Deciphering the VA Lender’s Handbook Chapter 7 Part 18
While something you may have not heard about before, something you’ll likely want to know about and keep an eye out for, is the possibility that home builders, sellers, or lenders may sometimes establish and fund a special escrow account for the purpose of reducing a borrower’s loan payments during the initial years of the mortgage. This is often used as a marketing tool to attract more buyers. In some cases, a borrower may also fund an escrow on their own as a financial management tool. The VA has no problem with these types of situations, as long as the borrower is eligible for the VA loan being offered and the lender is VA-approved. Additionally, such an interest rate buydown can be used with any type of loan except for a GPM.
There are some special rules that govern the way the escrow account works in these cases. First, whichever party is establishing the escrow (builder, seller, lender, borrower), the escrow must be out of reach of their creditors. In other words, it must be something protected from seizure should a creditor have legal cause to seek payment of a debt. The only exception to this rule is if the holder of the loan is the Federal National Mortgage Association. If FNMA is the holder, they can take direct custody of the funds. The escrow agent (not the party that established and funded the escrow, but the party that has the ability to access the funds), is required to make payments out of the escrow directly to the lender or servicer of the loan. The funds from the escrow can only be used for payments currently due on the note, and cannot be used for past due amounts. If the loan is foreclosed, the funds are credited against the veteran’s indebtedness.
Obviously, such an arrangement affects the borrower’s first year or several years of making payments on the loan. This begs the question of which monthly payment amount should be used to underwrite the loan and determine sufficient income. To clarify, if the payments the first year are $900/month and $1,100/month after the buydown runs out, should the lender use the $900 figure or the $1,100 figure in determining eligibility? For the most part, the lender will use the $1,100 figure. However, the VA does have provisions that allow the lender to use the $900 figure in certain cases. The main factor is whether the borrower’s income is likely to increase enough over the next few years to keep pace with the increase in payments as the buydown runs out. Generally, the lender is expected to use information such as an increase in wage guaranteed by a labor contract (teachers, auto workers, etc.) and other factors that strongly indicate that the borrower’s income will increase.
The buydown must run for at least 1 year, and the increases in payments (or interest rates) must be accomplished in equal amounts each year as the buydown runs out. If the borrower’s income cannot reasonably be expected to increase to keep up with the payments, then the loan must be underwritten using the full monthly payment that will be required after the buydown runs out. This ensures that the borrower will be able to keep pace with the payments even if their employment and income do not improve over the next few years. However, even in this case, the buydown arrangement can be considered a compensating factor if the borrower’s income or credit is not quite sufficient for loan approval, and may make the difference between getting approved for the loan and not, though usually more than one compensating factor is required to make that happen.
As a borrower, you should receive a clear, written explanation of the buydown agreement from the lender which you will need to sign. If there is anything about the buydown agreement that you do not understand, make sure to check it with your lender before moving forward. Buydowns are not very common and usually go pretty quickly when they crop up, but if you find a builder, seller, or lender offering a buydown, you should at least check it out to see how much benefit you will get out of it.