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• The direct Section 502 program discussed in this guide is a direct mortgage (homeownership) loan program.
• Section 502 mortgages are "last resort" loans. This means that a threshold for eligibility is the applicant’s inability to obtain financing from other sources, including their own resources.
• Because RHS is a lender of last resort, the program does not compete with private credit, and borrowers must refinance their loans when they are able to afford and obtain conventional mortgages.
• There is no down payment percentage requirement. Applicants make down payments only when they have sufficient assets, or when the maximum loan is less than total costs.
• Eligible families have incomes that do not exceed 80 percent of area median income.
• A minimum of 40 percent of appropriated funds are reserved for those with incomes at or below 50 percent of area median income.
• The loans are amortized for 30 to 38 years. Most are amortized over 33 years.
• Loans are made at a "note rate" (formerly called "market rate") of interest, but payment assistance subsidy can reduce the interest rate to as low as 1 percent.
• Borrowers must pay 22, 24 or 26 percent of their adjusted income for principal, interest, taxes and insurance (PITI) depending on how their income compares to area median.
• Subsidy is subject to recapture upon profitable sale or transfer. The recapture formula is designed to provide incentive to the borrower while returning all, or some portion, of the subsidy to the government.
• There are threshold requirements for borrowers’ credit history.
• The program funds only "modest housing," defined as units costing less than the Section 203(b) limits established by HUD.
• RHS/Rural Development determines the feasibility of repayment by an eligible applicant, based on the ratios of PITI to income and total debt to income.
• Use of Section 502 funds is prioritized.
• Nonprofit or public organizations may receive fees for "packaging" (preparing) Section 502 applications. The fee may be paid by the owner as part of the loan, or paid by RHS/Rural Development if the home is in a county eligible for the Housing Application Packaging Grant (HAPG) program and the packager is certified by RHS/Rural Development. The HAPG program, covered by Instruction 1944-B, applies to several RHS programs, including Section 502. Packagers who attend RHS training and receive certification annually can be reimbursed up to $500 for packaging Section 502 applications in 301 selected areas (counties or colonias in 29 states) that have high rates of poverty and occupied substandard housing.

The Section 502 direct loan program has changed in some significant ways since 1995 as a result of congressional directives and administrative actions. Those familiar with the program in its earlier form may wish to note the following alterations.

• Numerous regulations for the Section 502 program (and the Section 504 home repair loan and grant programs) have been replaced by a single new regulation -- Part 3550 -- and two new handbooks.
• There is now a more structured set of specific priorities for processing applications.
• Section 502 now provides 38-year mortgage terms for households at or below 60 percent of area median income and unable to afford 33-year terms.
• A minimum of 40 percent of Section 502 direct loan funds are reserved for use by very low-income applicants.
• The deferred mortgage payment demonstration program, which enhanced affordability for households with income at or below 50 percent of median by deferring mortgage payments temporarily under some circumstances, has not been funded.
• "Modest housing" for which Section 502 loans can be used was previously defined by square footage and types of amenities. Now housing is considered "modest" if it falls under the HUD-FHA dollar caps (Section 203(b) of the National Housing Act (12 U.S.C. §1709)), though amenities are still restricted.
• Affordability, or loan feasibility, was previously determined by examining families’ budgets to see what loan payment they could afford. Budgets have now been replaced by the ratios of principal, interest, taxes and insurance (PITI) to gross income and total monthly debt (TD) to gross income.
• The amount of interest subsidy provided to a borrower is now determined solely by the applicant or borrower’s adjusted income as a percent of area median income. This subsidy is termed "payment assistance." In FY 1996, payment assistance replaced interest credit subsidy, which had been used since 1968. Those already receiving interest credit will stay on interest credit, providing their use is continuous. Interest credit is far more beneficial to borrowers than payment assistance, so it is important that those receiving it promptly submit requested renewal information to avoid any lapse.
• Once payment assistance is determined, it is modified by requiring that applicants/borrowers pay 22, 24 or 26 percent of adjusted income for PITI. The effect will be to increase the amount paid by low-income homeowners. In most situations, the former requirement to pay 20 percent for PITI equated to 30 percent or more of income for total shelter costs (principal, interest, taxes, insurance, utilities and maintenance).
• RHS now emphasizes participation loans, those that are partly funded from another source -- in other words, loans that leverage other funds. Fees charged by participation lenders are now eligible loan purposes, provided they are the same charged by the lender to other applicants.
• Packaging fees charged by public and nonprofit packagers are now an eligible loan cost, up to limits established in the regulation.
• There is a new definition for a "minimum adequate site" -- essentially, this is a site that cannot be subdivided into two or more sites, and will have adequate water and wastewater facilities. When RHS issues new handbooks in late 1997, the site value will be limited to no more than 30 percent of total market value.
• Community land trust leaseholds and condominium ownership are now eligible sites, under certain conditions.
• A provision for mortgage insurance by tribes is suggested but not mandatory.
• Loans can include up to $280 over the market value of the property, to fund the appraisal fee and reimburse the applicant for participation loan appraisal fees.
• A variety of changes have been made in the way applications are processed. In some circumstances, Rural Development will process partial applications.
• The credit history standards have been modified slightly.
• Co-signers now must meet the same credit history standards as applicants, in addition to the requirement of having dependably available income.
• Rather than requiring approval of subdivisions, as it did formerly, Rural Development now approves only individual sites.
• Rural Development now escrows funds for taxes and insurance, and has created a centralized servicing system (the Dedicated Loan Origination and Servicing System, or DLOS) to handle escrow payments as well as other aspects of the program.

