Mortgages: February 2006 Archives

I got a search result for how to get out of mortgage pre-payment penalties, although I've never really dealt with the issue.



Prepayment penalties on real estate loans are something some people, often with less than stellar credit, accept, either in order to either get their mortgage rate lowered or because they don't know any better, or because they didn't ask, were lied to, didn't stick to their guns, didn't protect themselves from unethical loan providers, or any of a dozen other reasons people end up with them. Standard prepayment penalties are six months interest on the outstanding balance, but many companies with "twenty percent" allowances only require eighty percent of that.



Prepayment penalties come in two major varieties, "hard" and "soft", with the vast majority being hard prepayment penalties. Hard means that if the prepayment happens for any reason, you will pay the prepayment penalty. Soft means that if the reason you pay early is because you actually sold the property, there will be no prepayment penalty due.



Prepayment penalties can be further sorted into "first dollar" and "twenty percent". Either can be in the contract for either a soft or hard prepay, but first dollar prepays are uncommon for soft prepayment penalties. If you have a "first dollar" prepayment penalty and you pay one extra dollar above your regular payment, you will be assessed the penalty. These are most common with Negative Amortization loans, and are somewhere between ten and twenty percent of all prepayment penalties, judging from my experience with the problems people bring to me. A so-called "twenty percent" penalty allows you to pay up to twenty percent of the loan balance in any given year without triggering a penalty.



Common terms for prepayment penalties are one, two, three, and five years, although I have seen ten. Since the median time between refinancings is less than two years, and ninety-five percent of everyone has refinanced or sold within five years, it's very much like a hidden fee to the bank in most cases, one that will not apprear on your loan costs summary of the HUD 1, and yet since most people who accept them end up paying them, I would certainly advocate a dollar value being mandatory if there is a prepayment penalty associated with a loan. This is not to say that they are never beneficial or never necessary, but in a large majority of all cases they are simply the result of a loan provider who wants to make more money, who hides the prepayment penalty until it is too late to avoid. They want to raise your cost of going elsewhere so that you will keep the loan at least a minimum amount of time. No matter whether they are a broker or an actual lender, this means they make more money when they do or sell your loan. A lot more money. A two year prepayment penalty is worth about four points (four percent of loan amount), more or less, on the secondary market. Longer penalties are more.



Now, the answer to the question. I know of precisely four ways to get out of paying a prepayment penalty, and three of them are trivially easy to describe.



The first is not accepting a prepayment penalty in the first place. No matter how bad your credit is, you do have this option. Your interest rate will be higher, or they will charge you more for the loan, but you won't have a prepayment penalty. In general, my experience has been that the higher loan rate is worth not having a prepayment penalty. If your loan amount is $300,000 and your rate is 6 percent, your prepayment penalty will be about $9000. Nor is it, in general, deductible if you have to pay it. In this case, if you had to accept a rate one full percent higher to avoid a three year prepayment penalty, you'd be breaking even.



The second is equally trivial. Wait to sell or refinance until the prepayment penalty has expired. Let's say your loan amount is that same $300,000, and that you have a year and a half to go. In order to be worth refinancing, you would have to save two full percent on your new rate, and that's not counting anything you pay, costwise, to get the new loan.



The third way involves something not under the personal control of the borrower, in that it requires legal intervention for perceived legal wrongs done you, the borrower. It has happened in the past that courts have ordered prepayment penalties waived in such cases. It has also happened that companies have agreed to waive a prepayment penalty as part of a settlement. Both events, however, are quite rare, and require you to have gone through something bad enough to merit this. The one I'm personally familiar with involved the lender playing games with payments that were being made on time to the point where they actually marked the people as being in default. I got them to a lawyer specialist and did exactly what that lawyer told me to, when he told me to, and nothing else. They went through something worse than purgatory at the hands of this lender and ended up paying thousands of dollars in attorney's fees, which they didn't recover, but at least they kept their home. Getting out of a prepayment penalty this way is a cure that's worse than the disease.



The fourth and final way to avoid a prepayment penalty is to refinance with the same company. Most (although not all) lenders will agree to swap the old prepayment penalty for a new one if you do your refinance with them. This does not mean that if you've got eighteen months to go on a three year prepayment penalty, you've got eighteen months under the new loan. This means you've got a whole new three year prepayment penalty. It's like putting a problem off for another day, allowing it to fester. Far superior in most cases to just wait until the penalty is gone, because in the vast majority of all these cases your balance under the replacement loan will be significantly higher, and thus, the amount at risk due to a prepayment penalty will be more.



