Guide to Conventional Loans

Tuesday, January 12, 2021   /   by Randy Durham

Guide to Conventional Loans



When you take out a loan you think of this as a partnership between you and the lender. On your end, you have more advantage with the more money you have to put down on the loan. Taking a loan also puts benefits you because you have a place to live without having to fork over that 100 grand you buried in your backyard. For the lender, the advantage they have comes in the form of interest and other money they charge you to finance the loan. The most common are loan origination fees and discount points.  



Loan origination fees are typically one percent of the loan amount. This fee covers the cost it takes the lender to generate the loan. So if your loan is 100 grand, your fee is 1000 dollars. 



Discount Points are what lenders refer to as discount points and counts as prepaid interest. Every point is one percent of your loan amount, so if your lender is charging you two discount points on your 100 k loan then that equals 2,000. Lenders charge points at closing to get more yield on a loan and raise the of the loan. They do this because the lender can actually sell the loan in a secondary mortgage market, and discount points make the loan more competitive if and when they sell it. A rule of thumb is that each discount point raises the loan's interest rate 1/8th of a percent. So if a lender charges 4 points it would increase a loan with a 7 and 1/4 percent yield to a 7 and 3/4 percent yield. 



The next term is LTV or Loan to Value Ratio. Is the relationship of the loan amount to the price tag of the property. So if you have 20 grand to put down on that 100k home then your loan to value ratio would be 80%. In general, the more you have down means that you’re more serious about buying the home, less likely to default, and the lender is taking less of a risk when they loan you money. Also, if you default on the loan then the lender has a smaller loan balance to recover concerning the market value of the property so they are more likely to recover the loan balance in a foreclosure. 



Loan terms are the length of time in years the borrower has to repay the loan. Most residential loans have a repayment term of thirty years. However, you can take out loans for 15 or 20 years, your payments will be higher but the good news you will pay less interest than a 30-year loan. Your interest rate will also be lower because lenders think you're less of a risk. Your loan term will affect your monthly payment. 



The loan amount is called the principal. Obviously, the longer you pay on the loan, the less principal you’re gonna have on the loan balance. Your interest rate is determined by the percentage of the original loan amount that your lender charges you for lending you a truckload of money to buy your house. The interest rate and the principal combined equal the thing people freak out over every month that is called your payment. 



Loan structures:



The most common loan structures are Straight (interest only), Amortized, Balloon, and Adjustable Rate Mortgages often referred to as acute acronyms called an ARM. 



A straight loan is an interest-only loan and monthly payments only go toward interest. No principal is paid and the entire balance of the principal is due when the loan term is over. That’s weird and sounds really sketchy like that dude that got his race cars taken away by the feds on that Netflix show for charging poor people outrageous interest with those payday loans but don’t worry. These loans have a purpose and they are usually taken out by an investor who plans to resell the loan for a higher price after owning it for a short period of time. There is obvious risk involved with this loan type because the property may not have a higher value and the borrower winds up having to pay money instead of counting his profits. 



Amortized loans: With fully amortized loans, a borrower makes a periodic payment of principal plus interest, which means you will repay the loan gradually over time. Amortized loans are also called fixed-rate loans, and at the end of the term usually 15 t0 30 years the total balance is paid off. A fully amortized loan means that you have the same payment every month. Even though you have the same payment, the interest you pay at the beginning will be higher, and toward the end of the loan term, the amount of interest decreases so you start making more payments on the principal. The reason for this helps you generate more equity in the home down the road because you are paying off the principal balance at a quicker rate than you would with other loan types. 



Balloon loan: a balloon loan has one large final payment due when the loan term is over. An interest-only loan is a type of balloon loan. Another name for a balloon loan is called a partially amortized loan. A partially amortized loan means the payments aren’t large enough to leave the loan balance at zero by the end of the loan term, so you have a large final payment due





ARMs



Arms are popular when fixed-rate loans are high. So if the interest rates are super high for a fully amortized loan your lender will probably suggest an ARM. Also, if you’re planning on not living in the property until you have an AARP card, an ARM may be a good option for you. ARMS have a cute acronym but there are so many different parts that can leave someone who’s not a lender scratching their head. These terms are called index, margin, calculated rate, adjustment period, payment adjustment period, payment cap, negative amortization cap, conversion option, and step rate or buy-down. 



Index: is a measure of economic conditions. The most popular ones are the one-year treasury bill, five-year Treasury note, Cost of Funds index, and the Federal home loan bank average. The lender will select an index and uses that as a starting point to calculate the interest rate. The interest rate is usually the index plus the margin. 



Margin: the lender will set a margin, usually between two and three percent when they originate the loan. The margin is then added to the index rate, which provides the lender the desired yield on the loan. 



Note rate: the index rate plus the margin establishes the note rate. Since borrowers share their risk with the lender in this type of loan, the interest rates are lower than fixed-rate loans. Get why it’s a good alternative? 



Initial Rate: this is called a super shady term called a “teaser rate.” However, it’s not that shady but I’ll explain later. This is because the teaser rate is lower than the current market rate and the interest rate will probably increase over the life of the loan. I say this will all the finance videos that I don’t make the rules I just help you buy a house.



Adjustment period: ARMS have a specific time where the interest rate may change. The adjustment period could be only one year, but three to five are the most common. This is when your teaser rate changes. 



Mortgage Adjustment period: This determines when the lender will change the monthly payment amount to reflect the increase of the teaser rate. However, your rate could also go down so that means your payment does too. 



Interest rate caps: to make the teaser rate less shady ARMs actually have interest rate caps that lenders put on the loan to protect borrowers from unlimited interest rate increases.  


Payment caps: a payment cap sets a monthly payment ceiling even when the actual interest rate increases.