A Guide to Foreclosure Financing and Refinancing

For many homebuyers and investors seeking to purchase a pre-foreclosure or a bank-owned foreclosure property, one of the most difficult aspects of purchasing a distressed property is finding financing for the foreclosure deal. While homebuyers are very happy to see home prices dropping, the credit crunch has put a clamp on foreclosure financing and many foreclosure lenders are scrutinizing each deal.

Therefore, to purchase a pre-foreclosure property, homebuyers will need to come up with enough cash to reinstate the loan that is in default. Reinstatement will stop the foreclosing lender from foreclosing on the distressed borrower. To reinstate a delinquent mortgage or deed of trust loan, an investor or homebuyer may need to come up with $10,000 or $15,000 to put the loan back in the foreclosure lender’s good grace. Unfortunately, many buyers don’t have $15,000 or more in their savings account.

Depending on the price range of the foreclosure properties an investor plans to buy, he or she will need startup capital to pay the loan reinstatement costs, rehab costs, closing costs, carrying costs, sales marketing costs and other expenses associated with buying and carrying foreclosure real estate.

Foreclosure Lenders

Foreclosure lenders come in myriad shapes and forms. The money to finance a foreclosure deal can come from many places, including personal investment funds, home equity lines of credit (HELOC), credit cards, financial companies, conventional mortgage loans, hard money lenders, private investors or an investment fund created by family and friends.

Moreover, buyers can use any combination of the sources mentioned above to structure the foreclosure financing. For example, an investor could borrow 90 percent loan-to-value (LTV) on a conventional loan and borrow the remaining 10 percent using a line of credit (or credit card).

The good news for foreclosure investors is that mortgage interest rates have been slowly rising, but they are still low compared with past years. But most foreclosure lenders are now requiring larger down payments and higher credit scores before accepting a loan application to buy foreclosure real estate. Foreclosure lenders don’t want to get burned again with more foreclosures.

Fannie Mae Foreclosures

Fannie Mae, the largest U.S. mortgage finance company, changed its guidelines recently to discourage homeowners from walking away from their loans. Fannie Mae and Freddie Mac both help the mortgage market function by purchasing pools of loans and packaging them into securities. The two companies are known as government sponsored entities because they were created by Congress.

Fannie and Freddie primarily back so called conforming loans, those made to borrowers with good credit and large down payments. And Fannie and Freddie’s role in the mortgage and real estate markets is likely to grow, as Congress recently allowed them to back larger mortgages — up to $729,750 from the previous limit of $417,000.

Foreclosure Refinancing

Many foreclosure investors keep their properties as a rental after rehabbing the property. Some investors go out and refinance the foreclosure with a new conventional mortgage. Refinancing a foreclosure purchase loan is very common. Depending on the lender, homebuyers may be able to do what is commonly referred to as a cash out refi, pulling out a portion or all of their rehab money. The cash can then be used as a down payment on the next foreclosure property purchase.

Answers to Frequently Asked Questions

Q1: How much can I afford?

Answer: Basically, how much you can afford is dictated by the amount of cash you have on hand plus the amount a lender is willing to loan you. There are two rules of thumb to keep in mind in this area. First, you can afford a home that is up to 2.5 times your annual gross income. Second, your monthly principal and interest payments should equal one-fourth of your gross pay, or one-third of your take-home pay.

Of course, this is dependent on your lender’s approval and your own comfort level. From the lender’s standpoint, your credit rating, income and related factors will determine how large a mortgage you can support. You also need to take into consideration your own comfort level with the mortgage amount.

Q2: What types of mortgages are available and which is best for me?

Answer: There are basically three types of mortgages available: fixed-rate, adjustable-rate and hybrid.

Fixed-rate mortgages offer stability, since interest rates and monthly payments remain the same throughout the life of the loan. Adjustable-rate mortgages are loans in which the interest rates and monthly payments can go up and down depending on the market. Hybrid loans offer a combination of fixed and adjustable mortgages.