There you have them. The four ways to avoid paying a prepayment penalty. None of them is exactly wonderful, I know. But consider that the borrower agrees to the penalty when they accept the loan. It's part of the terms, and they do have alternative loans without prepayment penalties. It's just that most people jump to conclusions that this is a loan they want as soon as they hear the payment, and, if they're more cautious than average, the interest rate. Which is why you should be one of those who asks every potential loan provider about them, before you are stuck with one. An ounce of prevention is worth many pounds of cure.



Caveat Emptor.



UPDATE: I get all sorts of questions about other ways to avoid pre-payment penalties. These range from good, such as "What if my spouse dies?" to understandable, such as "What if my employer transfers me?" to the ridiculous: "What if my cat has kittens?" What they have in common is that in none of those cases will the prepayment penalty be waived. Bottom line: Accepting a pre-payment penalty is a risk you decided to accept, and without the pre-payment penalty, you would not have gotten as good a rate. You can always contact the lender and ask if they'll waive it under the circumstances, but the answer is going to be "no", and for the same reason that your auto insurance company won't pay the repair bill if you crash after your policy expires. You decided to assume the risk of pre-payment yourself, and you've been putting money in your pocket because of it. When that bill comes due, don't expect someone else to pay it for you when you have been putting money in your pocket because you said you would pay it if it happened. As I said above, an ounce of prevention is worth many pounds of cure.

UPDATED here

"Should People in their sixties take out a mortgage?"

The short answer is "Not if you don't have to." Now if I suddenly vanish, the explanation will be that the loan industry put a contract out on me.

Success in loans, and sales in general, is often attributable to selling people stuff they don't need. If you don't sell something, you don't eat. Getting people to call or stop by is expensive. The traditional idea of sales is that you have to make a sale at every opportunity, whether it really makes sense for the client or not.

The various tricks of selling a mortgage to retired folks is a case in point. "It's a cushion," "It's there in case you need it," and all sorts of other stuff to that effect. Combine this with the "If you wait until you need it, you won't qualify!" and most folks who don't know any better will cave in and apply.

This is exacerbated by the fact that most people seem to want to stay in the same home they raised their family in. This is very understandable, emotionally, and often the worst thing you can do financially.

Let's consider the typical three or four bedroom house with a yard, and the retired couple. It becomes more and more difficult, physically, for them to do the required routine cleaning, and even more difficult to do the maintenance and repairs that any home needs from time to time. Sometimes the kids are close enough and willing to help, sometimes they aren't. If their finances are tight in the first place, they get tighter and tighter over time.

Into this environment comes the guy with a Reverse Annuity Mortgage (RAM) to sell. This is a special kind of mortgage, with a special protection for the homeowner (here in California, and in many other states as well) that they cannot foreclose in your lifetime. You cannot be forced out. Well, what if you're sixty-five and live to 100, as a far larger proportion of today's 65 year olds will? That's thirty-five years they are locking this money up for, and there is always the possibility that by the time they consider the cost of selling, etcetera, there will be no equity.

Lending is a risk based business, and that kind of lending carries its own risks. Who pays for the risk to the lender? You do. Especially as opposed to the typical loan where half have refinanced in two years and ninety-five percent in five, this is a long term loan they are being exposed to. Yes, the recipient could get cancer and die in a few years, but they could well survive that. The lender has no way of knowing what the interest rate environment for the money will be in a few years. So either the rate the clients get is variable, or the clients pay a higher rate to have a fixed interest rate.

Once you start taking money out of the RAM, it starts earning interest. Since in the most common forms you are typically not making payments, it accrues interest. If you are making payments, it makes your cash flow even tighter, and you need to take more money. In either case, your balance is increasing, faster and faster with time, until you hit the limit, at which point you can no longer get additional money. This often happens surprisingly quickly, as you have the power of compound interest working against you. This all but guarantees that the family will have to sell the home, often for less than they could have gotten had they the luxury of a longer sale time. Furthermore, if keeping the home in the family is something you would like, a Reverse Annuity Mortgage is almost certain to torpedo the hope.

Contrast this with the swap down option. Suppose instead that adult children buy a small place suited to the parents needs such as a condominium, and the parents live there, while they live in the parents home. This minimizes cleaning, upkeep, and maintenance that the parents need done.

If this won't work, another option is selling the home and buying something smaller. Remember, a RAM will almost certainly cause the family to lose the home anyway. You get more mileage out of cashing in the equity by selling, and investing the equity, than you will from borrowing against the equity. Instead of working against you, compound interest is on your side. Most states have laws preserving property tax basis if that's something that is advantageous.

Let's say that with a $500,000 home, moving down to a $200,000 condo. Net of costs, you net at least $250,000 to invest, and let's say you do so at 7 percent, well below a well invested portfolio. This gets you $17500 per year, or about $1460 per month, indefinitely, and you keep both the condo and the $250,000. Contrast this with taking the $1460 per month out of your equity. Even if you can find a RAM at the same 7 percent, the entire equity is gone out of your home in a little over fifteen years, and that's without including initial loan charges.

