Games Lenders Play, Part V - Selling a Low Payment

Hello, I've been reading your website for awhile now, and have found it very helpful as I'm learning to navigate this crazy loan process! I had a question I was wondering if you could write about/answer.

We currently have a mortgage and a secondary line of credit on our condo (we didn't have a down payment, so we had to do it like this). We have been here one year, and the home values in our complex have gone up about $70,000 - $100,000 in that time period. (We live in Southern California.)

Recently we got a notice in the mail telling us that they can reduce our monthly payments ("by as much as $1,500!)" if we refinance with them. Frankly, it sounds way too good to be true, and I have a feeling they're not really telling us the truth in this notice. But it did raise a question in my mind: would it be wise to attempt to refinance, in the hopes that our higher valued home would allow us to refinance with only one mortgage, instead of two? I'm not even sure if that's possible...I'm having a hard time understanding how refinancing works. I should mention that we are currently in an interest-only loan, with no prepayment penalties. Our first loan is 4.75%, and our secondary line of credit is 6.375%.

Any help would be greatly appreciated.

Your feelings that they aren't telling the whole truth are justified.

Refinancing is the process of replacing one loan for another on the same piece of property. The idea is that the terms of the new loan are more advantageous to you than the terms of the existing loan. There are three main issues that you need to be aware of, however. The first is that there are always costs associated with doing the new loan. The second is that there may be a prepayment penalty to get out of the existing loan. The third is to make certain the terms you are moving to are enough better, for your purposes, than the existing terms to justify the costs associated with the first and second issues.

You state that you're in California, which is where I work. Realistic costs of doing the loan are about $3500 with everything that is necessary. This doesn't include origination, to pay the loan provider for the work they do on the loan, or discount, to pay for a rate the lender might otherwise not offer. I explain those costs, the difference between them, and many of the games lenders play in my article on Good Faith Estimate, part I. There will also be the possibility of you having to come up with some prepaid items, explained in Good Faith Estimate Part II.

Note that not every loan has points. I actually think that, given most client's refinancing habits, it's usually better to pay for a loan's cost, and the loan provider's compensation, through Yield Spread rather than out of pocket or adding it to the mortgage balance. Yield spread can be thought of as negative discount points, and discount points can be thought of as negative yield spread. Discount points are a fee charged by the lender to give you a rate lower than you would otherwise have gotten. Yield Spread is a premium paid by the lender for accepting a rate higher that you could otherwise have gotten, and can be used to pay the loan provider and/or loan costs. Each situation must be considered upon its own merits, of course, but most people don't keep loans long enough to recover the higher costs required to buy the rate down. There is always a tradeoff between rate and cost of a real estate loan

Now, let's take a look at your specific situation. Your current first mortgage is at 4.75% interest only. You don't mention what sort of loan this is (updated via email: it's a 5/1 Interest Only ARM), but there is no such thing as a thirty year fixed rate interest only loan. At most they are interest only for a certain period, usually five years, before they begin to amortize over the remaining twenty-five. On the other hand, you said you bought one year ago, and that rate didn't exist on thirty year fixed rate loans then and it doesn't exist now. (Via later email, the first mortgage is a 5/1 Interest Only ARM). Your second loan is a line of credit at 6.375. I'm also guessing that either you, or the person who sold to you, paid a good chunk of change in discount points to buy the rate down, and I'm hoping it wasn't you.

There's no way that this is a loan that's going to serve you indefinitely at that rate. When I first wrote this, there wasn't a 30 year fixed rate loan comparable to that available, with any lender I know of, no matter how many points you paid (at this update, it's getting dicey again). So what you have is at most a hybrid ARM (Yes, 5/1 Interest Only). No worries; I love hybrid ARMs. They are the only loans I consider for my own property in most circumstances. But they do have one weakness. There is likely to come a time when it is in your best interest to refinance, because after the fixed period the rate on them adjusts every so often, based upon a stated index plus a contractual margin, and the sum of these two is likely to be significantly higher than the rate for refinancing into another hybrid ARM.

Now what are they offering you? They're talking about cutting your payment by $1500 or more. But there just aren't any rates that much lower than yours available. Nothing even vaguely close. So how are they going to cut your payment?

The only hypothesis I can come up with that is not contradicted by available evidence is that they are offering you a loan with a negative amortization payment. I explain those in these articles:

Option ARM and Pick a Pay - Negative Amortization Loans and Negative Amortization Loans - More Unfortunate Details

There is more information on marketing games with this loan type in these articles: Games Lenders Play (Part II) and Games Lenders Play (Part IV).

Finally, there are a few more issues that may not be relevant to everyone in these articles: Regulators Toughen Negative Amortization Loans? and Negative Amortization Loan Issues on Investment Property

One thing to understand is that when lenders are sending out advertising, they are not looking for Truth, Justice, and the American Way. They're looking to get paid for doing a loan, and most lenders will do anything to get you to call, and then to get you start a loan. The creative fiction on many Good Faith Estimates and Mortgage Loan Disclosure Statements is only the start of this. If you find a loan provider who will pass up loans that they could otherwise talk you into because it doesn't put you into a better situation, keep their contact information in a very safe place, because you've found a treasure more valuable than anything Indiana Jones ever discovered. A valuable treasure that you can and should nonetheless share with friends, family, and anybody you come into contact with because you want them to stay in business for the next time you need them. Most lenders and loan providers could care less if they are killing you financially - what they care about is that they get paid. A negative amortization loan pays between three and four points of yield spread. Assuming your loan is $300,000, they would be paid between $9000 and $12000 not counting any other fees they charge you for putting you into a loan where the real rate is at least 1.5 percent higher than the rate you're paying now, and month to month variable. Warms the cockles of your heart, right? Didn't think so.

In short, they're offering you a teaser no better than a Nigerian 419 scam for most people in your situation. My advice is not to do anything unless you're coming up on the end of your fixed period, in which case you need to talk with someone else, who might have your interests somewhere closer to their heart than the Andromeda Galaxy.

Caveat Emptor

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