The Section 502 direct loan program changes are significant. This HAC guide does not describe all the details of all the changes. HAC strongly urges anyone using the program to obtain a copy of Part 3550 and the handbooks.

In order to qualify for an RHS Section 502 direct loan, an applicant must meet the following criteria.

• The applicant must be without decent, safe and sanitary housing.
• If the applicant is a farmer, he or she must be without decent, safe and sanitary housing for use by the person(s) for whom the Section 502 housing would be provided, which may be him or herself, tenants, sharecroppers, farm laborers, and/or farm managers. (In other words, on-farm housing is not subject to the personal occupancy requirement mentioned below. There are other differences for on-farm loans as well, not covered in detail in this guide.)
• The applicant must be unable to obtain decent housing with his or her own resources or through any other lender on reasonable terms. Co-owners of an undivided interest in the land must also meet this requirement. The applicant will need to include information with the application showing that he/she is not able to obtain credit elsewhere (a sample is included in Appendix 14-F of this guide).
• The applicant must be a citizen of the U.S., an alien (non-citizen) admitted for permanent residence, or an alien on indefinite parole (legally admitted for an indefinite period of time although not necessarily permanently). An alien applicant must present evidence such as Form I-151 or I-551, "Alien Registration Receipt Card" or I-94, "Immigrants on Indefinite Parole." (See Appendix 17.)
• The applicant must have an income at or below "very low-income," "low-income," or "38 year" adjusted income limits published by RHS for each county and Metropolitan Statistical Area. (Appendix 2 provides a sample of adjusted income limits.) As noted, individuals can obtain copies of the income limits for a particular county or MSA by contacting any Rural Development or RHS office or, if they are unable to provide the information, the Housing Assistance Council.
• The applicant must have an adequate, dependable income to meet family living expenses, taxes, insurance, maintenance and debt retirement on the housing loan; this is referred to as "feasibility." If the applicant’s income is insufficient, another party may co-sign. Feasibility is measured using "repayment income," defined as the gross income of all persons who will be parties to the note. RHS will consider income insufficient when PITI exceeds 29 percent of repayment income for those whose incomes are below 50 percent of median or 33 percent for those whose incomes are 50 to 80 percent of median, or when TD exceeds 41 percent of repayment income. Appendix 1 of this guide includes information about calculating income for feasibility.
• The applicant must have a credit history that indicates a reasonable ability and willingness to meet obligations as they become due. A record that includes bankruptcy, foreclosure, satisfied judgment or delinquent accounts does not automatically rule out the applicant. Those with such records should carefully examine Part 3550.53(h), which is set out in Section III.E, of this guide. RHS’s list of indicators of unacceptable credit is in Appendix 3 of this guide, and the agency’s Credit History Worksheet is in Appendix 4.
• The applicant must have the potential to occupy the home personally on a permanent basis. Housing financed through Section 502 direct loans is not intended for use as temporary housing for students or transient military personnel (certain exceptions can be made for military personnel; see 3550.53(c)).
• The applicant must have the legal capacity to incur obligations.