Nobody can make you do this, and there are many reasons why you might not want to. But looking at it from a strictly financial viewpoint, it's hard to find the justification for a Reverse Annuity Mortgage.

As a resource, here's the AARP page on reverse mortgages, and here's another page with some good general information.

Caveat Emptor

This sentence is a textbook illustration of the most effective way to lie. Tell the truth, but not all of it. Not that I'm trying to coach habitual liars, but I am going to deconstruct this astoundingly dishonest claim that I keep encountering. It's mostly used by less ethical loan officers trying to persuade someone not to shop around.



At the bottom-most level, all mortgage money does come from basically the same place. It's all investors looking for a return on their money in a historically well secured market where they are somewhat protected from taking a loss.



What happens to it after that, and whose hands it goes through, matters a lot. Just like saying all water comes from the ocean doesn't mean it's all drinkable, just because all mortgage money comes from investors doesn't mean it's all equal. The lender and loan officer make a huge difference.



Consumers cannot, in broad, go directly to mortgage investors and request a loan. Most of the investors wouldn't know how to do loans if it bit them. They don't have the actuaries, the underwriters, the tools, and the networks to get the best value for their money. That's where the lenders come in.



I'm not going to get into all the details of CMOs and MBSes- Collateralized Mortgage Obligations and Mortgage Backed Securities - how they are sold, how to price them, yada yada yada. It's something I am not involved in, and I don't really need to know as much as I do. Even when I was financial planner, the nuts and bolts just aren't that important to most investment portfolios. Two important things to note: The higher the interest rate, the better the price the lender will get from the investors, and the lower the rate, the lower the price. The higher the default and loss rates is expected to be, the lower the price, and the lower the default and loss rates are expected to be, the higher the price. Default and loss rates translate to "How tough are the underwriting standards?" Low interest rates at a lender usually means very tough underwriting, and fewer people qualify. High interest rates means relatively easy underwriting, and more people qualify.



What you really going on here is that the banks - the lenders - are the middlemen putting investors and consumers together. For this, they get paid. They get paid enough to pay for all those fancy offices and the executives' salaries and everything else the bank might have. Mortgage lending is big business. Lest it sound like I'm saying the fact they get paid is a bad thing, it's not. It makes the market far more efficient, as most individual investors can't afford an entire mortgage all at once, and individual borrowers would have a daunting problem in finding investors willing to lend money at a decent rate in their situation.



Each individual lender tries to hit a certain market segment. It works like branding in the consumer world, in that there are clients they are aiming at, and ones who are incidental to their business. Lending is a risk-based business, and the higher the risk to the lender, the higher the rate. What will happen the vast majority of the time with the vast majority of lenders is that they will sell the loans, whether or not they retain servicing rights. In other words, just because you have a loan with bank A doesn't mean they'll keep it. It is very rare for a lender to keep the loan. Even if they retain servicing (for which they get paid - and they're not even risking any money!), so that you keep sending that lender your payment, they don't hold the actual loan. Some lenders are interested in A paper, whether conforming with Fannie Mae and Freddie Mac, or nonconforming but to essentially the same standards. These loans are fairly uniform and highly commoditized, but lenders put their own stamps on them. One bank might have incredibly tight standards, but offer lower rates. They will have a record of fewer defaults, practically zero losses, and get a better price on their loan packages in the bond market. Another bank might be somewhat looser in their standards, and so not do as well on selling the loans, and they will charge a higher price, in the form of interest rate, in order to compensate.



This phenomenon expands out progressively farther in the A minus, Alt A, and subprime lending worlds. A paper has noticeable differences between lenders, while subprime's targets vary from the not quite A paper to those who specialize in the ugly loans to people with 501 credit scores, and even some lenders that will accept a borrower with only one FICO score at the 500 level. Almost all of them have their own niche, or niches, that they will underwrite to, trying for a mix of rates to borrower and underwriting standards for approval that results in fewer of their loans defaulting, and thus the ability to command a premium price in the bond market over and above what mostly equivalent lenders will give.



Below subprime is hard money. It's called hard money because before they fund your loan, they are recruiting individual lenders and syndicates who will hold your loan for as long as you have it. This is why hard money is typically multiple points up front, interest rates of thirteen percent and up, and three year hard prepayment penalties, as well as only going to about sixty-five or seventy percent of the property value at most. Without the lenders, every loan would be hard money.



No lender has the capability of running programs that are good fits for everyone. Some of them have a few dozen, some have only ten or twelve. This sounds like a lot, but it isn't. Every single loan type is a different program. Just to cover the most standard loan types for their market is usually between twenty and thirty. I can point to lenders with twenty-five or more different Option ARM programs.



