Mortgages: December 2006 Archives

You've probably heard the horror stories, and I've mentioned the possibility more than once. Some unsuspecting person is looking at properties beyond their price range, and it therefore has all kinds of attractive features that properties which are in their price range do not have. They are just about to regretfully but firmly put the notion of buying this particular property out of their heads when the Real Estate agent whispers seductively, "I can see that you want it, so let me show you how you can afford it!"



There are all kinds of reasons why this happens. Bigger commission check for the bigger sale certainly is one, but a far bigger concern to most of the predators who do this is that it's an easy immediate sale. Instead of having to take those folks around to dozens more properties that are in their price range (and perhaps lose them to some other agent taking advantage of an opportunity in the meantime), while the clients agonize about the trade-offs of linoleum versus carpet in the bathroom and kitchen, and maybe if they'll keep looking just a little while longer they'll find one that is perfect despite the market, so they're not going to make an offer today, thank you very much, this predator has shown them the equivalent of the holy grail, provided the clients do not understand the downsides of the loan that is necessary to procure that property.



There is a reason why I advise people shopping for a property to make a budget based upon what they can afford based upon current rates on 30 year fixed rate loans, or at the very most an amortized 5/1 ARM, and stick to it. That the maximum price you will offer - end of discussion. Even if you, the client, end up applying for another type of loan that has lower payments, if you could make the payment on a thirty year fixed rate loan, you are pretty certain you are not getting in over your head. But shop by sales price, not payment. "Creative financing" has become so pervasive that shopping by the payment the real estate agent has posted, or tells you about, is severely hazardous to your financial health. This number should be the most important thing buyer's discuss with their agents, and the budget must be quoted in terms of purchase price, not monthly payment. There are too many games that can be played with monthly payment.



Indeed, the very head of the list of reasons why buyers should fire an agent is that the agent showed them a property which can not reasonably be gotten for the sales price limit they told the agent about. You tell me that your limit is $320,000, it might be okay to show you a property listing for $340,000 or even $350,000. In the current buyer's market, that's a comparatively small amount of bargaining power. In a seller's market, of course, it would likely rule out anything where the ask is over $325,000. But if the agent show you a property listing for $450,000, simply ask to be taken home or back to your vehicle immediately, and then inform them that their services are no longer required and that you desire them to make no further efforts to contact you. Were I shopping for a property, I would demand to know the asking prices before I went, and not only fire the agent but also refuse to go if they cannot show me why they think this property can be obtained for the total cost limits we have agreed upon. Not monthly payment limits, sales price.



So what loans should not be used to purchase a property? Well keep in mind that this list assumes that your loan providers are telling the truth about the kind of loan they are working on for you, an assumption that, judging by a dozen or so different e-mails I've gotten from people who were scammed, is increasingly iffy. Furthermore, if you are a real financial and loan expert, there are reasons why these warnings may not apply, particularly if the property in question is investment property, but those sorts of experts should know the exceptions, should not be looking to this website for advice, and are always able to accept the financial consequences of not following these guidelines (in other words, they have the ability to absorb the losses).



The absolute head of the list, the loan that should never be used for purchase of a primary residence is the negative amortization loan. Known by many other friendly sounding names such as "pick a pay", "Option ARM", "COFI loan," "MTA loan," and "1% loan" (which it is not), this loan is a truly horrible choice for the vast majority of the population (99%+). It was only approved by regulators to service a very small niche market, and if you are a member of that niche market, chances are that your Option ARM will not be approved by the lender! This loan is usually sold strictly on the basis of the fact that the minimum payment is lower than any other type of loan, making it look like clients can afford a loan that they cannot, in fact, afford. This low payment is based upon a low nominal, or "in name only" rate that is not the real rate the money is accumulating interest at. In fact, the real rate that you are being charged is currently at least 1.5 percent above equivalent rates for thirty year fixed rate loans, as well as being month to month variable. How often do you think people who are being fully informed of the loan would agree to accept a rate a full 1.5 percent higher on a fully variable loan than what they would have gotten on a thirty year fixed rate mortgage, and with a prepayment penalty also? The lenders pay very high yield spreads for doing these loans, and the bond market pays even higher premiums, so many lenders push them hard, and many wholesalers push them even harder. Despite being warned that I was not interested in any loans that feature negative amortization, three new potential wholesalers have gotten themselves thrown out of my office in the last month. I guess they weren't interested - or able - to compete with other lenders on real loans.



The Interest only 2/28 does have one redeeming factor, as compared to the negative amortization loan: At least your balance isn't getting higher every month. With the average loan around here being about $400,000, a rate of 5.5% would have the payment being $1833. But if that's all you can afford, what happens in two years when the rate adjusts and it starts amortizing, and if the market stays right where it is today, the payment goes to $2771, an increase of 51%? You haven't paid the principal down. There's a pre-payment penalty stopping you from selling or refinancing until it does adjust. If prices have appreciated enough to pay the costs of selling you might not come out so bad, but what if they haven't, or if prices have actually gone down? This is not the sort of bet that someone with a fiduciary relationship should make, as real estate prices increasing is not something you can make a risk free bet on. Millions of people are finding that out right now.



The next loan on the list is the 3/27 Interest Only. This does offer you one more year to get your act together and start making more money to make the payments with than the 2/28. The downside is that it actually adjust higher due to the increased interest only period. In the example above, the payment would adjust to $2804, an increase of just under 53%. This also means you have another year for the value of the property to do the historically normal thing and appreciate a little. Still doesn't mean it's a bet somebody with a fiduciary responsibility should be making with your finances.



The next type of loan to be wary of is anything stated income or even lesser levels of documentation (NINA or "no ratio" loans). These loans are great and wonderful if you really are making that money and really can make those payments, but don't let the temptation to buy a more expensive property lead you to exaggerate what you really make, or allow a loan officer to exaggerate what you really make, in order to qualify for the loan. Remember, you are still going to have to make those payments, and if you can't, the bad things that will happen more than counterbalance the nicest thing that might happen. Again, millions of people are discovering this right now.