An applicant with an adjusted income below 50 percent of median, with PITI greater than 29 percent of repayment income, may be considered for a deferred mortgage loan. The Deferred Mortgage Payment program was not funded in FY 1996 or 1997, however.

An applicant with PITI or TD ratios that do not support eligibility will be rejected, but provided an opportunity to document a minimum of six months satisfactorily meeting similar related costs. Form 1944-3, "Budget and/or Financial Statement" (see Appendix 14-L) will be used to support approval for such applicants.

Applicants are deemed ineligible if they meet any of the following restrictions.

• The applicant has settled an RHS debt for less than full payment. Applicants whose failure to pay was due to circumstances beyond their control are the exception.
• The applicant is a corporation or cooperative association.
• The applicant intends to purchase land when he or she already owns land suitable for construction.
• The applicant is not likely to occupy the home on a permanent basis, such as military personnel or full time students (certain exceptions can be made for military personnel; see 3550.53(c)) .

E. Credit History

The following new credit history provision is reprinted verbatim from Part 3550.53(h):

(h) Credit qualifications. Applicants must be unable to secure the necessary credit from other sources on terms and conditions that the applicant could reasonably be expected to fulfill. Applicants must have a credit history that indicates reasonable ability and willingness to meet debt obligations. An applicant with an outstanding judgment obtained by the United States in a federal court, other than the United States Tax Court, is not eligible for a loan or grant from RHS.

(1) Indicators of unacceptable credit include:

(i) Incidents of more than 2 debt payments more than 30 days late within the last 12 months.

(ii) A foreclosure which has been completed within the last 36 months.

(iii) An outstanding Internal Revenue Service tax lien or any other outstanding tax liens with no satisfactory arrangement for payment.

(iv) A court-created or court-affirmed obligation or judgment caused by nonpayment that is currently outstanding or has been outstanding within the last 12 months, except for those excluded in paragraphs (h)(2)(i) and (h)(2)(ii) of this section.

(v) Two or more rent payments paid 30 or more days late within the last 2 years. If the applicant has experienced no other credit problems in the past 2 years, only 1 year of rent history will be evaluated. Rent payment history requirements may be waived if the RHS loan will reduce shelter costs significantly and contribute to an improved repayment ability.

(vi) Outstanding collection accounts with a record of irregular payment with no satisfactory arrangements for repayment, or collection accounts that were paid in full within the last 6 months.

(vii) Non-agency debts written off within the last 36 months unless paid in full at least 12 months ago.

(viii) Agency debts that were debt settled, or are being considered for debt settlement.

(ix) Delinquency on a federal debt.

(2) The following will not be considered indicators of unacceptable credit:

(i) A bankruptcy in which debts were discharged more than 36 months prior to the date of application or where an applicant successfully completed a bankruptcy debt restructuring plan and has demonstrated a willingness to meeting obligations when due for the 12 months prior to the date of application.

(ii) A judgment satisfied more than 12 months before the date of application.

(3) When an application is rejected because of unacceptable credit, the applicant will be informed of the reason and source of information.

See Appendices 3 and 4 of this guide for RHS’s list of indicators of unacceptable credit and the agency’s Credit History Worksheet.

Section 502 direct loans may be made to Rural Development or RHS employees who are otherwise eligible. Part 3550.9 details the safeguards utilized to avoid conflict of interest. Processing of such applications will be in accordance with Instruction 1900-D.