This is where brokers come in. There's an old saying about how "If the only tool you have is a hammer, pretty soon all the problems start looking like nails." You walk into a direct lender's office, and they has a couple dozen programs focused on one segment of the market. You're not an ideal fit for any of their loan programs, but so long as you can qualify for any of them, they are going to keep your business rather than refer you to someone else. They're hammering nails, never mind that your problem is a threaded bolt. They get you pounded into the board. Yes, you get a loan, but you could qualify for a better one if you wandered into a different lender's office.



Brokers have lenders wandering into their offices. Lenders who will give the brokers better deals than they give their own loan officers, because they're not paying for the broker's expenses, and the broker knows better than to be a captive audience. The fact is that brokers are usually capable of getting a deal that's enough better that they can pay their expenses and salaries, still have profit left over, and nonetheless offer the client a deal enough better than the lender's own branches as to be worth the trip. Brokers also shop multiple lenders, looking for a better fit. If you're a top of the line A paper borrower, someone that any major bank has a good program for, the broker can still get you a better loan, but maybe only by an eighth to a quarter of a point. On a $300,000 loan, that's $375 to $750 in cost at the same rate for the exact same loan. If you're in a marginal A paper situation, the difference made is liable to be that you qualify A paper with a broker who knows where to shop, where you'd likely have to go subprime, with inferior options and a prepayment penalty, by walking into a bank office. You get into subprime situations, and I have seen pricing spreads of two and a half percent on the interest rate between the best lender for a given loan, and the rest of the pack. You can physically go to twenty or fifty different banks, fill out an application and furnish paperwork in each - or you can go to a broker.



The point is that no lender is both offering low rates and loose underwriting. As everything else having to do with money, it's always a trade off. The lenders charge higher interest rates, they get a better price for their loans. The lenders underwrite to tougher standards so they will have fewer defaults, and practically zero losses, they get a better price for their loans. The lenders need a certain margin to keep their owners happy, and a certain margin to keep investors happy, and neither one of those in the business of giving away money for less than it is worth.



The ideal thing for a given borrower is not an easy loan. Unless you're so high up on the ladder of borrowers (credit score, equity in the property, lots of documented income) that you'll qualify for anything easily. The ideal loan, where you get the best tradeoff of rate and cost, is to find the loan where you just barely scrape through the underwriting process. With average loan amounts in California being about $400,000 now, chances are that any extra time and effort you spend will be handsomely rewarded when you compute the hourly costs and payoffs.



So you see the partial truth of the title statement, and the utter falsehood. All mortgage money pretty much does start out in the same place. Nonetheless, what happens to it after that, before it gets to the consumer, renders the statement "All mortgage money comes from the same place" incredibly dishonest.



Caveat Emptor

UPDATED here

Supply and Demand.



Now that I've given the short answer, it's time to explain the macro factors behind interest rate variations. But I'm going to keep referring to those first three words. It is a tradeoff between the supply of money and demand for it.



The most obvious thing influencing loan rates is inflation. This is a general environmental factor. If the inflation rate is higher, then other factors being equal, there will be fewer people willing to lend at a given rate, and more people willing to borrow. Who wouldn't want to borrow money if the money you have to pay back is actually worth less than they money you borrowed? All loans are priced such that a given inflation is part of the background assumptions of making it. If inflation is 4 percent, someone lending money at seven is making an effective 3 percent. If inflation is ten percent, they are losing that selfsame three percent. Which scenario would you prefer to loan money in? Which scenario would you prefer to borrow money in?



On the other hand, when inflation is high, loan rates usually rise to compensate. When the prime rate is twenty-one percent, that means that a business borrower has to make a minimum of twenty-one percent on the money just to break even. That's if they're a prime customer. Making twenty one percent is tough. The reason you borrowed ("rented") the money was because you have a use for it to make money. There's a lot fewer opportunities that make enough over twenty-one percent to make them worthwhile, than there are opportunities making enough over seven. This is one reason why inflation is a Bad Thing.



What alternatives exist is a major factor on the supply side, as well. If you absolutely must invest your money in US Government securities, that's where you're going to invest, and since you're increasing the supply of money to the treasury, the price is less. Supply and Demand. This is one of the many reasons why Congress' handling of the trust fund is a national disgrace. If they were private trustees, they would be help liable for not investing it where the best returns are. If, however, you think that stocks are looking more attractive now, that means that the supply of money for loans will shrink by whatever dollars you move out, and the rates will rise. The effect for any one person is small, but there are a lot of people in the market. In aggregate, it's many trillions of dollars. Supply and demand.