Somewhat less dangerous are interest only loans with a longer term or extended amortization loans. A five, seven, or ten year interest only period, while much more endurable than a two or three, is still not a certain bet of making a profit. Same thing with a forty or fifty year amortization loan. Given the way the rate structure is applied by most lenders, these loans are given out by lenders wishing to cover questionable lending practices to people who do not qualify for interest only loans according to bond market guidelines. Still, if it's got a good long fixed period of at least five years, you are paying the balance down and it's a reasonable bet that you will be able to sell for a profit before the adjustment hits. Not a certain bet, but a reasonable one, as in "the odds of making a profit or being able to refinance on more favorable terms before the payment becomes something you cannot afford are definitely on your side."



The ordinary 2/28 and 3/27 are dangerous enough for most fully informed adults. Using the interest only examples above, the 5.5% rate actually becomes 5.25% fully amortized, as it's a less risky loan. The initial payment becomes $2208, which does pay the loan down some, but then the payment becomes $2691 (in the case of the 2/28) or $2678 (3/27) holding the market constant as it sits and keeping other background assumptions constant. If you cannot afford these smaller jumps when they happen, at least you've got several thousand dollars that you have paid the principal down to use for closing costs on the new loan or towards the costs of selling, but be aware that the market is never reliable in its fluctuations over a short period of time, and using these loans for a purchase can and many times has meant that when the fixed period ran out, those people who choose these loans are in the unenviable position of being unable to afford their current payments, being unable to refinance, and being unable to sell for enough to break even when you consider the costs of selling.



There is nothing really wrong if you can afford the thirty year fixed rate loan but deliberately choose some other loan. I do this myself to save money on interest charges, which is the real major cost of the loan, but as narrow as the gap in rates is right now, even I might choose a thirty year fixed rate loan if I needed to refinance. It's not being able to afford the sustainable loan that will kill you. If not a thirty year fixed rate loan, at least a fully amortizing ARM with a fixed period of at least five years.



The most important things about any loan is the interest you are being charged for the money you are borrowing, how long it lasts, and the cost in dollars of getting that loan done, not a lower minimum payment that, certain as gravity, has a gotcha! engraved on it that will cause you to regret getting that loan. Unfortunately, we cannot go back to the past with information we learn in the future, and real estate loans are especially unforgiving of borrowers who do not understand the future implications of their current loan decisions.



As a final note, I have structured this essay around the loan to purchase a property, but the arguments work just as strongly and just as universally for so-called "cash out" refinances as they do for purchase money loans.



Caveat Emptor

UPDATED here

Yet that is exactly what you want them to do.



To avoid competing on price, they have all kinds of distractions they offer to make life more convenient, but not cheaper. They offer automatic payment options, the convenience of having your mortgage at your corner financial institution, biweekly payments, mortgage accelerators, and even negative amortization loans, which offer the apparent benefit of lower payments, at the price of a much higher interest rate than you would otherwise be able to get, which is the price the lender really cares about, and the one you should also.



There is always a trade-off between rate and cost for a given type of loan. That doesn't mean that different lenders won't have different trade-offs. Some are less willing to compete on price than others, so they tell you about how great their service is, how you are such a difficult loan that nobody else can do, or how easy their paperwork is, or how easy their loans are to qualify for. As a matter of fact, the lender with the easiest paperwork and loosest qualification standards will usually have the highest price trade-off, because their loans are statistically more likely to default, and therefore have to bring in a higher interest rate in order to have the same return.



Just like branding in the world of consumer products, which is also in effect for mortgages (why else would National Megabank be spending all that money for commercials? They expect to make a profit on it!), all of these little extra bells and whistles increases the price they can charge consumers for their loans, which is to say, the rate that you get, and the cost to get that rate.



So long as the terms are comparable, a loan is a loan is a loan. Provided that it has no hidden gotchas, a 5.875% thirty year fixed rate loan is exactly the same loan from National Megabank as it is from the Lender You Have Never Heard Of. No pre-payment penalty, and lower costs for the same rate? That's the lender I'll choose. It should be the same one you choose as well. It doesn't matter to me what name I make the check out to, or what address I put on the envelope. It shouldn't matter what routing symbol you put on the automatic payment, either, if that's what floats your boat. Lower rate for the same cost? Same situation. Everything else is window dressing.



(Okay, it doesn't often matter to me. There are lenders that I'll bet you've heard of where I won't place my client's loans no matter how good the price due to some issues with their lending practices. But those lenders trend heavily to be the ones with massive consumer ad campaigns that don't really try very hard for broker generated business, anyway, because brokers learn to stay away from them fast. Nor are they usually competitive on price, because they're aiming for the "consumers shopping by name recognition" market).



So how do you force lenders to compete based on price? It's actually very simple. Ignore all of the stuff that they try to distract you with, like low payments for a while or mortgage accelerators or biweekly payment programs. Those are bait, and they serve the same purpose as bait: To get you to take the hook. Think about the things that happen to the fish after it takes the hook. You don't want to be like the fish, do you? Concentrate on the type of loan, the rate, and the cost to get that loan. Here is a list of Questions You Should Ask Prospective Loan Providers. Ask all of them with every conversation you have about what is the right loan for you, and the best rate and cost they can deliver on that type of loan. After you have settled on one provider (or a primary and a back up), it is then okay to ask about the bells and whistles that lenders (and every other sales organization) love to distract you with. If you want auto-pay, or biweekly payments, or a mortgage accelerator, these are just as much in the lender's best interest to offer you as they are convenient for you to have. I wouldn't pay for them, but many people think they're nice to have, and that's fine. Just don't let them distract you from what's really important: The price of the money you're buying.



