Refinancing When You Owe More Than The Home Is Worth

I've been looking around for an answer to this but my searches haven't returned anything useful.

Say you buy a house and with that house you finance in a pool. House was $210,000 and pool is $40k. $250k mortgage. Okay, so two years later (the average!) you decided to refinance. Especially since you didn't get a good deal in the first place because you wanted a new house and to get the incentive you decided it was okay to finance with the company the builder tells you to finance with. Anyway, in those two years the housing market slumps a bit but for the most part after that time your house doesn't loose value. At the same time, the pool does not add value to your house. Comps in the area put your house at $220,000 but you still owe $245k. Is it possible to refinance? Was all the refinance hype only because the markets kept going up? Is this the reason why people who got an bad loan, maybe thinking they could refinance, are going to loose their house because no one will refi a house that isn't worth more than it was when you bought it?

No, the refinancing craze was only partially because values kept going up. Rates kept going down as well. What this combination meant was that not only were better rates coming along all of the time, but that people who were stretching to the utter limit for 100% financing could refinance into more favorable loans as their equity picture improved. If you bought for $180,000, and comparable properties are selling for $360,000 now, that's 50% equity even if you didn't have a down payment. So people who bought for $180,000 were refinancing into single loans without PMI once values hit $225,000. Let's use the rates when I originally wrote this as a comparison. Instead of a first for $144,000 at 6.25% and a second for $36,000 at 9%, with payments of $886.64 and $289.67, even if the rates are absolutely the same and you refinance after 18 months for the $177,000 you owe (paying closing costs out of pocket), when your appraisal says $225,000, that's one loan at 6.25%, with a payment of $1089.82. This cuts $86.49 off the monthly payment, which is how most people think, and cuts your monthly cost of interest by $81, which is how smarter people think. It probably isn't worth refinancing at anything like par for such relatively small savings, but rates were dropping at the same time. This led a lot of unethical agents and loan officers to lead a lot of clients down the primrose path by saying things like "real estate always increases in value," and "You can hold on for a year, right? You'll have equity and we'll be able to refinance you." Lots of folks have a tendency to assume trends of the moment are going to continue, and it's amazing how consistently they get burned by this assumption.

A lot of what I wrote for the original article wasn't true for a while, but is now the way things are again. For a while, there were two new twists: a cluster of special programs from Fannie Mae and Freddie Mac allowing refinancing up to 125% of value (now ended) for loans originally done "A paper" and Mortgage Loan Modification for loans that were originally sub-prime or variable rate, basically renegotiating your existing loan. As a note, the so-called "minor" modifications of forbearance and displacing any missed payments to the end of the loan have over a forty percent recurrence of default within about a year. In plain English, unless your situation has changed permanently for the better (e.g. found a better job, or recovered your previous one) or you have fully worked through the one time problem that got you into trouble (e.g. temporary disability that is now in the past), all you're likely to be doing is delaying the inevitable. Most people need at least an interest rate modification that puts them at a bearable debt to income ratio. Better the bank do this than lose money through a default. On the other hand, many people want their principal modified, which is not likely to happen - one case in sixty are the statistics I'm hearing, all of them having to do with the "killer Ds" of death, disability and divorce. Rather than reduce the principal owed, the bank might as well lose the money they'll lose by foreclosing. At least that way, they know their losses are at an end.

Rates as I write the update are the lowest they have ever been, but prior to that tumble due to the financial meltdown, had been broadly rising for a while. People don't like refinancing when it will raise their rates, and quite often, they can't afford to refinance, even if they have to, if the payment is going to go up. This has caused many lenders to get desperate, and is certainly one of the reasons for the way the negative amortization loan had been pushed. Loan Officers don't get paid unless they are originating new loans this month, and negative amortization loans look wonderful on the surface, when all you know about is the minimum payment. (I've also published an article debunking the Weighted Average Cost of Capital scam some lenders are also using to persuade people to refinance out of low rates into high ones).

If your equity situation has deteriorated due to decline in property value, however, it can be a real problem. Outside of the two alternatives I talk about above, both of which were temporary, lenders don't want to risk money in situations where Loan to Value ratio doesn't support them getting all of their money back if you default. The problems created by declining value are far deeper than the benefits that arise when prices are rising rapidly. When the loans total $500,000 and the property is only worth $420,000, that's a problem. That's a real problem. Lenders do not want to lend more than a property is worth. The highest financing regularly available is 100% of value, even when the market was going gonzo with Make Believe Loans and 90% is the highest refinance I'm seeing now. The situation I have just illustrated is a 120% financing situation. On a straight refinance, that's not going to happen. Period.