Savings rates means a lot, also. When there is a lot of new money coming available in the borrowers market that money is going to be cheaper to borrow, in the form of lower interest rates. This is partially why rates went down throughout 2002, and stayed down into 2003, and 2004. People who had been burned in stocks wanted nice "safe" mortgage bonds. When there is comparatively little new money coming into the market, the only source becomes old loans being paid off. Negative savings or negative investments in the bond market means that what money is coming off older loans is at least partially being used to fund the withdrawals. Competition for money gets fierce, and price - by which I mean interest rate - rises. Supply and Demand.



Competition for money is also a part of the demand side. When the government needs to borrow a lot, for instance, that increases the competition. Even on the scale of our capital markets, whether the government is breaking even or needs to borrow the odd $100 billion has a real and noticeable effect When they need to borrow $400 billion, you can bet it'll raise the cost of money. The government doesn't care, and the bureaucrats running the treasury have been told to get this money. They will do their jobs and get the money, whether it costs 4 percent, 14, or 24. Every time competition from the government drives up rates, a certain number of borrowers whose profit margin on the loan was likely to be marginal will drop out of the auction. But government spending rarely grows the tax base. It's those corporations and small businesses investing in future opportunities that grow the tax base, and they are the ones dropping out of the auctions as money gets more expensive. This is why government deficits are a Bad Thing. Supply and Demand.



The desirability of the alternatives is another factor on the demand side, as well. There's more than one way to make money for most. If it become prohibitively expensive to borrow (bonds), sell part ownership instead (stock). There is a point at which even the most die-hard sole proprietor needs the money, and just can't afford it as opposed to selling some stock to new investors. This can dilute earnings, and cause you to lose control of the company (there were multiple reasons why the high inflation period of the seventies and eighties was followed by the era of the corporate raider, but that's one part), but better to dilute your share of the pool by ten percent while increasing the size of the pool by fifteen. That is a net win, while borrowing the money at twenty-something percent is likely not.



Now, let us consider the money supply here in this country, and thence the state of likely interest rates. We have increased government borrowing. We have the social security trust putting decreasing amounts of money into the government. We have a national savings rate that's negative (and it is the overall rate, not just working adults that we're concerned with, here). More and more people are becoming comfortable with foreign investment. And mortgage bonds are looking jittery right now, with foreclosures up. Supply and Demand, remember?



Therefore, in my judgement, we are likely to see continued raises in the interest rate for some time. If you're on a short term loan that is likely to adjust in the next couple of years, the time to refinance is now, unless you're planning to sell before it adjusts. And if you had asked me a year ago if I'd ever be recommending thirty year fixed rate loans, I would have said, "Not likely". I'm recommending them now. When it's the same rate or higher to get a 5/1 ARM, there is no reason not to choose a thirty year fixed rate loan instead.



(If, on the other hand, you have a long term fixed rate loan, stay put. Once you've actually got the loan funded, they can't just draw the money back unless you do something like fraud or default. Even if you go upside down on your loan for a while, if you're already in a fixed rate loan, that's okay. The market price of the home only matters at loan time and at sales time. If you don't need a loan and you don't plan on selling, why should you care? Note to the young: home prices will rise again.)



Caveat Emptor

UPDATED here

No, I'm not turning into a country western singer. Just got a search for "no closing costs no points loan cheapest rates loan". The visit (to this article) lasted less than a full second. The obvious implication was that it wasn't what that person was looking for.



As I have said before on many occasions, cheapest rates or lowest rates do not go with no points or no closing costs loans. Period. One of these things does not go with the others. Rate and total cost of the loan are always a tradeoff.



This is not to say that one loan with no closing costs may not be cheaper than another loan with no closing costs. The point is that there will be lower rates available with some closing costs, progressively more as you get higher closing costs. Then if you start paying points, there will be still lower rates available. There is a reason why they are paying all of your closing costs - you're choosing a loan with a higher rate than you otherwise could have gotten.



No cost loans can be and often are the smart thing to do. Because they are the only loans where there are no costs to recover, they are the only loan that can possibly put you ahead from day one. Consider the zero cost loan as a baseline, and compute what lower rates will cost you in closing costs. Consider: If the zero cost loan is 6.75 percent at $270,000, your new balance should be $270,000. If you can get 6.5 at par with closing costs of $3500, your new balance is $273,500. Your monthly interest in the first instance is $1518.75 to start. Your interest charges in the second case are 1481.46. The lower rate cost you $3500, but saves you 37.29 per month. Divide the cost by the savings, and you break even in the ninety-fourth month - not quite eight years. So in this example, if you think you're likely to refinance or sell within eight years, you'll be ahead with the zero cost loan.



If the loan has a fixed period of less than the breakeven time, you also know that the costs are not a good investment. If this loan were only fixed for five or seven years, well even if you decide to hang onto the loan after it adjusts, the rates go to precisely the same rate after adjustment. If you haven't broken even by then, you never will.