Section 502 direct loans may be used for the following purposes.

• To buy, build, rehabilitate, improve or relocate a dwelling and provide related facilities for use by the applicant as a permanent residence.
• To purchase and/or site a manufactured home that meets the conditions in 3550.73.
• To refinance debts under certain conditions (see 3550.52(b)), to avoid losing a home, or when needed in conjunction with necessary housing rehabilitation, except for manufactured homes.

A loan made under the first two categories above may be used for the following:

• Purchase a minimum adequate site (lot). RHS defines this as a lot that is not subdividable, nor costing more than 30 percent of the as-improved market value of the property.
• Pay a reasonable acquisition cost for a leasehold interest in a minimum adequate site.
• Provide adequate water supplies or sewage disposal facilities.
• Provide site preparation including grading, landscaping, walks, fences, and driveways.
• Purchase and install essential equipment including ranges, refrigerators, washers and dryers, when normally sold with dwellings in the area (they cannot be the primary purpose of the loan).
• Provide special design features or equipment for handicapped, disabled or elderly persons.
• Purchase and install approved energy saving measures, and approved furnaces or space heaters, which use common, economical and dependably available fuel.
• Pay reasonable connection fees for utilities.
• Provide storm cellars and similar protective structures.
• Pay lenders’ charges and fees in connection with participation loans.
• Pay the borrower’s share of social security taxes for labor hired by the borrower.
• Establish escrow accounts for payment of real estate taxes or property insurance premiums in authorized states.
• Pay part of the cost of constructing, remodeling, repairing or buying a domestic water or waste disposal system jointly owned and used by not more than 10 participants.
• Pay real estate taxes due and payable at initial loan closing (they cannot be the primary purpose of the loan).
• Pay expenses incidental to the loan, such as legal fees, tax monitoring services, credit reports, architectural and surveying services, incidental expenses related to financing manufactured homes, etc. as authorized by Section 3 in Chapter 9 of the Field Office Handbook.
• Finance the purchase of units in a planned unit development that has a homeowners’ association.
• Pay fees for the development and packaging of loan applications by tax-exempt nonprofit and public organizations. Packagers must:

1. comply with Attachment 3-A in the Agency’s handbook.
2. have reasonable charges, but may not exceed those allowable in Exhibit B to 1944-B (maximum $500 for a complete application packaging). State Directors may establish a state supplement to determine a "reasonable amount," which may not exceed the 1944-B amount.

RHS Section 502 direct loans may also be used to refinance debts to avoid the loss of a home and/or to eliminate financial hardship caused by the additional cost of making necessary repairs or rehabilitation. Refinancing is not authorized for manufactured homes, or for paying off an existing RHS debt in lieu of a transfer with assumption.

In order to refinance non-RHS debts, the original debt must have been made for a purpose eligible under Section 502; incurred prior to the date of application; and be a lien against the property or be an unsecured debt in combination with such a lien; and refinancing must be necessary to establish sound repayment. The applicant must be in danger of losing the home at an early date and delinquency must be due to unavoidable circumstances such as loss of income or illness. A loan of $5,000 or more needed to correct major deficiencies may be made, and combined with a loan to refinance an existing housing debt. (See RHS 3550.52(b) and (c).)

Dwellings with in-ground swimming pools and/or dwellings designed for income producing facilities or like purposes are prohibited from receiving Section 502 direct loans, regardless of whether they fit within the dollar caps.

Section 502 direct loans cannot be made:

• to pay for finder or referral fees;
• to pay for packaging RHS inventory property or where the loan packager is receiving a 1944-B grant, or for packaging by a mutual self-help housing grantee;
• to purchase or improve income-producing property;
• to finance manufactured homes not constructed and installed in accordance with Section 3 of Chapter 9 in the RHS handbook and 3550.73.

