum is below $100,000.
First mortgage
The first-priority claim against the property in the event the borrower defaults on the loan.
Fixed rate mortgage (FRM)
A mortgage on which the interest rate is specified in the loan contract and remains unchanged throughout the term of
the mortgage.
Float
An option which the borrower may exercise at the time of the application to allow the rate and points to vary with
changes in market conditions rather than to "lock in" those prevailing at that time. The borrower may elect to lock at
any point but must do so a few days before the closing.

Mortgage Industry Basics 26

Fully amortizing payment
The monthly mortgage payment which, if maintained unchanged through the remaining life of the loan at the then-
existing interest rate, will pay off the loan over the remaining life. On some ARMs the mortgage payment may not
rise whenever the interest rate increases, or the payment increase may be limited by a payment increase cap. In such
case, the payment is not fully amortizing -- if maintained it will not pay off the loan at term -- and at some point it
will have to be raised to make it fully amortizing.
Fully indexed interest rate
The current index value plus the margin on an ARM. Most ARMs have initial interest rates well below the fully
indexed rate. If the index does not change from its initial level, after the initial rate period ends the interest rate will
rise to the fully indexed rate after a period determined by the interest rate increase cap. For example, if the initial
rate is 4% for 1 year, the fully indexed rate 7%, and the rate adjusts every year subject to a 1% rate increase cap, the
7% rate will be reached at the end of the third year.
Good faith estimate
The list of settlement charges that the lender is obliged to provide the borrower within three business days of
receiving the loan application.
Graduated payment mortgage (GPM)
A mortgage on which the payment rises by a constant percent for a specified number of periods, after which it levels
out over the remaining term and amortizes fully. For example, the payment might increase by 7.5% every 12 months
for 60 months, after which it is constant for the remaining term at a fully amortizing level.
Graduation period
The interval at which the payment rises on a GPM.
Graduation rate
The percentage increase in the payment on a GPM.
Hazard insurance
Insurance purchased by the borrower, and required by the lender, to protect the property against loss from fire and
other hazards. It is the second "I" in PITI.
Historical scenario
The assumption that the index value to which the rate on an ARM is tied follows the same pattern as in some prior
historical period.
Housing expense
The sum of mortgage payment, hazard insurance, property taxes, and homeowner association fees.
Housing expense ratio (Front-End Ratio)
The ratio of housing expense to borrower income, which is used (along with the total expense ratio and other
factors) in qualifying borrowers. See qualification requirements.
Initial interest rate
The interest rate that is fixed for some specified number of months at the beginning of the life of a mortgage. On an
ARM, the initial rate is sometimes referred to as a "teaser" because it is below the fully indexed interest rate.
Initial rate period
The number of months for which the initial rate holds. On ARMs this period can range from 3 months to 10 years,
but on an FRM the initial rate holds for the life of the loan.
Investor
A borrower who owns or purchases a property as an investment rather than as a primary residence.
Interest cost
A time-adjusted measure of cost to a mortgage borrower. It is calculated in the same way as the APR except that the
APR assumes that the loan runs to term, and is always measured before taxes. Interest cost is measured over the
individual borrower's time horizon, and it may be measured after taxes at the individual borrower's tax rate. In
addition, the cost items included in interest cost may be more or less inclusive than those included in the APR.