So whereas a true zero cost is often the best and smartest way to go, it will never be the lowest rate available.



Caveat Emptor.

UPDATED here

A reader named Terri at Educating the Wheelers sent me an email giving me a heads up on the antics of the state of Illinois. here is the link. Here is the original article at blackprof. The link to the original source is broken, but here is the Illinois Department of Financial and Professional Regulation, here is the full text of HB4050, the new law, here is a synopsis, among other things, and here are enforcement regulations.



Critical sections:

Based on information submitted to the Department by the originator, requires the Department to make a determination as to whether credit counseling is recommended to the borrower. Requires the Department to notify each borrower for which it recommends counseling of all HUD-certified counseling agencies located within the State and direct the borrower to interview with a counselor associated with one of those agencies. Requires the borrower to select an agency from the notice and to interview with a counselor associated with that agency within 10 days after receipt of the notice. Prohibits the borrower from waiving the recommended credit counseling. Requires the title insurance company or closing agent to record simultaneously with the mortgage a certificate of its compliance with database reporting requirements and, if it fails to do so, provides that the mortgage is not recordable

and

Changes the definition of "pilot program area" to all areas designated by the Department of Financial and Professional Regulation because of high foreclosure rates due to predatory lending practices. Deletes a requirement that a broker or originator provide each borrower with a notice disclosing the names of at least 3 lenders and comparing the rates and terms of those lenders (emphasis mine). Provides that nothing in the predatory lending database provisions is intended to prevent a borrower from making his or her own decision as to whether to proceed with a transaction.

blackprof's take:

Nevertheless, Tuesday was a key moment in African-American History. On Tuesday, in addition to Mrs. King's passing and Justice Alito's elevation, the State of Illinois enacted a law that requires all mortgage applications within nine Chicago zip codes to undergo a process of review by the state's Department of Financial and Professional Regulation. The department's review process determines whether mortgage applicants in these neighborhoods must undergo compulsory credit counseling. If they must, then the mortgage lender must pay the cost of the counseling.



Anyone familiar with Chicago geography and demography knows these nine zip codes. They are all neighborhoods on the South and Southwest side of Chicago. They are predominantly African-American neighborhoods. These neighborhoods are some of the most impoverished in the City of Chicago, and indeed, the nation. On Tuesday, they suddenly became much poorer.



Although the legislators responsible for the new law were motivated by good intentions, they failed to consider the inevitable consequences of their bill. They wanted to protect poor homeowners in certain neighborhoods from high interest rates and predatory lending practices. The new law, however, necessarily increases the costs, time and uncertainty associated with mortgage applications in these black neighborhoods. The cost of credit counseling will be born by and charged to mortgage applicants. This, in turn, will necessarily decrease the price that new home-buyers can afford to pay for homes in these neighborhoods. If they can choose to buy in other neighborhoods, where housing money is more affordable, they, on the margin, will. Furthermore, recent studies of credit counseling programs suggest that these programs have little effect on borrower behavior. The end result is that homeowners in these poor black neighborhoods suddenly have less equity in their homes than they had on Monday.



Legislation like this is often motivated by an unspoken belief that poor black people are incapable of making important decisions for themselves. We see this belief reflected in the protection of failed public schools, and now with respect to personal finances. But the very people for whom such a law was enacted were responsible and wise enough to save to make the down payments necessary to buy these homes in the first place. Suddenly, these same people must have their choices reviewed and second-guessed by state bureaucrats who have no stake in the outcome, or accountability for incorrect or unresponsive decisions. It is hard to imagine the fate of a similar but broader law imposing credit counseling upon all Illinois residents, including white professionals residing in the Chicago suburbs of Evanston, Winnetka, or Kennilworth. Would there have been enough votes in Springfield to impose these "benefits" on everyone, rather than just the residents of the Southwest side of Chicago?

I'm just a nuts and bolts guy. I see some issues here:



First, by increasing the cost of doing business in the relevant zip codes, the law is increasing the lender's cost of doing business. It is not plain how the lenders will pass this on to the consumers, but pass it on they will. This has the effect of making loans more expensive. I can see two methods: either requiring everyone on the state of illinois to pay more, or requiring only those owners actually within the area to pay it. If they require only those within the area to pay, an excellent case can be made that higher loan costs makes for functional redlining, and the federal courts can intervene, and almost certainly will, possibly invalidating the law. If they require that everyone pay the extra costs, this functionally raises the cost of doing business everywhere in Illinois. This will also make it harder to qualify for loans in the requisite areas, as lenders will have incentive to throw roadblocks in the way of potential clients from those areas. Due to redlining regulations, I'm not certain how far that lenders will go, but it certainly won't make loans easier to get or cheaper.