Caveat Emptor

UPDATED here

This one came from a search engine:

amortization of real estate loans early payoff based on a lump sum payment

This is one of the smart things you can do. Not necessarily the smartest, mind you, but smart. Unless you have a pre-payment penalty, you can always pay more than your minimum payment, and often even with a penalty. The question is if there's a better way to get a return on that money, whether by paying down a higher interest debt or by investing the money in a new asset. If you owe thousands of dollars on a credit card at twenty-four percent when your mortgage is at six, why would you want to pay down a tax deductible six percent instead of a non-deductible twenty four?



Similarly, if you can earn ten percent somewhere else with the money, why do you want to pay your six percent loan down? Net of taxes, a six percent loan costs you about 4.5 percent, depending upon your tax bracket. Even if the return is not tax deferred, the net return on ten percent is somewhere over seven percent for most folks. Say you are in the twenty-eight percent tax bracket and the ten percent is completely taxed every year. $10,000 over the course of 15 years will turn into $28,374 if invested. If it's fully tax deferred, it turns into $41,772. For comparison with other numbers later on in the essay, at twenty-seven years the numbers are $65,352 and $131,099, respectively. Not half bad.



Suppose you've got the cash flow to instead buy another property? That puts the power of leverage to work for you, and if you can rent out one of your properties or something, possibly multiply your money by a factor of ten within a few years. When you put ten percent down, and your new property appreciates ten percent while giving you a few dollars per month of cash flow, that's smart investing. At seven percent annual appreciation (historical average), you've doubled your purchase price in a little over ten years. A three hundred thousand dollar property will likely be a six hundred thousand dollar property in about ten years (It's just numbers), while you've paid the loan down from $270,000 to about $226,000. Even if your expenses of selling are seven percent, your gross is $558,000, less the $226,000 you've paid the loan down to, and you've come away from the property with $332,000, not counting those few dollars per month you netted after paying your expenses. Sure there are places and properties that don't pencil out, and being a landlord is a headache, but as you can see the potential rewards are substantial if it does "pencil out".



Now, let's say you do this every nine years on a three to one split, and 1031 Exchange the first two at least. After nine years you have $281,267 pre-tax, net in your 1031 account. You then turn around and buy three $600,000 properties. You end up with three loans of about $506,000 each. Assuming net zero cash flow on the properties, after nine more years, you have three loans at $434,100, netting you $1,775,286 into your 1031 accounts, which you then roll into three more properties each at $1.2 million purchase price. Your loans are $1,000,000 each, but you rent them for enough money to break even on expenses. After nine years, you sell all of these properties, and end up with just a little under $10,750,000 net of sales costs in your pocket before tax, which at long term capital gains rates (15%) nets you $9.13 million or thereabouts. Now, you did start with three times as much money, and nobody in their right mind sells off nine highly appreciated properties in one year, and you did have the headaches of being a landlord on an increasingly widespread basis for those twenty-seven years, but this illustrates the money to be made for the same investment. Patience and leverage working for you over time are far more powerful than any quick flip.



But assuming there are no better alternatives, it is a smart idea to pay down your mortgage. Here's why: Let's say your balance is $270,000 at six percent, and you pay your loan balance down by $10,000. Your regular payment was $1618.78, and it still is, but interest is $1350 of that. Only $268.78 would normally be applied to principal. Yeah, you've just sent them about six months of payments - but it just paid your loan down by three years of principal payments. Assuming you never sell and never refinance and never pay an extra penny again, you will be done in month 324 - saving yourself thirty-six payments for a total savings of $58,276. Not to mention that if you do refinance, you'll pay lower fees. Not in the league of some of the alternatives above, but still a nice return on investment. Definitely beats spending the money.



Caveat Emptor

UPDATED here

That was a question that brought someone to the site and the answer is very simple: they don't give you the loan. You haven't agreed to pay them back, so why should they?



There are two major cases of this, one of which has two sub-cases. The first case is that if it's a purchase money loan. Because you don't get the loan when you don't sign mortgage documents, there may be issues with whether or not the seller is entitled to keep your good faith deposit. Now, if you can come up with the cash to pay the seller from somewhere else, for instance, if you have it sitting around and just would have preferred to get a loan, no worries. You still have the option of hauling out your checkbook, and you can get a loan later, although it will be "cash out" loan which generally has a rate and term trade-off a little bit higher than "purchase money". If you applied for a back-up loan, you can sign the other loan papers. But since most people don't fall into either of these two categories - people with the cash lying around and people who applied for more than one mortgage - you are probably looking at the unpleasant reality of not having the money to purchase the property. In most cases, the loan contingency has expired, assuming there was one to start with. Matter of fact, usually all of the contingencies have expired, leaving you without anything to excuse not consummating the transaction. Therefore, any good faith deposit is at risk, not to mention that the transaction may well be dead. The seller only agreed to give you that exclusive shot to buy the property for so may days. If you want to extend escrow, most sellers will require some additional consideration in the form of cash in order to allow the extension. In fact, many agents and loan officers have gotten very lazy and lackadaisical about deadlines, with potentially severe repercussions to you, their client. Once those contingencies have expired, usually on day seventeen, you typically are stuck. Consult a lawyer for the exceptions, but there really aren't very many. This is one of the many reasons why being successful in real estate is about anticipating possible problems and taking precautions. If you wait until the problem crops up, it's usually too late, and often, the best thing to do is sign the loan documents even though they are nothing like the loan quote that got you to sign up with that company, because otherwise the consequences of not signing are even worse than signing. Many loan companies target the purchase money market with this in mind.



The second major case is if you are refinancing, which leaves you in pretty much the same boat you were in before you started the transaction. You own the property already. You have a loan now. Unless you have a balloon loan coming due, you just continue on with what you were doing before you started the process of refinancing.



