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© Cengage Learning 1
CHAPTER 6
Conventional Lending
OBJECTIVES OF CHAPTER
Upon successful completion of this chapter, students should be able to:
Discuss how the standard fixed-rate mortgage developed and
why it was an important tool for reviving real estate and
mortgage lending after the Great Depression.
Understand that a self-amortizing (direct reduction) mortgage
can save the mortgagor a meaningful amount of interest over a
term loan.
Explain the dilemma mortgage lenders were in during the high
interest period of the early 1980s and what the consequences of
that dilemma were to profitability.
Describe the components of an adjustable-rate
mortgage (ARM).
Understand the various types of alternative mortgages and
which is more beneficial to the borrower and lender at various
times in the interest rate cycle.
Discuss how the typical adjustable-rate mortgage is priced and
how that interest rate can change.
Understand the differences between what a loan program is and
what a product is.
Explain what a conforming loan is and what a conventional
mortgage is to a layperson.
© Cengage Learning 2
SUGGESTED TRUE/FALSE
I. Introduction
II. Evolution of the Standard Fixed-Rate, Fully-
Amortized Mortgage
A. Direct Reduction Instrument
B. Mortgage Lenders Dilemma
C. Alternative Mortgage Instruments
D. 1990 to 2010: Return of the Standard Fixed-
rate Fully-amortizing Mortgage
III. 10-, 15-, 20-, OR 40-YEAR MORTGAGES
A. Sharing the Risk
B. Mortgage Program Nomenclature and
Definitions
C. Conventional vs. Government vs. Other
D. Conforming vs. Non-conforming
E. Non-traditional
F. Adjustable-Rate Mortgages (ARMs)
G. Structure of an ARM: Adjustment Period
H. Index
I. Margin
J. Interest Rate Caps
K. Fully-indexed accrual rate
L. Discounts
M. Spread
N. ARM Programs
O. Buydowns
P. Convertible Mortgages
Q. Two-Step, or Reset, Mortgages
R. Graduated Payment Mortgages (GPMs)
IV. Biweekly Mortgages
V. Conforming Mortgage Loans
A. Conforming Maximum Loan Amount
B. Fannie Mae and Freddie Mac Mortgage
Programs
C. Maximum Loan-to-Value Ratios for
Standard Purchases
D. Mortgage Insurance Requirements and
Credit Enhancement
VI. Non-Conforming Mortgage Programs
VII. Non-Prime (subprime) Mortgage Programs
What are the basic differences between conforming,
non- conforming and conventional loans?
Which is the least risky loan product and program a
borrower can obtain for a primary residence?
Give some examples of ARM mortgage products
and discuss which ones would be the best for which
situation.
How would you go about explaining the different
components of the ARM loan so that your client
could understand it?
With bi-weekly mortgages, the lender is sometimes
selling a service. What alternative methods would
you give your client to speed up the payoff their
mortgage?
Discuss how loan to value and FICO scores play a
part in loan risk.
Explain the difference between sub-prime and Alt-
A products and how did they evolve into such a
negative thing?
List five criteria for offering a client a sub-prime
loan. How would you analyze the risk factors
involved with the performance of that mortgage?
Teaching Tips
© Cengage Learning 3
QUIZ
1. Fixed-rate mortgage loans are the norm around the world.
2. Self-amortizing loans started in England about 400 years ago.
3. Over the past thirty years variable-rate loans originations have
been as high as 60 percent.
4. Direct reduction mortgage costs more in interest than a year-end
payment loan.
5. The most popular index for an ARM loan is the one-year treasury
adjusted to a constant maturity.
6. The most common margin for an ARM loan is 325 basis points.
7. A problem with most ARM loans is there is no limit on how
much the interest rate may increase.
8. Discount ARM loan are illegal under most state laws.
9. A biweekly mortgage requires 24 payments are year.
10. Reverse Annuity Mortgages are only for people over 62.
© Cengage Learning 4
MULTIPLE CHOICE QUESTIONS. More than one answer may be
correct – select all correct answers. (Correct answers are italicized.)
1. The maximum interest rate a mortgage lender may charge for an
ARM loan is called
a. margin
2. The primary reason mortgage lenders are interested in ARM loans is
to
a. limit mortgage choices for borrowers
3. Reverse Annuity Mortgages are designed for which borrower
a. first-time homebuyers
© Cengage Learning 5
4. The biweekly mortgage loan requires how many payments in a normal
year?
a. 12
5. The 15-year loan is designed for the borrower who wants to
d. will only be in home for five years.
SUGGESTED SHORT ESSAY QUESTIONS
1. List and briefly describe the features of at least four alternative
mortgage instruments.
ANSWER:
Adjustable Rate Mortgage: Index + margin = initial interest rate.
Graduated Payment Mortgage: designed to provide borrowers with
© Cengage Learning 6
Reverse Annuity Mortgage: designed to enable older retired
Shared Appreciation Mortgage: designed to give a borrower a
Price Level Adjusted Mortgage: designed to keep the real mortgage
Biweekly: designed to allow a borrower to match paydays with
ANSWERS TO ORAL DISCUSSION POINTS
The discussion points at the end of each chapter are intended for
oral discussion in class. Suggested answers/points to emphasize
for the questions are found below.
1. Discuss how the standard fixed-rate mortgage developed in the United States
and why it was an important tool for reviving real estate and mortgage
lending after the Great Depression.
© Cengage Learning 7
ANSWER: Before the Great Depression, most mortgages were short-
term; interest only paid every six or twelve months. Because these
mortgages needed to be refinanced at the end of the term, many
2. Explain why a self-amortizing (direct reduction) mortgage can save a
mortgage borrower a substantial amount of interest over a term loan.
ANSWER: The standard fixed-rate mortgage is a monthly amortized, direct
reduction instrument. This means that equal monthly payments for the term
of the loan are used to directly reduce the amount owed by first paying
interest on the loan due since the last payment and then using the remainder
© Cengage Learning 8
3. Discuss the differences between conventional and conforming mortgage
programs
ANSWER: A conforming loan is one that meets Fannie and Freddie
criteria. It can be a first or second mortgage or any other product, as long as
4. Identify and discuss the components of an adjustable-rate mortgage.
ANSWER: The student should explain that one of the various
Indexes is used which establishes an index rate to which is added the
5. What must a mortgage lender do to attract consumers to an adjustable-rate
mortgage when fixed-rate mortgages are attractively priced?
ANSWER: In order to make an ARM loan attractive to more consumers,
most lenders lower the initial interest rate (and thus the payment rate) from
© Cengage Learning 9
6. What makes a mortgage loan “subprime” and what are some of the benefits and
challenges in this area of lending? How do they differ from “non-prime”
mortgages?
ANSWER: A “subprime” loan does not meet the basic criteria of standard
Freddie and Fannie guidelines. In other words, it is not a prime loan, due to
credit history, income source, asset source, underwriting documentation,
7. What is the difference between an eligibility issue and an underwriting
guideline?
ANSWER: If a borrower is not eligible for a mortgage product or program,
they simply do not meet the basic criteria such as loan amount, loan to value,
© Cengage Learning 10
8. Explain the difference between mortgage instruments, programs, and
products
ANSWER: A mortgage programs can be conforming, non-conforming and
non-prime in nature. A mortgage product would be a type of ARM, fixed