Mortgage Industry Basics 27

Interest due
The portion of the mortgage payment which goes toward interest on the loan, expressed in dollars. It is computed by
multiplying the loan balance at the end of the preceding period times the annual interest rate divided by 12 (on a
biweekly mortgage it is divided by 26). It is the same as interest payment except when the total mortgage payment is
less than the interest due, in which case the difference is added to the balance and constitutes negative amortization.
Interest payment
The dollar amount of interest paid each month. It is the same as interest due except when the total mortgage payment
is less than the interest due, in which case the interest payment is less than the interest due; the difference is added to
the balance and constitutes negative amortization.
Interest rate
The rate charged the borrower each period, by custom quoted on an annual basis. A rate of 6%, for example, means
a rate of 1/2% per month. For a monthly payment mortgage the rate divided by 12 is multiplied by the balance at the
end of the preceding month to determine the monthly interest due.
Interest rate adjustment period
The frequency of rate adjustments on an ARM after the initial rate period is over. The rate adjustment period is
sometimes but not always the same as the initial rate period. As an example, using common terminology, a 3/3
ARM is one in which both periods are 3 years while a 3/1 ARM has an initial rate period of 3 years after which the
rate adjusts every year.
Interest rate index
The specific interest rate series to which the interest rate on an ARM is tied, such as "Treasury Constant Maturities,
1-Year," or "Eleventh District Cost of Funds." All the indices are published regularly in readily available sources.
Interest rate ceiling
The highest interest rate possible under an ARM contract; same as "lifetime cap." It is often expressed as a specified
number of percentage points above the initial interest rate.
Interest rate floor
The lowest interest rate possible under an ARM contract. Floors are less common than ceilings.
Interest rate increase cap
The maximum allowable increase in the interest rate on an ARM each time the rate is adjusted. It is usually 1 or 2
percentage points.
Interest rate decrease cap
The maximum allowable decrease in the interest rate on an ARM each time the rate is adjusted. It is usually 1 or 2
percentage points.
Jumbo mortgage
A mortgage larger than the maximum eligible for purchase by the two Federal agencies, Fannie Mae and Freddie
Mac, currently $227,150 (see Non-conforming mortgage). However, some lenders use the term to refer to programs
for even larger loans, such as, e.g., greater than $500,000.
Junk fees
Fees charged the borrower by the lender for a wide variety of services, actual and hypothetical, expressed in dollars
rather than as a percent of the loan amount.
Lender
The party who disburses funds to the borrower at the closing table, and receives the note evidencing the borrower's
indebtedness and obligation to repay, and the mortgage on the subject property.
Lien
The lender’s right to claim the borrower’s property in the event the borrower defaults. If there is more than one lien,
the claim of the lender holding the first lien will be satisfied before the claim of the lender holding the second lien,
which in turn will be satisfied before the claim of a lender holding a third lien, etc.
Loan amount
The amount the borrower(s) promise to repay, as set forth in the mortgage contract. It differs from the amount of
cash disbursed by the lender by the amount of points and other credit charges.

Mortgage Industry Basics 28

Loan-to-value ratio
The loan amount divided by the lesser of the selling price or the appraised value. Also referred to as LTV.
Lock
An option exercised by the borrower, at the time of the loan application or later, to "lock in" the rates and points
prevailing in the market at that time. The lender and borrower are committed to those terms, regardless of what
happens between that point and the closing date.
Lock period
The number of days for which any lock or cap holds.
Margin
The amount added to the interest rate index, ranging generally from 2 to 3 percentage points, to obtain the fully
indexed interest rate on an ARM.
Maturity
The period until the last payment is due.
Maximum loan amount
The largest loan size permitted on a particular loan program. For programs where the loan is targeted for sale to
Fannie Mae or Freddy Mac, the maximum will be the largest loan eligible for purchase by these agencies. On FHA
loans, the maximums are set by the Federal Housing Administration, and vary somewhat by geographical area.
Maximum loan to value ratio
The maximum allowable loan-to-value ratio on the selected loan program.
Maximum lock
The maximum period for which the lender will provide a rate/point commitment on any program. The most common
maximum lock period is 60 days, but on some programs the maximum is 90 days; only a few go beyond 90 days.
Minimum downpayment
The minimum allowable ratio of downpayment to sale price on any program. If the minimum is 10%, for example, it
means that you must make a downpayment of at least $10,000 on a $100,000 house, or $20,000 on a $200,000
house.
Monthly housing expense
The sum of the monthly mortgage payment (which includes principal and interest), taxes and insurance.
Monthly debt service
Monthly payments required on credit cards, installment loans, home equity loans, and other debts but not including
payments on the loan applied for.
Monthly total expenses
Monthly housing expense plus monthly debt service.
Mortgage Banker
Same as mortgage company.
Mortgage broker
An independent contractor who offers the loan products of multiple lenders, termed wholesalers. A mortgage broker
counsels on the loans available from different wholesalers, takes the application, and usually processes the loan.
When the file is complete, but sometimes sooner, the lender underwrites the loan and funds it. In contrast to a
correspondent, a mortgage broker does not fund a loan.
Mortgage company
A lender who sells all loans in the secondary market. As distinguished from a portfolio lender, who retains loans in
its portfolio. Mortgage companies may or may not service the loans they originate.
Mortgage insurance
Insurance provided the lender against loss on a mortgage in the event of borrower default.
Mortgage insurance premium
The up-front and/or annual charges that the borrower pays for mortgage insurance. There are different mortgage
insurance plans with differing combinations of monthly, annual and up-front premiums.