There are two major reasons why people refinance: Better terms, or cash out. If you are doing it for better terms, and the new loan doesn't deliver, there pretty much is no reason to sign those documents. This includes if they are actually willing and able to deliver the rate, just not at the cost they indicated when you sign up. There is always a trade-off between rate and cost in mortgage loans. Usually, the lowest rate will not be worth the costs you have to pay to get it, but if they lie about what it really costs to get you to sign up, those final loan documents are going to have a rude surprise if you look at them carefully. All but the worst scamsters will usually deliver that rate and type of loan they talk about. Where they fall short, or actually, go over, is in the costs department, because a loan with $5000 more in costs will likely have a lower payment than the loan where they don't hit you for those extra $5000 in costs, but do give you the rate that the costs they talked about really buys. Most people shop and compare loans by payment. It may be short-sighted and the best way there is to end up with a bad loan, but they do it anyway. They are more likely to bail out of a loan where the monthly payment is $60 more than they were initially told but has the same costs, then they are to back out of a loan where the payment is $25 more, never mind that the former is probably a better loan for them.



Refinancing for cash out is a more nebulous area. Since it's a refinance loan, you probably don't have a deadline, so you can go back to the beginning and start all over if you want to. Sometimes, however, rates have shifted upwards since you started the process, and so it can be to your advantage to go ahead and reward the company that lied to you in order to get you to sign up. If they haven't done so, however, dump that problem provider and see if you can go find someone honest! Furthermore, sometimes people have absolute deadlines as to when they need that cash, or it saves them so much money that they are better off signing those documents anyway, or the improved cash flow means they don't have to declare bankruptcy. Most often, there is plenty of time to go back to the beginning and try again, but there are exceptions. In this situation, I'd be particularly careful to sign up for a back up loan, or require a written loan quote guarantee, but people don't always understand the problem until they have been bitten.



Now when you don't sign loan documents, if you have put down a deposit with the lender, you are going to lose it. Low cost ethical loan providers who really can deliver what they talk about, and whose rates really are competitive, do not typically ask for deposits, and are willing to work without them if they do ask. They know their rates are competitive, that they intend to deliver what they talked about and that there are any rates significantly better out there. It's only when the company fails one of these tests that they have a real need for a deposit, in order to commit you to their loan.



One more item needs to be covered: Irrelevant documents aren't needed. I don't need anybody except those folks who are getting a negative amortization loan to sign a negative amortization disclosure. The same thing applies to pre-payment penalties. If they don't apply to your loan, they shouldn't be required. If they can't fund your loan without it, there is a reason, so don't sign disclosures you aren't willing to accept the implications of. If you sign a negative amortization disclosure, the legal presumption is going to be that you realized it was a negative amortization loan and accepted it on those terms. Ditto a pre-payment rider. Of late, unscrupulous companies seem to be asking people to sign these after loan funding "for compliance". Consult with your lawyer, but I wouldn't sign them at all. If they were able to fund your loan without them, they are obviously not a necessary part of the loan structure. If not, why did they fund your loan without them? The only "compliance" aspect is to this is complying with them getting paid more money. Admittedly, it's small-minded to refuse to sign the pre-payment rider when you were informed at sign up that the loan had a pre-payment penalty, but bottom line, they shouldn't fund your loan if they aren't willing to accept it as it sits, and that's not the situation most folks are running into. They are asking the questions and being told the answer is "no," only to discover later that the answer was really "yes," but by lying to their prospective customers, some loan providers can get paid large amounts of money and pawn bad loans off on most of their customers.



Caveat Emptor

UPDATED here

Cold Hard Fact for today: The average Real Estate Agent or Loan Officer is not motivated to tell you that you can't afford your property.



For the agent you are trying to talk people out of a property after they have already fallen in love with it. Let's face it, if it's higher in price, it should have features that lower priced properties do not, and it should have fewer things that consumers do not want. Indeed, one of the easiest and most common ways unethical real estate agents sell properties is by showing you several lower priced properties, fixers which lack those attractive extras, then show you the blinged out immaculate property while whispering sweet nothings like, "I can show you how you can afford the payments!" (which is not the same as being able to afford the property!)



All agents learn that by telling the client "no," or anything that sounds like "no," they are likely to lose that business. Good ones know that putting a client into something beyond their budget is a good way to have the transaction come back to haunt them. But for most, the temptation of the easy sale that made itself if too strong. They want that commission check. Nothing wrong with commission checks. If they provide real value to the client, they are a way of showing the world that you have done something valuable, same as a doctor, carpenter, or computer programmer. It's when you use your position of trust to sabotage them that problems start - and you should experience problems. Many agents have not been around long enough to understand flat or declining markets. In truth, I wasn't in the business the last time we had one, either. But I am old enough to remember, and careful enough by nature that I refuse to assume that a rapidly rising market will save my bacon, as many agents have become used to.



And for the foreseeable future, rapidly rising markets are unlikely to save anybody's bacon, because the market isn't going to be rising rapidly. Inventory is high, long term rates are set to rise, and we're just seeing the leading edge of a wave of problems caused by over-the-top practices of the last few years. I think we're past most of the price decline locally, but conditions aren't there for a return to the market we had most of the last decade.



Lest you be wondering, the loan officer is even more unlikely to counsel you on whether you can really afford the property. Between Stated Income, Negative Amortization Loans, and loans that are both of these, you can get anybody with an income and a not too putrid credit score into the property. In fact, I heard some real howls of outrage from certain brokers when lenders tightened their recourse on brokers this last year. Even so, the paycheck is now and certain, the risk of default vague and indefinite, and for most loan officers, there's another concern as well.