Exactly which type of mortgage is best for you can be a matter of individual preference, so it’s best to consult with your lender and review comparisons as they apply to the loan you require.

Q3: What types of loans are available?

Answer: Here is a quick rundown on the types of loans currently available.

Convertible loans offer a fixed rate for the first three, five or seven years, and then switch to a traditional adjustable-rate mortgage that fluctuates with the market. If you strongly believe that interest rates will fall, then selecting a convertible loan might be a smart move.

Balloon loans are short-term loans with smaller payments for a certain period of time, and then one or more large payments for the remaining principal amount, due at a specified time.

Secured loans are those for which you have given the lender a lien on personal property such as an automobile, boat or real estate property to serve as collateral for the loan.

FHA loans are designed to make housing more affordable to first-time buyers and those with a low-to-moderate income. Both fixed-rate and adjustable-rate FHA mortgages are available. FHA loans are insured by the U.S. Department of Housing and Urban Development (HUD). With FHA insurance, eligible buyers can put down as little as 3 percent of the FHA appraisal value or the purchase price (whichever is lower). Qualifying standards are not as strict and rates are slightly better than with conventional loans.

VA loans are special loans to make housing affordable to U.S. veterans. To qualify, you must either be on active duty, a veteran, a reservist, or a surviving spouse of a veteran with 100 percent entitlement. This type of loan is simply a fixed-rate mortgage with a very competitive interest rate. Qualified buyers can also use a VA loan to purchase a home with no money down, no cash reserves, no application fee and a reduced closing cost amount.

There are many loan options available to you, but it’s important to make sure you fully understand the terms of each and how they will affect your finances long term. Your mortgage is probably the biggest loan you’ll ever have, so it’s prudent to take the time to make the most informed decision possible.

Q4: How do you calculate the cost of a mortgage?

Answer: There are basically five things to consider when determining the cost of your mortgage. These include:

Principal — The principal is the amount of the loan, calculated as the purchase price minus the down payment.

Interest Rate — The interest rate is basically the cost associated with borrowing money from the lender. Interest rates can fluctuate widely over time, so keep this in mind when timing your purchase. During times when interest rates are high, you may want to consider an adjustable rate, which is periodically increased or decreased over time to more closely match up with current rates and economic trends. A fixed rate is set, locking the interest rate for the remainder of the mortgage. Regardless of whether you select a fixed or adjustable interest rate, you should note that the interest amount will add significantly to the overall cost of your home – sometimes more than the price of the home itself!

Term — The term is the length of time until the loan is paid off. While a longer term means smaller payments, it usually means more interest as well, so the overall cost goes up the longer the term is. The following table shows the differences in monthly payment amounts and overall interest paid for different term lengths for a $350,000 loan with a fixed interest rate of 5.5 percent.

Term	        Monthly Payment	Interest Paid
30 Years	$1987.26	$365,414
20 Years	$2407.61	$227,825
15 Years	$2859.79	$164,763

Points – Points are optional, but give you the ability to decrease the interest on your loan and make monthly payments smaller. Paid at closing time, each point equals one percent of the loan. They are considered a form of interest paid on the loan.

Fees – Paid to the lender at closing, fees cover the administrative cost of preparing a mortgage. They can vary based on what type of loan you need as well as where you live.

Q5: What do lenders look at when considering a loan for approval?

Answer: Lenders will consider a variety of factors when determining whether to approve you for a loan.

The first consideration is your ability to make payments. To establish your ability to afford the loan amount, the lender will look at your average housing expenses and weigh it against your net monthly income. Your housing expenses include the loan’s monthly payment, as well as insurance costs, property taxes and any homeowner’s association fees paid to the community.

Additional considerations include your total debt, meaning any credit card balances, child support, alimony payments, tuition, car loans or any other payments you are required to make in installments over the course of more than 10 years. To qualify for a loan, your monthly mortgage payment ideally should be less than 28 percent of your net monthly income. That said, lenders will sometimes make concessions for first time buyers, as they will typically have a smaller down payment amount available and therefore higher monthly payments to make against a loan.