Second issue: no matter the intent, no matter who pays, this will cause loans to take longer and cost more, in addition to previously discussed costs of the program. For previous work as to why, see my essay on Mortgage Loan Rate Locks. The point, however, is that the State of Illinois is going to take some unknown period of time to consider the case. Then the client is potentially going to have to go to a credit counselor, who is going to have to get paid before providing the necessary legal blessing to the transaction. Furthermore, if the credit counselor wants more work at the expense of delaying the transaction, they can apparently make it happen by my reading of the law. All rate locks are for a specified period of time. Given this, there are three alternatives. One, float the rate (don't lock) and hope that rates don't rise. Second, lock for a longer period, which costs more. Third, pay an extension. Since the outcome when you don't lock for long enough or don't pay extensions is pretty much universally "worst case pricing" (i.e. the worse of rates when you locked or current rates), this means significantly higher loan costs, loan rate, or (most likely) both.



Third, as I said before, since this is going to motivate lenders to not want to do business there, and makes it harder to get loans in the effected areas, and quite likely increase the rates and costs of loans in the area as a consequence. This directly restricts how much of a house, price-wise, people in the area can qualify for, which in turn will have the net effect of decreasing sales prices in the area, further hurting current residents.



There are probably further detrimental aspects to new requirements, but the Illinois legislature deleted an existing requirement that, while apparently weak and subject to abuse in that a prospective loan provider was free to provide a prospective client with information only on loans that are worse than the first proposal, at the very least gave the client some further information as to alternative loans.



In short, the actions of the Illinois Legislature in this instance could, according to my understanding, basically be taken from a manual on "How To Hurt Poor People Even More".



Caveat Emptor (and Caveat Voter).

UPDATED here

I've seen a fair number of questions on impound accounts in the last several months. An impound account, also known by the confusing term escrow account because the lender is holding it in escrow, is money that you give the lender in order to pay the property taxes and homeowner's insurance on the property.



The first thing to note and emphasize is that money going into an impound account is not a cost of doing the loan. It is your money. You own it. It will be used solely to pay your property taxes and insurance. At the conclusion of the loan, whether you paid it off with cash or refinanced or or sold the property, you get this money back. The lender is required to send you the check within sixty days of loan payoff.



An impound account is meant to address any lender's two largest worries in regards to a loan: Uninsured destruction of the property or losing the property to an unpaid property tax lien.



The problem with an uninsured destruction should be obvious. The structure is destroyed or heavily damaged and no money exists to rebuild. The borrower doesn't have it and the bank isn't going to throw good money after bad. Here in California, the average property is worth maybe $500,000 or so, but without the home sitting on it, the property may only be worth fifty to a hundred thousand. Within ten miles of my office sit hundreds, probably thousands, of new homes that sold for $700,00 and up even though they sit on a lot that's less than 5000 square feet (0.115 Acres). Many condominiums are over $400,000. Given the location, a 5000 square foot lot may be $200,000, but it's not $500,000, and the lender will take a loss even on the $200,000 because they're not in the business of real estate. They loan $500,000, it burns down without insurance, they lose $350,000. People also lose their jobs over this.



Property tax liens are a major issue as well. They automatically take priority over everything else, and the rules about what the condemning governmental entity has to do are much looser than they are for the bank. They will usually do quite a bit over the minimum, but they will sell the property most of the time, no matter how minimal the best bid. Minimum auction amounts, etcetera go out the window. Many times this situation can require the lender to step in and pay the property taxes, intending to turn around and sell the property themselves merely to take a smaller loss.



A lender wants you to pay property taxes and homeowner's insurance, and they want to know you've paid them. They encourage this via the method of impound accounts. The theory is simple. Every month you pay the lender, in addition to your actual loan payment, an amount equal to your pro-rated property taxes and homeowner's insurance, and they will pay these when they are due.



No lender is perfect about these, and some are less so than others. A large percentage of the biggest and worst messes I have ever dealt with came about as the result of the lender somehow messing up the inpound account. Others have arisen because even though the lender acted within the law, the client got angry about something. Sometimes it's for a good reason, sometimes it's not.



Because lenders want you to have them, however, they are ubiquitous, and every lender I know of charges extra on your loan if you do not want to do an impound account. Usually this amount is about one quarter of a discount point. On a $500,000 loan, this amounts to a charge of over $1250 just to not have any impounds.



On the other hand, in places where property values are high, you can have to come up with $5000 or more at loan time just to adequately fund an impound account. Here's a computation of how much you need to fund it works. The lender will divide the annual property taxes and homeowner's insurance by twelve. This will be the monthly payment. The lender is legally able to hold up to two months over the amount required to make the payments, and they want this reeve. So they will look at the projected payments for the next year and figure out how many months they need up front to always have two months worth in reserve. I'm writing this on February 3, and California taxes were due on the first even though they are not past due until April 10th. But the lender uses February first to calculate even though they won't actually make the payment until early April (they earn interest on the money, whether or not they pay any. Some states require that interest be paid, but it is typically something small and worthless like two percent).