You see, most loan officers cultivate some friends who are real estate agents, and that's how they get their business. That agent brings them business because they have a history of getting the loan through, so that agent gets paid. Sometimes they may have their hand out for a referral fee as well, but the important thing for you to know as a consumer is that referral you get from an agent to a loan officer has nothing to do with how great their rates are, and everything to do with how creative they are in getting some sort of loan approved so that agent gets paid for the house they sold. Tell just one prospect who has made an offer on their dream house that there is an issue with being able to really afford that loan, and the word will get around the real estate community in no time. Result: For causing one agent to not get paid, Joe Loan Officer not only will not get any referrals from them in the future, if the client does find Joe Loan Officer on their own, the agents are going to do their best to talk them away from Joe, who, from their point of view, "stole their paycheck" by telling the client that they really could not afford the loan that was necessary to make the transaction work! Even if they took that transaction to some other loan officer who got it closed, Jane Realtor doesn't want her clients to have anything to do with Joe, lest she lose another potential commission check!



So what can you, the consumer, do about this? Well, I can't tell you all about the special cases, and I lack the programming capability to embed a spreadsheet and loan calculator. But I can give you some good general rules of comparison, and guidelines laid down by lenders as to whether or not you can actually afford that loan.



Start with your total monthly gross income. Assuming you printed this out, write that number here:

Loan Type A Paper ARM A Paper fixed sub-prime general sub-prime severe sub-prime extreme

Multiply Income by (DTI*) 0.38 0.45 0.50 0.55 0.60

Result _______ _______ _______ _______ _______

Notes A,B B

*DTI: Debt to Income Ratio



Notes:

A: use fully indexed rate for qualification purposes. This means the underlying index plus the margin after it adjusts, assuming current values.

B: If interest only, use fully amortized rate for qualification purposes.



Any four function calculator will do this much. Now this is the largest number you will qualify with. As you should be able to see, it's more difficult to qualify for A paper, even though that is where you want to be. But we're not done. This is total housing and debt service, the so-called "back end ratio." So from that number, you need to subtract your monthly debt service: Car payments and other installments, and minimum credit card payments. You pay this much already. You obviously cannot afford to pay it out for housing also!



So add up your credit card, car payment, and other monthly debt obligations. Subtract it from your numbers for back end ratios, computed above. This will give you a set of five numbers that tells what you can afford for housing costs, depending upon how far you want to go. But we're not done! This is total cost of housing; the so-called "PITI payment." It includes not only principal and interest on the loan, but also property taxes, homeowner's insurance, Condominium Association dues, and Mello-Roos assessment districts (or their equivalent outside of California, if applicable). So from this, you need to subtract all of the known stuff or stuff you can make a close approximation on, like Association dues and insurance and taxes, to arrive at how much of a loan you can afford. Please note that for Negative Amortization Loans, loan officers may use the minimum payment for qualification, but you are still being charged the real interest rate! Still, it should become obvious as to why Negative Amortization loans are so popular in high priced areas right now. Not only will the lenders pay between 3.5 to 4 percent commission for them, not only do they allow lower payments to be quoted, but they make it look like you qualify for a bigger loan than you can afford, which means the real estate agent gets a bigger commission from selling you a more expensive property, and the loan officer gets paid more, also, because now you have applied for a larger loan! I have heard every rationalization under the sun from loan officers and real estate agents on this score, but they are still inappropriate for the vast majority of people who have them. I can get a better interest rate on a better loan for less cost, every time, but then I have to tell the client about the full amount they are really being charged every month, and they might have to content themselves with a less expensive property, meaning that real estate agent is going to have to do some real work. Go out onto the web and look for some loan calculators (Auto loans use slightly different assumptions, so don't use those calculators), or if you have a financial calculator, use it! Use the real interest rates that are available, and if the number you get comes out much higher than your quoted payment, they are trying to snooker you with a negative amortization loan. There is no magic about loans, and a healthy skepticism will help you prevent problems from happening in the first place.



Now add the down payment you intend to make to the loan you can afford, and that tells you whether or not you can afford the property.



Caveat Emptor

UPDATED here

I get people asking me about how much their mortgage loan providers make, usually with an idea towards negotiating it down but often with the idea of choosing one loan or the other based upon the loan officer's compensation. This is a bad idea.



First off, there are several forms loan officer compensation takes. There is so-called "front end" compensation paid directly by borrowers. There is "back end" compensation paid by lenders, also known as yield spread. There are also volume incentives given by most lenders, and promotional give backs and offsets. Then there are times when the loan officers is holding out their hand for kickbacks behind your back or by "marking up" third party services that they order on your behalf. This is illegal, but it still happens. Trying to judge a loan by loan officer compensation is actually fairly difficult if they are trying to hide it.



Furthermore, it's actually a distraction from what is most important, namely, the best possible loan for you. For instance, a couple of weeks ago I was shopping a loan for a decidedly sub-prime prospect. The lowest quote I got enabled me to give a quote of a 7.25% retail rate at par, which is to say no points to the borrower. But that lender was better than half a percent better than their nearest competition because he fit neatly into one of their targeted niches. Had I merely not shopped that loan with that lender, the best I could have done would have been 7.8 percent at par, and one full point from the borrower would only have driven it down to 7.3 percent. Now suppose I didn't shop that one lender who gave me the best price, and my competition had found something even better, say a 7.00 percent par rate loan. For that particular loan, they could have made a full percent and a half of that loan amount more than I did, and still delivered a better loan for the client.



Now in point of fact, I actually beat my competition by quite a bit, and I was willing to guarantee my quote where they were not willing to guarantee theirs. But the point I was making is still valid. Judge the loan by the best loan for you: Type of loan, rate, and total cost in order to get that rate.