Financed dwellings must provide decent, safe and sanitary housing, and are legally required to be "modest." Homes are now considered "modest" if they meet the maximum loan limits used by HUD-FHA (RHS no longer uses square foot and amenity restrictions). The loan limit in April 1997 is $81,548. HUD-FHA publishes a listing of higher limits for high cost areas. Since these limits change frequently, HAC recommends obtaining them from HUD Area Offices or checking them at https://entp.hud.gov/cgi-bin/websql/idapp/html/hicostlook.hts on the Web.

State Directors are authorized to make exceptions, in individual cases, and with permission of the Administrator where documented housing cost exceeds the limits.

New dwellings must meet the construction requirements in Instruction 1924-A. They must also meet the Council of American Building Officials (CABO) model energy code (MEC), for thermal performance, indicated in Exhibit D to Instruction 1924-A.

Existing homes in the program must be inspected by RHS or a third party inspector to determine that:

• The unit is structurally sound, functionally adequate and in good repair (or will be made so with Section 502 direct loan funds).
• The unit meets the thermal standards for existing housing in Exhibit D to Instruction 1924-A.
• The unit has adequate electrical, heating, plumbing, water and wastewater disposal systems and is free of termites, etc.

Note: Inspections are not required on public water and waste disposal systems.

Dwellings repaired with Section 502 direct loan funds must be structurally sound, functionally adequate and be placed in good repair.

If the loan is $7,500 or less, the home may lack some features or equipment normally required by 1924-A. Such a dwelling must meet the applicant’s needs and provide decent, safe and sanitary housing.

Manufactured homes must meet the following basic conditions to receive a Section 502 direct loan. Also, loans for manufactured homes must meet the requirements of 3550.73 and Section 3 in Chapter 9 of the RHS handbook. They must:

• be constructed to the "Federal Manufactured Home Construction and Safety Standards" (FMHCSS);
• meet RHS site and thermal performance standards;
• be a new unit, or one in RHS inventory, or owned by a current RHS borrower.

Property financed with RHS Section 502 direct loan funds must:

• be located on an all-weather street, dedicated to and maintained by a public body, unless an exception is granted by the RHS National Office. Properties may have an extended driveway that has an all-weather surface and serves no more than two households. Instruction 1924-C applies. Note: RHS can approve housing on unpaved roads, etc., on a case-by-case basis where road maintenance is not a burden on the homeowner;
• not exceed a minimum adequate site, which is of such size that it cannot be subdivided into two or more adequate sites under existing local zoning ordinance;
• have an adequate water and wastewater disposal system (see Instruction 1924-C).

Applicants should also take note of special flood requirements (Instruction 426.2) for loans made to buy, build or repair dwellings in an area with flood or mudslide hazards. For example, the first floor of habitable space must be above the 100-year flood plain and the structure must be anchored to prevent flotation. In addition to examining the agency instruction, the applicant should check maps prepared by the Federal Emergency Management Administration (FEMA) to determine if the proposed site is in a designated flood area.

A loan can still be made when part of the property does not meet the requirements above when the defect cannot be cured at reasonable cost, no improvements using loan funds will be made on the defective portion, and no security value will be accorded that portion of the property.

After loan closing the applicant must have one of the following interests in the property:

• a full marketable title;
• possessory rights on an American Indian Reservation or state-owned land subject to the requirements in 3550.58(e) and 5.11 B.5 in the handbook;
• an undivided interest, if the co-owners meet specific requirements set out in 3550.58(d) and 5.11 B.4 in the handbook;
• a life estate with the right of possession, control and beneficial use, if the remainder meets specific requirements set out in Instruction 3350.58(c) and 5.11 B.3 in the handbook;
• a secure leasehold interest when the conditions in 3550.58(b) and 5.11 B.2 in the handbook are met. The unexpired term of the lease must be at least 50 years, though RHS will consider a lease for 25 years with an option to renew for another 25 years.

See Appendix 20 for supplemental requirements for Section 502 direct loans on condominiums and community land trusts (Chapter 9 Section 2 in the handbook).