The lender will also consider your credit history in order to determine whether you are a risk. The lender will review any mortgage payment history, rent payment history, credit card use and payment history on any installment debt you’ve accumulated. This concerns some people, as it’s not uncommon to have made one or two late payments over one’s lifetime, but keep in mind that the lender is really looking for patterns of late payments, especially those resulting in collections, repossessions, foreclosures or bankruptcies.

When you apply for a home loan, the home itself becomes collateral against your ability to make payments. Therefore, you will be expected to prove that the home is worth at least as much as the loan you are applying for. This will be substantiated by an inspection by a professional home inspector.

Lastly, the lender will likely evaluate your personal character. This is determined by the manner in which you conduct financial transactions. If it is apparent that you are a responsible borrower who is serious about paying off your debts on time, and if you appear to have integrity, you will likely be considered a good candidate for a loan.

Q6: What information will I need to supply when seeking loan approval?

Answer: Since a home loan is, in most cases, the biggest loan the average person applies for, lenders require substantial documentation.

You will be required to provide personal information, including the address and phone numbers of each applicant on the loan, any previous addresses for the past seven years, Social Security numbers for all applicants, the ages of applicants and their dependents, the name and address of any lenders or landlords for the previous two years and proof that payments were made. You will also need to detail your housing expenses, including rent, mortgages, taxes and insurance.

Each applicant will need to provide the name and address of all employers for the past two years. They must be able to show actual pay stubs for the past 30 days and W-2 forms for the past two years. If there are any gaps in employment over a two-year period, the applicant must supply a valid explanation for them. If an applicant is self-employed, they will need to show complete, signed Federal Income Tax returns for the past two years, as well as a year-to-date profit and loss statement and balance sheet for their company.

Any additional income, such as social security, pension, disability or VA benefits must be proven by either an awards letter, tax return or a copy of the most recent check. Any rental income can be proven by supplying a copy of the current lease.

Debt disclosure is required, including anything owed on credit cards, loans and current mortgages. The name and address of each creditor must be supplied, along with account numbers, monthly payments and outstanding balance for each. You must show proof of recent payment with a current statement. If you owe child support or alimony, you must provide documentation regarding the amount you are required to pay. If any past credit problems exist, you will be required to provide written explanation for them.

Required loan application documentation includes a complete, signed copy of the sales contract and a copy of your canceled earnest money check.

Q7: What are the fees when applying for a home loan?

Answer: The application fee typically costs about $350 and the credit report fee is about $50.

Q8: What do closing costs consist of and is there any way to reduce them?

Answer: Closing costs include any, and in some cases all, of the following: Down payment, lender’s points, prepaid interest, loan origination fee, mortgage insurance, credit reports fee, appraisal and inspection fees, fees for surveys of the property, homeowner’s insurance, attorney’s fees, title search and insurance, prorated property taxes, recording fees, closing taxes, escrow account and insurance, as well as any other costs as specified in the purchase agreement.

Closing costs usually amount to about 1-2 percent of your total loan amount. You are typically required to pay these costs along with your down payment in the form of a cashier’s check at closing. However, there are methods of reducing these costs – or even eliminating them altogether! One option is to have your mortgage amount increased to cover closing costs. In some cases, you can even negotiate with the seller to have them pay a portion of the costs prior to making a commitment to buy their home. You can also defer payment rather than paying some of these fees in large lump sums by opening an impound or escrow account. This allows you to divide your payments into installments billed monthly along with your loan principal and interest payment.

Q9: What can refinancing do for me and what does it cost?

Answer: Though it does cost money to do so, refinancing can help decrease your monthly payments, cash in on your home equity, switch from an adjustable to a fixed rate, consolidate debt, or pay off your mortgage sooner.

The cost associated with refinancing usually takes about three years to pay off. Some lenders do offer no-cost refinancing, but keep in mind that this is typically in exchange for a higher interest rate. If you plan to stay in the house at least five more years and the new interest rate is at least 1.5 percentage points below your current interest rate, it’s usually wise to refinance.