Furthermore, brokers and people who work at brokerages legally must disclose their company's compensation from other sources, while direct lenders do not. Direct lenders are making, if anything, more for the average loan than the brokerages, but because they do not have to disclose compensation not paid by the borrower, if you try to use loan officer compensation as a way of judging the value of the loan, the direct lender will look better than the broker for most loans. Until you go and compare the loans they actually were prepared to deliver from the most important perspective: What it means to you, the consumer. A 6 percent thirty year fixed rate loan with no pre-payment penalty that cost you a grand total of $3500 is a better loan than a 3/27 that has a pre-payment penalty, cost you $8700, and is at a rate of 6.25%, regardless of how much the respective loan officers or their companies made, or would have made. Loan Officer compensation is a distraction. Much more important is the loan they are willing and able to deliver, it's type, rate, costs, and whether or not there is a pre-payment penalty.



Caveat Emptor

UPDATED here

The most recent hot thing in mortgage circles is a mortgage accelerator program. Now I've heard other things, most notably biweekly payment programs, called mortgage accelerators in the past, so let me take a moment to define exactly what I'm talking about.



A mortgage accelerator is essentially a combined mortgage and checking account, where every month you deposit your entire pay, and then write checks out of it as the month goes on to pay for your living expenses, and the mortgage interest of course accrues on a daily basis. The good things about it for consumers (and it is a good thing, as far as this goes) is that the entire paycheck is applied against your mortgage balance on day one, when your pay is deposited. This means that instead of just the minimum monthly payment, your entire pay goes towards the mortgage, lessening the amount of interest you pay in any given month. The bank, for its part, gets your entire paycheck and a significantly lower incidence of default.



This isn't a new concept. Several banks had somewhat different versions back in the late eighties. It went away. Why?



Several reasons, some administrative, some financial. First, the administrative. This bank has basically your entire financial activity. Let's say someone gives you a better deal. Now you either have to stick with a mortgage accelerator program, or go through the hassle of coming up with enough cash to start a new checking account if you go back to having a standard mortgage. Furthermore, when you do refinance, what happens to outstanding checks? That payoff is as of a specific day at a specific time. Your escrow officer comes in and gets the payoff demand, and then more checks clear and everything has to be re-figured. The alternative to this is freezing the account as is done with Home Equity Lines of Credit. So all of a sudden while you are going through this refinance, you have to come up with the seed cash for a new checking account, get new checks rushed through, and then pay your bills with the new checks. May the Universe Help You if you normally pay by automatic debit or any of the primary variants, because you have to set that up as well.



So what else does the bank get out of it, looking at the above? Increased opportunity costs for refinancing. In short, it makes it more difficult for you to take your business elsewhere. Cha-Ching! as the bank officer's eyes light up with dollar signs.



Now obviously, this mortgage accelerator saves you money, if you assume it's just a matter of math, and that math shows how much interest you save as opposed to the same loan at the same interest rate, providing you keep money in your checking account, of course. But how many people do? Not that many, these days.



Furthermore, it assumes you get the same loan at the same interest rate that you normally would. I haven't comparison shopped many of these yet, but my general impression is that the rates, and costs to get them, are higher than you might otherwise get. The assumption that it is the same rate and the same costs on the same type of loan is just that, an assumption, made for modeling purposes. I have used the metaphor of the matador in the past. The bull (consumer) wears himself out on the obvious large red cape, namely the cool service and the fact that all your pay is applied to your mortgage, and never sees the sword, which is the fact that your interest rate is half a percent higher than you might have gotten, you paid an extra point of origination as well, and you're being dinged $10 per month administrative tracking charges for this cool new toy you just got, the accelerator mortgage. Let's say your mortgage is $400,000. Half a percent of $400,000 is $2000 extra interest per year. An extra point of origination is $4000. And $10 per month is about what the average person might save on their mortgage interest if they weren't paying a higher rate, which they are.



($6000 per month deposited, instead of maybe $2500, leaves $3500. You save an average of one half months interest per month on this difference. $3500 at 6% divided by 24 is $8.75. If they bill you $10 per month for the service, you are out $1.25 per month net, on top of the additional interest charges and the one time fee of several thousand dollars of origination)



So lenders with mortgage accelerators charge you more money, charge you more up front costs, and you pay higher interest charges, as well as making it more difficult for the consumer to refinance into a better deal somewhere else. The banks love this one. Only the fact that your parents figured out what a rotten deal most of these are kept them from becoming a permanent fixture of the mortgage landscape nearly twenty years ago.



Now if you can find a mortgage accelerator at the same interest rate, for the same costs, and without the monthly fees that you don't have to pay for your other mortgage, then YES it makes a huge amount of sense to have one of these programs. But that's not what most of the lenders are offering. They are hoping that you are so distracted by the mathematics of how much you will save if you keep your mortgage until it's paid off, that you will never see how much extra you are really paying. Nor do most people keep any given mortgage longer than a few years. In fact, the median time living in a particular piece of real estate is only nine years - less than one third of the time until payoff. The metaphor of the matador is extremely apt. This is precisely what the matador does with the bull. Distracts them and wears them out with the cape so that they never see the sword. The banks dangle this wonderful mathematical concept of what might happen thirty years down the line for that one tenth of one percent of people who actually keep the loan that long, while hoping you are so fascinated by it that you never notice that they're charging you more up-front fees and a higher interest rate than you would have gotten with a traditional mortgage, and often, more in monthly maintenance fees that you save by depositing all of your pay. In short, the lender is making more money off of you by pretending to do you a favor.



So shop loans by interest rate and cost, and then if they'll let you put a mortgage accelerator on it for free, great! If not, they're just trying to distract you from what is really important by offering you a convenience and a cool-looking trick, while charging you hefty amounts of money and tricking you into thinking you are getting something beneficial.



Caveat Emptor

UPDATED here

I got a question about what I think about those online quote services.



The answer is that they vary from okay to putrid.