Now before anyone goes too far off the deep end, being upside down is no problem at all if you don't need to sell or refinance. You just keep making the payments and everything is fine. It may be possible that real estate won't eventually return to the pattern of appreciation we've come to expect these last hundred odd years, but that's not the way the smart money is betting. You will have equity again. I was upside down myself for a little while after I bought in 1991. It was no big deal. I just kept making those payments, and the prices came back. By the time I had a reason to refinance, I was back at 80% loan to value. For those people who have sustainable loans, being upside-down is a non-event.

Where it becomes a serious problem is when you've got an unsustainable loan. Whether it's negative amortization, or something somewhat less hazardous to your financial future such as a 2/28 or something short term interest only, you're looking at a time when refinancing is going to be pretty much mandatory. If you could have afforded the payment it's going to adjust to, you could have had a sustainable loan. But people have a tendency to stretch too far and buy more of a property than they can really afford.

There used to be more options and potential options if you needed to refinance while you're upside down. The one involving the least amount of mental effort was and is to come up with the difference in cash. Most people don't want to do this even if they have it, but it's an option. Actually, it's a pretty good option if you have that cash.

The second option for refinancing was a 125% equity loan piggybacked onto an 80% first loan. The first problem was that the terms on these were ugly. It's not likely to cut your interest rate or your payment, and they are all full recourse loans, where purchase money loans are mostly non-recourse. This doesn't work for a lot of people, not the least of the reasons for which is that the lenders that were offering these when prices were increasing rapidly have largely withdrawn them from the market now that prices have been decreasing. 125% loans were a function of a rapidly increasing market. I can't remember the last time I had a wholesaler offer me one. Still, if you're in trouble it can be on option worth asking your current lender about - the worst that can happen is they tell you those are no longer available. The situation is this: If you can't make your payment now and go into default, they lose money. If you can afford the payments on the 80/125 combo loan, and don't go into default, they won't lose money, not to mention they potentially move you from a non-recourse purchase money loan to a full recourse refinance, a very good thing from the lender's viewpoint. Easier to do a loan modification, but this option might be available.

In some circumstances, it is conceivable if highly unlikely that the holder of a second trust deed may agree to subordinate their loan to a new first. They're not going to agree if your payment or the loan amount on the new first increases, so you're going to have to pay all closing costs out of pocket. The amount on the new first is also obviously going to be above 80% of value, so you're likely to have PMI on it, but if it gets you from a 2/28 that's adjusted to 9% to a 30 year fixed at 7, it's probably worth doing. If the second goes from sitting behind a $410,000 first at 9% to sitting behind a $410,000 thirty year fixed at 7%, it has become more likely that second loan is going to be repaid in full, where if you default on the first trust deed that second is likely to be completely wiped out. Obviously, the holder of the second would rather not do this - they'd rather be refinanced out of their losing position. But nobody is going to come along and rescue them from their bad decision making if the property is only worth $420,000 and you owe $495,000. If you need to refinance your first in order not to lose the property, the holder of the second can either agree to subordinate, step up to the line themselves and be on the hook for the full amount, or be wiped out completely when the first forecloses. The options for them might all be bad, but subordination is the least bad.

The next option is the worst of all possible worlds: default and foreclosure. This is something you want to avoid if there's any way around it. Slightly better is a Deed in Lieu of Foreclosure, where you sign the title of the property over to the lender. Lenders may or may not allow this if you're upside down, though. Typically, they want to have at least a little bit of theoretical equity in order to agree to a Deed in Lieu. On the other hand, if they avoid the money that the whole default and foreclosure process costs, they may agree. A Deed in Lieu does hit your ability to get a future real estate loan, although it's not nearly so bad of a hit to that or your general credit as a foreclosure, particularly if you can see it coming and take action before you have a spate of late payments. Most folks won't.

Finally, if you need to refinance and can't, you can get yourself a good listing agent and execute a sale subject to a short payoff. This has potential consequences for your financial situation that start at 1099 love notes and might include a deficiency judgment. This is definitely not something to try "For Sale By Owner" or even with a discount listing agent. You're going to need an on the ball full service agent in order to make it happen, because the lender isn't going to listen to you as the owner, and a discounter is unlikely to be willing and able to devote the time necessary to get the lender to approve it. The big advantage to this is that it doesn't hit your credit nearly so badly as a foreclosure, perhaps less even than Deed in Lieu, and if you want another real estate loan sometime in the next decade, you would probably rather do a short sale than go through foreclosure.

None of these situations where you need to refinance a mortgage you can no longer afford, but owe more than the property is worth, is a good situation to be in. But if you take action before you've got late payments or a notice of default, let alone a notice of trustee's sale, you can get away surprisingly little damaged. The worst thing that can happen, will happen if you don't do something to fix an untenable situation before it gets that far.

Caveat Emptor

Original article here