Mortgage Industry Basics 29

Mortgage payment
The monthly payment of principal and interest made by the borrower.
Mortgage program
A bundle of characteristics of a mortgage including whether it is an FRM, ARM, or Balloon, the term, the initial rate
period on an ARM, whether it is FHA-insured or VA-guaranteed, and if is not FHA or VA whether it is
"conforming" (eligible for purchase by Fannie Mae of Freddie Mac) or "non-conforming".
Negative amortization
A rise in the loan balance when the mortgage payment is less than the interest due. Sometimes called deferred
interest.
Negative amortization cap
The maximum amount of negative amortization permitted on an ARM, usually expressed as a percentage of the
original loan amount (e.g., 110%). Reaching the cap triggers an automatic increase in the payment, usually to the
fully amortizing payment level, overriding any payment increase cap.
Negative Points
Points paid by a lender for a loan with a rate above the rate on a zero point loan. For example, a wholesaler quotes
the following prices to a mortgage broker. 8%/0 points, 7.5%/4 points, 8.75%/-3 points. On some mortgage web
sites, negative points are referred top as "rebates" because they are used to reduce a borrower's settlement costs.
When negative points are retained by a mortgage broker, they are called a "yield spread premium".
No change scenario
The assumption that the value of the index to which the rate on an ARM is tied does not change from its initial level.
Non-conforming mortgage
A mortgage that does not meet the purchase requirements of the two Federal agencies, Fannie Mae and Freddie
Mac, because it is too large or for other reasons such as poor credit or inadequate documentation.
Non-Permanent resident alien
A non-citizen with a green card employed in the US. As distinct from a permanent resident alien, which lenders do
not distinguish from US citizens. Non-permanent resident aliens are subject to somewhat more restrictive
qualification requirements than US citizens.
Origination fee
An upfront fee charged by some lenders, expressed as a percent of the loan amount. Should be added to points in
determining the total fees charged by the lender that are expressed as a percent of the loan amount.
Payment adjustment interval
The period between payment changes on an ARM, which may or may not be the same as the interest rate adjustment
period. Loans on which the payment adjusts less frequently than the rate may generate negative amortization.
Payment increase cap
The maximum percentage increase in the payment on an ARM at a payment adjustment date.
Payment decrease cap
The maximum percentage decrease in the payment on an ARM at a payment adjustment date.
Payment rate
The interest rate used to calculate the payment, which is usually but not necessarily the interest rate.
Payment shock
A very large increase in the payment on an ARM that may surprise the borrower.
Payoff month
The month in which the loan balance is paid down to zero. It is the same as the term on most loans.
Pipeline risk
The lender's risk that between the time a commitment is given to the borrower and the time the loan is closed,
interest rates will rise and the lender will take a loss on selling the loan.