The amount of loan a family can obtain is governed by three factors: (1) repayment ability (see Section III.O, below), (2) appraised value of the specific property, and (3) the modest dwelling limits (see Section III.K). Loans may not exceed development cost or appraised value, whichever is lower (except that the $280 cost for an appraisal may be added to the development cost or appraised value when it will be included in the loan). Appraised value is usually determined by examining data on comparable sales and replacement cost. Rural Development is authorized to use cost appraisals -- that is, to base the estimate of value on the actual cost of the home -- in remote rural areas and on Indian reservations, where comparable sales data are lacking.

The term for housing except manufactured homes is 33 years, or 38 years to households with adjusted incomes at or below 60 percent of area median and who need the extra term to meet qualification requirements for repayment ability. The term for manufactured homes is 30 years.

Loans are made at "note rate," formerly called "market rate" (7.25 percent in March 1997). At the applicant’s request, the interest rate will be the lower of the rates in effect at the time of loan approval or loan closing. Eligible low-income families may obtain loans subsidized below market rate to as low as 1 percent. The actual interest rate an eligible family pays is based on their adjusted income as a percentage of area median income (see Table 1) and subsidized by "payment assistance." Note: Loans made prior to October 1, 1995 may continue to receive interest credit assistance, the regulations for which are found in Instructions 1951 and 1951-I.

There is no down payment percentage requirement. Applicants make down payments only when they have sufficient assets, or when the maximum loan is less than total costs. Many applicants make no down payment.

The method for computing adjusted family income is explained in Appendix 1 of this guide.

Additional requirements for obtaining payment assistance are as follows.

• The family’s net worth normally should not exceed $7,500 ($10,000 for the elderly). Net worth calculations exclude cash used to reduce the loan amount. Exceptions may be made for farmers and others whose assets are needed to produce income and for documented extenuating circumstances.
• Assets above the $7,500 or $10,000 cited are computed for income (using applicable rates of return) and added to the family’s total income.
• The income of all adults living in the household must be counted, although only the income of those who will be parties to the note are included to determine feasibility.

The family’s promissory note is executed at the note rate and a one-year agreement for payment assistance may be entered into, using Form 1944-14, "Payment Assistance/Deferred Mortgage Assistance Agreement," which is in Appendix 5 of this guide. The older Form 1944-6, "Interest Credit Agreement," is in Appendix 6.

Income and payment assistance must be renewed annually; then the subsidy may increase, decrease or be eliminated depending on the family situation. Rural Development officials review family circumstances prior to expiration of the contract. Section 3550.157 describes the requirements and processes for renewal. (See Appendix 22.)

A family whose income increases to the point where they can refinance the loan through normal lending channels (from a commercial lender or a cooperative) is expected to do so. However, RHS does not schedule "graduation reviews" of Section 502 direct loan borrowers until their loans are at least five years old.

^* or promissory note rate, whichever is less.

Borrower interest rates are as shown in Table 1, except that a minimum payment for PITI is required, as shown in Table 2. In many, or most, instances this will result in a higher effective, or actual, interest rate.

The payment assistance interest rate may be further reduced by 1 percent (to no lower than 1 percent) in high cost areas when the Rural Development State Director submits evidence that there is no lower cost housing that will reduce subsidy need.

The minimum mortgage payment will be the greater of two possibilities: either the mortgage payment at the applicable interest rate (with payment assistance), or the percent of adjusted income listed in Table 2 (but not more than the payment would be at the promissory note rate of interest).

Interest subsidy to borrowers in the form of payment assistance is subject to recapture by RHS when a borrower ceases to occupy a home or sells it. For details, see 3550.162 and Chapter 2 Section 5 in the centralized servicing center handbook. All borrowers who receive payment assistance credit must sign Form 3550-12, a "Subsidy Repayment Agreement." Appendix 10-A to this guide (Attachment 2-A in the agency handbook #1) is a "Final Payoff Worksheet" that includes a formula by which recapture is calculated when dwellings are sold or loans transferred.

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