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Solutions for the Emerging Purchase Market

January 31, 2014

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Freddie Mac's November 2013 U.S. Economic and Housing Outlook projects that the major shift for 2014 will be a transition from a rate-and-term refinance-dominated mortgage market to a home purchase-dominated market. With interest rates for the 30-year fixed-rate mortgage expected to increase this year, adjustable-rate mortgages could regain popularity. In addition, our Construction Conversion and Renovation Mortgages will be a good option for borrowers preparing for construction conversion and those in need of home renovation funds. Here's how these mortgage options can help you grow your business.

Adjustable-rate Mortgages: A Viable Option in 2014

Adjustable-rate mortgages or ARMs, which practically disappeared during recent years, will become an important option for your borrowers in today's rising interest rate environment. These mortgages can help keep the monthly payment affordable in the short term by offering an initial interest rate that is lower than fixed-rate mortgages – but that rate can move up and down over the life of the loan as the market interest rates fluctuate.

What is an ARM?

Also known as a variable-rate loan, ARMs usually offer a lower initial mortgage rate than fixed-rate loans. The interest rate is tied to an index, such as the LIBOR or the Treasury index, plus a rate add-on called a margin. Since the index reflects current market conditions, the interest rate can change at specified time periods. The ARM promissory note states maximum and minimum rates.

ARMS are most suited for borrowers who:

  • Understand that their rate may increase after the initial period.
  • Don't anticipate holding on to the property for the full term of the mortgage.
  • Want the benefit of a lower initial rate and monthly payment.

Flexible Financing Options Allow You to Reach More Borrowers

With a variety of Freddie Mac ARM products, you can help borrowers tailor their financing terms to suit not just their current, but also their expected future income streams. Starting with 3/1, 5/1, 7/1, and 10/1 ARMs, our ARM offerings leverage more home financing flexibility. There are no occupancy or property type restrictions for ARMs – you can use them for primary residences, second homes and investment properties that are single-family homes, condominiums, or manufactured homes. You can also combine ARMs with Home Possible® Mortgages and other specialty mortgage products.

To help you understand how ARMs work, consider the following examples:

  • A 5/1 ARM has a fixed interest rate for the first five years. After five years, the rate can change once every year for the remaining life of the loan. The same principle applies for a 3/1, 7/1 and 10/1 ARM. If the rates increase, the borrower's monthly payments will increase; if rates go down, their payments may decrease.

Most ARMs also typically feature an adjustment rate "cap" which limits how much the interest rate can go up or down at each adjustment period and for the life of the loan. For instance:

  • A 7/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but on the eighth year the rate can increase by a maximum of 5 percentage points (the first "5") above the initial interest rate. Every year thereafter, the borrower's rate can adjust up or down by a maximum of 2 percentage points (the second number, "2"), but the interest rate can never increase more than 5 percentage points (the last number, "5") throughout the life of the loan.

Benefits and Risks of ARMs

The benefits of an adjustable-rate mortgage in a rising fixed-rate mortgage environment are relatively easy to see. Freddie Mac market data shows that the average rate for a 30-year fixed-rate mortgage was 4.53 percent during the first week of January, moving higher than it had been over the past year. The average rate for a 5/1 ARM during the first week of January was 3 percent.

However, it is important to consider and weigh the risks of ARMS. The interest rate of the ARM is subject to change throughout the life of the loan. For the lowest-rate ARMs available, that initial low rate is locked in for only three years, with subsequent resets on an annual basis. If short-term interest rates start to increase, then the borrower's monthly payment will skyrocket. Longer fixed-rate initial interest rate periods allow ARM borrowers to defer the first adjustment for as long as 10 years, giving them time to financially prepare for any impending interest rate increase, but the trade-off is a higher initial interest rate.

Helping Borrowers Decide if An ARM is Right for Them

As you work with your borrower to help them determine if an ARM is right for them, here are some questions to consider:

  • If the mortgage rate increases, can the borrower afford a higher mortgage payment? For certain Freddie Mac-eligible ARMs, there are new qualification requirements effective for mortgages with application received dates on or after January 10, 2014. Use our calculator to estimate how a higher mortgage rate can impact a borrower's mortgage payment.
  • Does the borrower plan to live in their home for less than five to seven years – or less than the adjustment period? If yes, an ARM might be the right mortgage option.
  • Will the borrower be taking on other sizable debts, such as car loan or school tuition, in the near future?
  • Is the borrower planning to make any additional payments or pay the loan off early?

