Discovering You've Got A Bad Loan - Don't Panic!

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No, this isn't the Hitchhiker's Guide to the Galaxy

But having written half a dozen articles roundly critical of the way in which these loans are generally sold, it's not unusual for me to get e-mail like this one:


Hi, Dan:

Okay, I'm absolutely PANICKED after reading your article on negative amortization loans as I have one! I thought it was an "option ARM" and that my entrusted Realtor's entrusted loan officer was wise beyond his years in his financial advice. He was semi-retired, wealthy, and said that this was the only loan he'd ever use for his own substantial real estate portfolio. I even reassured a good friend of mine who is economically savvy not to worry as it wasn't a negative amortization loan!

I purchased December of 2006. The home I was going to purchase was appraised at $780,000 eight months prior to my purchasing it for $570,000; I put $100,000 down, had a good credit score, but the stickler was my monthly income. I knew I would make a substantial bonus and raise June of 2007, so DELETED sold me on the Option ARM. The bonus was one third what I expected ($2700) and my raise was only 4% rather than 7%.

My question is this - what do I do now? Is the loan okay as long as I pay the principal and interest amount of payment? I've only been paying the minimum, but could swing it by squeezing. It's a high rate - 7.5%. And I would have a prepayment penalty if I refinanced. I'm a single mom, 46, with two kids and annual earnings of $64,000. I have $50k in savings.

Yes, I am that poor sap you speak of in your article, completely trusting, desperate for my dream house, blind sided and now stuck. Any advice would be helpful! Thanks so much...

First rule of getting out of holes: Stop digging! Pay at least the interest every month!

Now, let's look at your situation. You owe $470,000 on a $570,000 property. The real payment on that is $3286.30 per month, as opposed to a "nominal payment" of $1511.70 at 1%. Actually, by my calculations, you owe about $483,000 now and will owe more than $527,000 by the time your pre-payment penalty expires, if you make just the minimum payment.

Now, let's consider what's actually available out there. When I originally wrote this, one rate sheet picked at random showed a 30 year fixed rate loan at 6.375% costing half a point retail. Let's figure out if you're likely to qualify for that. $64,000 divided by 12 is $5333 per month. 45% of that is $2400. Both of those are potentially important figures. Let's assume your value is still $570k, so 80% of that is $456,000. Paying the penalty and costs of the loan via rolling it into your balance, I get that you'd be left with a balance of between about $507,000. The payment on the first mortgage would be $2845, which is more than you can apparently afford right there. On the other hand, many single parents have alimony and or child support that can be used if they so desire that they don't include in their income.

At this update, 30 year fixed rate loans can be had for a considerably lower rate of 4 percent or under, depending upon how much you can afford to pay in costs - the lowest rates since my grandparents first bought a house. That yields a payment of $2245. The bad news is that values have declined almost everywhere, so it's likely that you cannot refinance due to that. It's possible that the 125% loan to value ratio HARP loans may help, but Fannie and Freddie don't generally hold negative amortization loans. But that's the lowest payment we can figure on ever being able to refinance you into.

I'm trying not to build fairy castles in the air. From the information presented, you can not afford the loan by standard measurements. The flip side of that is you don't have to qualify for the loan you already have, and you say that you actually can afford to keep making at least the interest only payments. As long as you do so, you're not digging yourself in any deeper. If you can actually afford to make at least the interest only payment, there is no reason to panic.

Getting yourself that 6.375% fixed rate loan would have cost you roughly $24,000 - $18000 plus in pre-payment penalties, about $6000 in loan costs. To save 1.125 percent originally, about 3% now, albeit fixing the loan. Your current cost of interest at the $483,000 balance is $36,225 per year. Cost of interest after refinancing: $32,321 per year. Interest savings $3904 per year. Your break even on this is about 6 years, 2 months - if you could qualify, which you don't appear to. Even the 4 % loan has a breakeven of about 20 months, which is good, but that's if you can do it, and I'm not at all certain you qualify.

If you make the payments for the next 27 months until the penalty expires, that higher interest rate will have cost you roughly $8900, offset to a certain amount by lowered income taxes. But here's where everyone's getting ulcers right now: Rates and the costs of getting them aren't set in stone - they're all "right now today" good only until tomorrow morning at most. Not that I expect tomorrow's rates to be much different, but I won't know until I see them. The cold hard fact is that only some kind of deity might know at this point what the rates are going to be like when your prepayment penalty expires. I certainly don't, and neither does any other human agency with which I'm familiar. There's a lot of estimates out there, but nobody knows. Furthermore, with a negative amortization loan, you don't know what your rate will be a year from now, as most of these abominations adjust month to month. So no matter which way you choose, stay or refinance, there are pitfalls, and there's no way to be certain of the right decision except in retrospect - when your penalty expires - at which point today's rates will no longer be available.

In your situation, I'd probably sit tight. As bad as it is, the alternatives all look worse. I wouldn't refinance into a loan that took me six years to break even on the costs of, and I doubt whether anyone else should, either. Alternatively, keeping in mind the fourth solution to Getting Out of Paying Pre-Payment Penalties, some people might want to see if their current lender will refinance them into a thirty year fixed without charging the penalty, although in your case that does not apparently help because you don't appear to qualify.

But your situation is not the same as the person who is only looking at a negative amortization loan. Like it or not, you've already done it. That narrows your choices to "What do I do from here?"

The first thing to set in motion is a consultation with your lawyer. I'm not a lawyer, but I've been reading about the courts ordering these abominations rescinded, brokers paying damages, etcetera. The wheels of justice grind slowly, but that means the sooner you start them grinding, the sooner they get there. It seems likely to me that there were some misrepresentations and gross negligence somewhere along the line there.

My local market colors my perceptions, and what may be appropriate for San Diego may not be appropriate elsewhere, but as long as you can make at least the interest only payment, and make it long enough such that your prepayment penalty expires, I think you're likely to see a profit on the sale of the property then, provided things go as I think they will. It might be rough in the mean time, and preliminary numbers indicate that you're not likely to be able to afford to keep the property then, but panicking rarely does any good. There's nothing you can do at this point that does not have significant and costly risks. But from what you've sketched out, holding on until the penalty expires seems to be the least risky, most attractive alternative to me.

A couple of other options: A short sale or a loan modification. The first gets you out of the situation by accepting the immediate damage when there may not be any reason to do so; the second keeps you in the property and buys you time, but nobody knows for certain whether most market will recover enough in the bought time so that it will turn out better than accepting the damage in the first place. Every situation, in every market, is different. I can't give a universal answer as to what's likely to be best because there isn't one.

Caveat Emptor

Original article here

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1 Comments

Imee said:

Wow, panicky much? That guy needs to relax a bit--it's not the end of the world for him. Stuff out there like loan modification can really help him. And I like your very first advice: to get out of a hole, stop digging!

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About this Entry

This page contains a single entry by Dan Melson published on March 13, 2020 7:00 AM.

Option ARM and Pick a Pay - Negative Amortization Loans was the previous entry in this blog.

Discovering an Unpermitted Addition After You Buy is the next entry in this blog.

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