There are two sorts of online quote sources. The first is where mortgage companies have their rates online, and people come along and browse. Those are pretty much a waste of your time. Here's why: Those companies have absolutely no hold and no real tracking on the people who come to browse. They might put a cookie on your machine, but it's hard to parlay those into contact information, which is their whole entire goal: Getting loans out of it. Unless they have some way of contacting you, which they don't, they need to use that forum to get you to contact them. They do this by low-balling their quotes, making it look like they are offering something nobody else has. Unfortunately for consumers, that's not even an estimate. Here in California, the one caveat is that the rate must exist, but the real costs of getting that rate can be many times the costs they quote. This suffers from all of the limitations that a Good Faith Estimate does, plus more. They can say that they've got a 3.625% rate, and as long as they have a 3.625% loan, they are in the clear. Never mind that it costs a full six points and adjusts every month, that sounds like a great loan to the uninformed. Furthermore, many places will quote the nominal ("in name only") as opposed to real interest rate on the negative amortization loan. When there are people apparently offering you 0.5%, that's who most consumers will call, ignoring the people who have and can really do 5.5% thirty year fixed rate loans, more so on those forums where they include a payment quote as well. I've got the same 0.5% nominal rate forty year amortization loan available to me, but it will always be a putrid loan, as the real rate is a little over 8% and the rate is subject to change every month. I should note that lenders pay a lot of yield spread to brokers who do those loans: How often do people sign on the dotted lines for mortgage rates in excess of 8% (with a three year prepayment penalty!) when 5.5% is available on a thirty year fixed rate mortgage with no prepayment penalty at all? I'll tell you how often: Whenever people aren't smart enough to realize that that $960 payment on a $417,000 loan isn't the real rate. Indeed, they'd have to pay $2794 per month just to pay the interest - while the fully amortized payment on a thirty year fixed rate loan is only $2368. But there are an awful lot of people who aren't smart enough right now.



Furthermore, those online forums are supposed to enforce their quotations policies. I've never heard of one that enforces real concrete penalties for violators. On two separate forums, I went straight down the line contacting every listed company, using a loan scenario that was close enough to what they were supposed to be quoting to that I should have gotten the same quote or a little bit better, if they could really do those loans. Not once did I get a rate that was within half a percent of the rate listed online, and most of them were over a full percent off, and with negative amortization loans, most are not even in the correct ballpark. When I contacted the forums themselves, neither of them was interested in enforcement.



In short, those online quote forums tend very strongly to get business for the company that tells the biggest, most boldfaced lie. Often, the consumers are lulled by the existence of the forums into thinking they're getting a deal, and they don't bother going through the necessary steps to shop their loan around. Meanwhile, the companies that will advertise honest rates quit those forums in disgust. Since there are a lot more companies playing games with their quotes than honest ones, the forum wins by not enforcing their rules. However, since the consumer wants to find companies that really will deliver the loans they advertise, consumers lose. Matter of fact, I don't think I've ever seen a real rate on a loan I would be willing to sign up for advertised in any forum: online, newspaper, or otherwise.



The second type of online quote forum work like the advertisements plastered all over the internet. "$510,000 loan for $1698 per month!" (to use the first I found just now). They show a couple dancing happily, having a party because their mortgage payments are reduced, or so they think. Another shows a guy jumping for joy. What they don't show is those same people when they figure out all of the downsides to the negative amortization loan that they signed up for. "This is Jack calling his lawyer again, only to be told there's nothing the lawyer can do again. This is John and Jane losing their home to foreclosure."



Their come on is that you're supposed to get four competitive loan quotes. The company advertises negative amortization loan payments because more people will click on them and sign up for the service if they think they might get something so great that anyone would want it. Unfortunately, just like every other negative amortization loan out there, the payment or interest rate they quote to get you to click their ad and complete their form online is not the real payment and it is not the real rate. Yes, they will accept that as a monthly payment. But the interest you are being charged is based upon a rate of 7.87%, and you have to pay $3345 per month just to break even on the interest - that other $1647 gets added to your loan, so that next month you owe $511,647. Doesn't seem like a lot of extra, but go along for three years until the pre-payment penalty expires, and even if your rate doesn't adjust upwards, your balance is now $576,600. If you go the full five years that the minimum payments last, you owe $630,000, and now your payment jumps to $4813, and you can't refinance because you are upside-down on your mortgage, and your credit score is 100 points lower!



The games don't stop here, by any means. You'll be told that there are "no costs out of your pocket," and even though they'll be rolling $23,000 in costs and points into your loan, they give you a quote based upon the amount of money you tell them you need. No, $23,000 doesn't make that much difference at half a percent forty year amortization, but it lets them quote that payment just a few dollars lower, even though they know that you want the $23,000 rolled into your loan. Nor is what they're telling you about a good loan in any way shape or form, but most people shop mortgage loans based upon payment.



Furthermore, they aren't telling the truth about four mortgage providers calling you. They may sell the lead to four different places, but those four places turn around and sell them to four others each, and each of those sells them to four more. There may be as many as six levels of this going on, and the average person who does fill out their form will be called by at least fifty providers in the first week, with others trailing out for potentially years. The lead seller doesn't care - they made their money, and they don't give refunds simply because the loan they talked about is toxic. Nor does it matter to them that the loan they talked about puts the loan providers paying them for leads in the position of either telling people - honestly - that the loan that was used to get you to sign up is a piece of garbage that causes people to lose their homes, or just selling you one of the abominations. They don't get refunds from the lead seller in the first case; they're just out the money. In the second case, they get paid roughly 3.75% of the loan amount by the bank ($19,125 on a $510,000 loan), plus whatever points of origination that they can con you out of. Finally, if they don't, they know that one of the fifty or more other companies that will be calling you will sell you one of those loans. So their motivations are not on the side of telling you the downsides of their loan. Matter of fact, their motivations are never aligned with telling you the downsides of the loan, so if you find someone willing to talk frankly about good and bad, they are a treasure and it is worth keeping their contact information, and making a habit of talking to them first about future loans.



