The term “guarantee” is fairly straightforward. There is an inherent pledge from one party to another to ensure the performance of an agreement. In the mortgage world, it also has a meaning and specifically with the USDA home loan program. But for those that aren’t familiar with loan guarantees, the first notion is any applicant is guaranteed loan approval. That, however, isn’t the case here. The loan guarantee is issued to the lender.
There are three government-backed programs and they all three carry some degree of insurance to the lender. The three loans are VA, FHA and USDA programs. VA offers a guarantee of 25 percent of the loss should the loan go into default. FHA loans carry a full guarantee to the lender in case of default. USDA loans also provide a 100 percent guarantee. This is one of the reasons why lenders may be a bit more lenient when approving one of these loans. As long as the lender approved the loan using proper guidelines the guarantee remains in place. Conventional loans with a low down payment can require more stringent approval guidelines as there are no such guarantees to the lender in case of default.
Conventional loans with a down payment of less than 20 percent of the sales price do require private mortgage insurance, but the compensation is much lower compared government-backed loans. The compensation is just the difference between 20 percent of the sales price and the actual down payment. The lender is on the hook for the remaining balance of the loan in case of default.
The USDA loan is financed by two separate mortgage insurance premiums, and yes, they are indeed insurance premiums. These premiums are paid for by the borrowers in two separate ways. The first with an upfront fee of 1.00 percent of the sales price. On a $200,000 loan, that comes to $2,000. This $2,000 does not, however, have to be paid for out of pocket but instead is rolled into the loan amount. Using this example, the final loan amount will be $202,000.
There is also an annual fee paid monthly over the life of the loan. This fee is 0.35 percent of the outstanding loan balance. Using the same example, the monthly mortgage insurance premium is $58.33 added to the total monthly mortgage payment. Included with the mortgage payment is the principal and interest amount, and a monthly installment for property taxes and insurance. These two fees are referred to as Guarantee Fees.
The guarantee is paid directly to the lender in the instance of default. However, there is no guidance from the USDA as when a lender can begin the foreclosure process. A lender won’t start to foreclose when one payment is made more than 30 days late. If the outstanding payment goes beyond 60 days the lender will issue a Notice of Default or NOD. In some areas this process is referred to as a lis pendens, translated as pending legal action. Beyond 90 days the lender then has the option of proceeding with a foreclosure. Different states have different “redemption” periods the lender must follow ranging from as short as 45 days to as long as one year.
Even if a foreclosure is filed however, the guarantee paid to the lender isn’t automatic. A lender can file for foreclosure as legal protection but still work with the borrowers with a new repayment plan or a loan modification agreement. Lenders are hesitant to foreclose, something many not be aware of. Foreclosures are expensive and the lender would rather work something out and begin collecting payments again instead of taking back the property and proceeding with legal action. With a USDA loan, the guarantee will be paid should the lender fail to work out some sort of agreement and the property is foreclosed upon.
When a USDA loan is initially approved, the approval is the result of evaluating the applicant’s income, credit, and other factors. The minimum credit score is 640 for most lenders but borrowers don’t apply for a USDA loan with the intent of being foreclosed on at some point in the future. Instead, something outside the borrower’s control occurred such as a death in the family, divorce or medical issues. USDA guidelines make allowances for such events and provide lenders guidelines on how to proceed. The goal is to avoid foreclosure at all costs. But should the foreclosure come through, the lender is compensated using funds generated from the guarantee fee.
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