Mortgage Industry Basics 30

PITI
Shorthand for principal, interest, taxes and insurance, which are the components of the monthly housing expense.
Points
An upfront cash payment required by the lender as part of the charge for the loan, expressed as a percent of the loan
amount; e.g., "3 points" means a charge equal to 3% of the loan balance. It is common today for lenders to offer a
wide range of rate/point combinations, especially on fixed rate mortgages (FRMs), including combinations with
negative points. On a negative point loan the lender contributes cash toward meeting closing costs. Positive and
negative points are sometimes termed "discounts" and "premiums," respectively.
Preapproval
A commitment by a lender to make a loan prior to the identification of a specific property. It is designed to make it
easier to shop for a house. Unlike a prequalification, the lender checks the applicant's credit.
Prepayment
A payment made by the borrower over and above the scheduled mortgage payment. If the additional payment pays
off the entire balance it is a "prepayment in full"; otherwise, it is a "partial prepayment."
Prepayment penalty
A charge imposed by the lender if the borrower pays off the loan early. The charge is usually expressed as a percent
of the loan balance at the time of prepayment.
Prequalification
Same as qualification.
Principal
The portion of the monthly payment that is used to reduce the loan balance.
Processing
What the lender does with your loan application. Processing involves compiling and maintaining the file of
information about the transaction, including the credit report, appraisal, verification of employment and assets, and
so on. The processing file is handed off to underwriting for the loan decision.
Qualification
The process of determining whether a customer has enough cash and sufficient income to meet the qualification
requirements set by the lender on a requested loan. It is sometimes referred to as "pre-qualification" because it is
subject to verification of the information provided by the applicant. Qualification is short of approval because it does
not take account of the credit history of the borrower. Qualified borrowers may ultimately be turned down because,
while they have demonstrated the capacity to repay, a poor credit history suggests that they may be unwilling to pay.
Qualification ratios
Requirements stipulated by the lender that the ratio of housing expense to borrower income, and housing expense
plus other debt service to borrower income, cannot exceed specified maximums, e.g., 28% and 35%. These may
reflect the maximums specified by Fannie Mae and Freddie Mac; they may also vary with the loan-value ratio and
other factors.
Qualification rate
The interest rate used in calculating the initial mortgage payment in qualifying a borrower. The rate used in this
calculation may or may not be the initial rate on the mortgage.
Qualification requirements
Standards imposed by lenders as conditions for granting loans, including maximum ratios of housing expense and
total expense to income, maximum loan amounts, maximum loan-to-value ratios, and so on. Can be viewed as a
quantifiable subset of underwriting requirements, which is more comprehensive and takes account of the borrower's
credit record.
Rate/point options
All the combinations of interest rate and points that are offered on a particular program. On an ARM, rates and
points may also vary with the margin and interest rate ceiling.