You may also want to look at mortgage rate trends by following Freddie Mac's weekly Primary Mortgage Market Survey (PMMS). While no one knows for certain where mortgage rates are likely to go in the future, it is worth understanding why they move and how they have moved.

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Stay Competitive with Construction Conversion and Renovation Mortgages

As the housing recovery stabilizes, new home construction is expected to increase, creating more options for homebuyers. Forecasters see 2014 as a year of measured expansion for the construction industry, projecting that total U.S. construction starts will rise 9 percent to $555.3 billion. This is higher than the 5 percent increase to $508 billion estimated for 2013*. This increase should help boost options for homebuyers, allowing them to construct newer homes that have the latest designs or are more energy efficient.

Against this backdrop of moderate home construction growth borrowers – who are looking to secure financing for both site-built homes and land – can take advantage of Freddie Mac Construction Conversion and Renovation Mortgages. Here's how this niche mortgage can help you originate more mortgages.

*2014 Dodge Construction Outlook, McGraw Hill Construction.

What Is a Construction Conversion and Renovation Mortgage?

The Freddie Mac Construction Conversion and Renovation Mortgage is designed to provide permanent financing that replaces the interim (short term) construction financing obtained by the borrower to construct or renovate a site-built or manufactured home. Two components to this mortgage allow you to offer borrowers competitive permanent financing options to meet their construction needs:

  • Construction Conversion Mortgage: Provides the borrower with funds to:
    • Purchase or refinance the land on which the site-built home or manufactured home will be constructed and affixed, and
    • Construct a new site-built home, or
    • Purchase and permanently affix to the site and convert to real property, a new manufactured home.
  • Renovation Mortgage: Proceeds are used to purchase or refinance the land and an existing site-built home and to repair, restore, rehabilitate or renovate the site-built home.

Purchase money Construction Conversion and Renovation Mortgages may be secured by:

  • 1-4 unit site-built homes that are primary residences, second homes or investment properties,
  • 1-unit manufactured homes (Construction Conversion Mortgages only), and
  • Condominiums (Renovation Mortgages only).

Note that Freddie Mac does not purchase the interim construction financing.

Benefits for Your Borrowers

With Construction Conversion and Renovation Mortgages, your borrowers can take advantage of the following financing flexibilities:

  • A variety of eligible mortgage products: Offer the financing flexibilities your borrowers need when you combine Construction Conversion and Renovation Mortgages with many other Freddie Mac products, including 15-, 20-, and 30-year fixed-rate mortgages, ARMs, super-conforming mortgages, and more.
  • Flexibility when securing permanent financing: Our requirements for eligible borrowers on Construction Conversion and Renovation Mortgages allow the removal of a co-borrower in the event of death or divorce, or the addition of a related person to the permanent financing under specific circumstances.

How to Structure the Permanent Financing

Construction Conversion and Renovation Mortgages can be structured as a purchase or refinance transaction, depending on when the borrower took ownership of the land. The chart below illustrates how you can determine how to structure the permanent refinancing.

Purchase or Refinance

If, prior to the closing of the Interim Construction Financing, the borrower is...The transaction is a...And proceeds from the Interim Construction Financing may be used to...
Not the owner of record of the land, or if the site-built home is on a leasehold estate, not the lessee of the leasehold estate Purchase transaction
  • Purchase the land, or for a site-built home, acquire a leasehold interest in the land
  • For Renovation Mortgages, purchase the site-built home
  • Pay construction or renovation costs of the site-built home
  • For a Manufactured Home, acquire the Manufactured Home and pay construction costs, including costs to install and anchor the Manufactured Home on a permanent foundation system
The owner of record of the land, or if the site-built home is on a leasehold estate, the lessee of the leasehold estate Refinance transaction
  • Pay off any existing liens on the land and on the improvements if a Renovation Mortgage
  • Pay all transaction costs, such as Closing Costs, Financing Costs and/or Prepaids/Escrows
  • Pay construction or renovation costs of the site-built home
  • For a Manufactured Home, acquire the Manufactured Home and pay construction costs, including costs to install and anchor the Manufactured Home on a permanent foundation system on land owned by the borrower
© Freddie Mac
Guide Section K33.6(a)

Sign Up for Our Free, Live Webinar

For details on how to originate and underwrite these mortgages, sign up for our Construction Conversion and Renovation Mortgages webinar on February 18, 2014. This webinar is designed exclusively for community lenders.

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