February first is usually when the lenders here in California figure will be the low point of the account for the whole year. But if you closed on a loan today, February 3rd, you wouldn't make your first payment on that loan until April first, and of course, they cannot count on you making your February payment right on the first. So they are going to figure that you will make payments on the first of every month April through January, ten months, before they have to pay your property taxes. Since they have to pay twelve months, and they get to keep two in reserve, that's fourteen months of payments they want to have on February first. Fourteen minus ten is four months that you will have to come up with in advance, or have rolled into the cost of your loan. On a $500k property, that's about $2000 for property taxes even in a basic tax zone, and if your insurance is $1200 per year, you'll have to come up with another $400 for that. $2400 into the impound account.



It gets better. Because the property taxes are due within two months of your purchase, you're going to have to come up with your pro-rated share right up front as well as paying for an entire year of insurance. Since California requires six months property taxes at a time, that adds almost another five months taxes and twelve months insurance up front. Total cost of this in the example given: $3700. Actually, this is due whether you have an impound account or not. Total you need just for property taxes and homeowner's insurance: $5900.



It can be worse. Suppose you were closing on a refinance in October. You originally bought in February. You are only going to make two payments (December and January)before the insurance is due, so your impound total for the insurance alone $1000 for insurance. You are going to have to come up with $3000 to pay the first half of your property taxes, plus because you only have two payments before the second half is due, another $3000, or six months payments for that. Total due, $7000.



There are really only two methods for coming up with the money for an impound account: Bring in the cash from somewhere else, or have the lender loan it to you, adding it to your loan balance. Except in rare circumstances where you are refinancing the same property with the same lender (and usually not even then), existing impound accounts cannot be used to "seed" the new account. This is because it's your money, held in trust. The rules for these accounts are rigid, and I'm not certain I understand well the rules about whether a bank even has the option of rolling one impound account into another.



This typically means that you have to come up with a good chunk of change out of your pocket for a short period, or add the additional amount into your loan, where you'll be paying for it as long as you have a loan on the property. Every situation is different, but most often I prefer to either come up with the money myself or not have an impound account. The extra charges may be sunk as opposed to refundable, but I'm not paying interest for thirty years on thousands of dollars.



Furthermore, if you are adding the money to create the new impound account to your loan balance, since it's going in before the computation of points, it can add another $50 to $100 to your costs of the loan per point you're paying. Minor in and of itself, but adding insult to injury if the loan has points involved. More to the point is that adding impound creation it to your loan balance means there may be a couple years before your balance gets as low as it was before the refinance, just from this. Indeed, the fact that it raises your loan balance is the worst thing about the impound account issue. On the other hand, unless you have a "first dollar" prepayment penalty, what you can do is turn around and put the check for the previous impound account when it arrives into paying down the new loan. It typically won't bring you even, and it won't reduce your contractual payments on the new loan (although that is usually a good thing), but it will ameliorate the damage to your loan balance.



Initial loan closing is not your only opportunity to start an impound account if you want one. If you don't have one to start with, the lenders will be very happy to let you start one later. I've literally never heard of a lender saying anything but "YES!" (usually with a pump of the fist) to a request for an impound account. Why? Because now they know that your taxes and insurance will be paid, and get to use your money, and after you paid a fee for no impounds. Oh, happy banker!



If you want to cancel an impound account, expecially within a year of whenever the loan was funded, you can expect to pay the "no impounds" fee, possibly prorated, but usually just the whole thing. Roll thousands of dollars into your loan balance where you'll be paying interest on it and then pay a lender's charge for no impounds? Ouch!



Can you force the bank not to do any of this? Not really. They don't have to lend you money. Yes, they are in the business of lending money, but if they don't loan it to you, they'll find other uses for it. Somebody else is always willing to accept the bank's terms. You try to violate guidelines that lenders have established in order to lend you the money, and you'll be told, "Sorry but you don't qualify." The golden rule of loans is that those with the money make the rules.



Furthermore, those lenders who didn't require this would be at a competitive disadvantage as regards rates, because their loan portfolio would be a significantly riskier one, and they would have to increase their rates to compensate for this. You could qualify for a better rate or lower closing costs somewhere else. Better to not argue. Assuming that I already have an impound account, all the extra I lose is a maximum of sixty days interest. Two months interest on $5000, even at ten percent, is $83. That's a lot cheaper than either of any of the alternatives.



Caveat Emptor

UPDATED here