Mortgage Industry Basics 31

Rate protection
Protection against the danger that rates will rise between the time a borrower applies for a loan and the time the loan
closes. This protection can take the form of a "lock" where the rate and points are frozen at their initial levels until
the loan closes; or a "cap" where the rates and points cannot rise from their initial levels but they can decline if
market rates decline. In either case, the protection only runs for a specified period. If the loan is not closed within
that period, the protection expires and the borrower will either have to accept the terms quoted by the lender on new
loans at that time, or start the shopping process anew.
Recast payment
Raising the mortgage payment to the fully amortizing payment. Periodic recasts are sometimes used on ARMs in
lieu of negative amortization caps.
Required cash
The total cash required of the home buyer to close the transaction, including downpayment, points and fixed dollar
charges paid to the lender, any portion of the mortgage insurance premium that is paid up-front, and other settlement
charges associated with the transaction such as title insurance, taxes, etc. The total required cash is shown on the
Good Faith Estimate of Settlement that every borrower receives.
Scheduled mortgage payment
The amount the borrower is obliged to pay each period, including interest, principal, and mortgage insurance, under
the terms of the mortgage contract.
Second mortgage
The second-priority claim against a property in the event that the borrower defaults on the loan. The lender who
holds the second mortgage gets paid only after the lender holding the first mortgage is paid.
Servicing
Administering loans between the time of disbursement and the time the loan is fully paid off. This includes
collecting monthly payments from the borrower, maintaining records of loan progress, assuring payments of taxes
and insurance, and pursuing delinquent accounts.
Simple interest mortgage
A mortgage on which interest is calculated daily based on the balance at the time of the last payment. The daily
interest charge within the month is constant -- interest is not charged on the interest charges of prior days.
Standard mortgage
An FRM with a single rate and level payments that fully amortizes over its term
Subordinate financing
A second lien on the property securing the loan at the time of closing. This arises when there is a second lien on the
property at the time the new loan is taken out, and the new loan does not pay it off.
Swing loan
See Bridge loan.
Temporary buydown
A reduction in the mortgage payment in the early years of the loan in exchange for an upfront cash payment
provided by the home buyer, the seller, or both. As an illustration, a 2-1 buydown on an 8% loan results in a
payment in year 1 calculated at 6%, in year two the payment is calculated at 7%, and in year 3 and thereafter it is
calculated at 8%. The upfront cash payment must be large enough to cover the difference between the reduced
payments made in the first two years by the borrower and the regular payment calculated at 8% received by the
lender.
Term
The period used to calculate the monthly mortgage payment. The term is usually but not always the same as the
maturity. On a 7-year balloon loan, for example, the maturity is 7 years but the term in most cases is 30 years.
Total interest payments
The sum of all interest payments to date or over the life of the loan. This is an incomplete measure of the cost of
credit to the borrower because it does not include up-front cash payments, and it is not adjusted for the time value of
money. See Effective Rate.

Mortgage Industry Basics 32

Total expense ratio (Back-End Ratio)
The ratio of housing expense plus current debt service payments to borrower income, which is used (along with the
housing expense ratio and other factors) in qualifying borrowers. See qualification requirements.
Underwriting
The process of examining all the data about the borrower(s), property, etc. to determine whether the mortgage
applied for by the borrowers should be issued.
Underwriting requirements
The standards imposed by lenders in determining whether a borrower qualifies for a loan. These standards are more
comprehensive than qualification requirements in that they include an evaluation of the borrower’s creditworthiness.
VA mortgage
A mortgage on which the lender is insured against loss by the Veterans Administration. The major advantage of a
VA mortgage is that the required down payment is very low, and maximum allowable loan amounts are higher than
on FHA loans, but only veterans are eligible.
Waive escrows
The borrower has the right to pay taxes and insurance directly. This is in contrast to the standard procedure where
the lender adds a charge to the monthly mortgage payment that is deposited in an escrow account, from which the
lender pays the borrower’s taxes and insurance when they are due. On some loans lenders will not waive escrows,
and on loans where waiver is permitted lenders are likely either to charge for it in the form of a small increase in
points, or restrict it to borrowers making a large down payment.
Wholesaler
A lender who provides loans to borrowers through mortgage brokers or correspondents. The mortgage broker or
correspondent initiates the transaction and takes the borrower's application.
Worst case scenario
The assumption that the index to which the rate on an ARM is tied rises to 100% in the second month and remains
there. The resulting rise in the interest rate will depend on the interest rate increase cap and the interest rate ceiling.
Wrap-around mortgage
A mortgage on a property that already has a mortgage, where the new lender assumes the payment obligation on the
old mortgage. Wrap-around mortgages arise when the current market rate is above the rate on the existing mortgage,
and home sellers are frequently the lender. A due-on-sale clause prevents a wrap-around mortgage in connection
with sale of a property.
Yield-Spread Premium.
See Negative Points.
3/2 Down payment
Programs offered by some lenders under which a borrower who is able to secure a grant or gift equal to 2% of the
downpayment will only have to provide a 3% downpayment from their own funds. This can be a good deal for a
cash-short borrower.

Mortgage Industry Basics 33