Once upon a time, if you could cut through the morass of fifty or more companies calling, those "competitive quotes" ads were a great way to find a good loan provider. Ethical low cost loan providers could make a very good living buying those leads. Unfortunately, that is no longer the case. First off, ninety-nine percent of the leads you pay for were lured in with the promise of a negative amortization loan. You don't get refunds for those. You are just out the money, time, and phone expense of calling those folks - unless you make a habit of selling negative amortization loans, which low cost ethical providers do not. Furthermore, even on the few leads that are not lured in by Negative Amortization payments, just because you don't try and sell them a negative amortization loan doesn't mean that one of the other fifty companies won't. Having been there and done that, I can tell you from experience that trying to talk people out of negative amortization loans is usually a waste of breath - the competing company will use conspiratorial tactics like, "That's because this mortgage is too good - they don't want you to have it!" People want to believe in Santa Claus, the Tooth Fairy, and Negative Amortization Loans. Bottom line for ethical loan providers: paying these services for leads no longer works. You cannot make any money at it. Since making money is what you're about, and the payoff is too low to survive on the thin margins of good providers, you are driven elsewhere for your business leads. Since that's the type of loan provider you want, it's a waste of time to go to either sort of online mortgage quote service.



Caveat Emptor

UPDATED here

from an email:

First let me say that I really learned a lot from your postings/articles/website; its awesome that a resource like yourself exists.



Now to the problem. I recently refinanced and the mortgage broker lied to me about many, many things. I was sold a negative amortization mortgage. The broker provided me a chart showing my payment schedule for 30 yrs; it showed my payment split between interest & principal. I was told that my rate was fixed for 5 yrs and that it would go up to as high as 9% after the 5 yr period. When the closing came and I inquired about the 9% highlights in the docs and the negative amortization disclosures he stated that they didn't apply to me or this loan. He pointed to the section of the doc that stated that my payments would be fixed for 5 years and that my interest rate would also be fixed for that 5 year period. After closing I received the docs from the lender which outlined the fact that I had 4 choices for payments and when I called for the explanation I almost died. The broker apparently didn't really understand the loan at all; he has now offered to refinance me without any fees...but I am supposedly stuck with the prepayment penalty. When the broker and I originally discussed the penalty he explained that I would probably want to refinance at the end of the 5 yr period anyways so I shouldn't worry about it. The broker also took my lead from a mortgage company he was working with when I originally inquired about the refinance. About 2 weeks into the process he told me that he had quit his job @ the mortgage company and was now out on his own as a broker (emphasis mine DM). Only now did I just realize that he really didn't have the ownership of my lead as his original employer paid for it & provided it to him during his employment. I'm sure that his original employer would be very disappointed to learn that he had taken the business with him when he resigned.



Now that the problems been explained my questions are as follows; Can I sue the broker to recover the refinance fees and the prepayment penalty?



Can the broker that lied to me and provided all the false info be sued or charged; can he lose his mortgage brokers license?



Any advice as to what I can do/what I should do at this point? Thanks in advance for any info you can provide. Please let me know if you respond directly to emails or if I need to go to a specific website to look for a reply.

There are several issues raised here. The largest major red flag is about the Negative Amortization Loan Disclosures. If it didn't apply to your loan, why did they present them to you? There isn't a good answer to that question. If something does not apply to your loan, you are within your rights to not sign. If they don't apply to your loan, then the lender doesn't need it. I don't have my clients sign negative amortization disclosures for thirty year fixed rate loans, or anything else to which they don't apply. Now there are any number of disclosures that legally have to be filled out for every loan and sometimes multiple disclosures for basically the same purpose. I had to do four "equal opportunity" disclosures for my most recent loan. But those are utterly harmless, simply informing you of your rights. A negative amortization disclosure isn't. With that, they can prove that you were told that your loan was negative amortization, and you must have been expecting it, because you signed it, didn't you? That's the lawyer's logic.



I am rapidly becoming more aware of a trend with unscrupulous mortgage lenders: Instead of putting bad stuff in the actual Note, they are adding it on as part of the all the disclosures people have to sign, hiding it in packs of supplemental stuff along with all of the standard stuff that everyone knows have to get signed. Sometimes, they are even coming back to people after funding and asking them to sign horrible things, prepayment penalties and negative amortization disclosures, among others, "for compliance." I want to see a standard booklet or checklist of forms that actually are required by law for every loan, so that innocent consumers who are trying to do the best they can know what is and isn't required by law.



If disclosures do not apply to your loan, do not sign them. They don't need it to fund your loan. There is no reason why someone who's getting an amortized, or even interest only loan, needs to sign a negative amortization disclosure. Just refuse to sign. If it doesn't apply to your loan, then they don't need it to fund your loan. If they then fund your loan and it is negative amortization, you have a good case, so they're not likely to fund it. Refusing to sign stuff that does not apply to your loan protects you.



Now, as to the broker not understanding that the loan was negative amortization: I suppose it's possible. There are people out there in my industry who are mind-numbingly stupid. But the odds are overwhelmingly in favor of the likelihood that they lied to you. There are required submission forms on every loan that most consumers will never see, but it's a requirement for the loan officer to fill them out. They are filled out and submitted with your loan package, and they quite clearly indicate all the relevant facts of your loan.



Now, as to your options going forward. There's nothing wrong with people quitting their employers and going into business for themselves, if they provide good loans at a good cost. Yes, his former employer may want to sue him for the commission he earned, and such might be one way of extracting vengeance, if such is your mindset, but it's not going to help you at all. Nor should you care about who "owned" the lead. You as a consumer are not obligated to anyone except the provider who delivered the best loan at the lowest real cost. And of course the broker who did your loan wants to get paid again with a new loan. Since they are claiming to be stupid enough to drop your state's average IQ by twenty points, you may have to give him directions as to exactly which tall building or cliff you want him to jump off of. They have proven that they are not worthy of your business or anyone else's. Please do make a formal written complaint to your state department that regulates mortgages. In most states it's the department of real estate, but if it's not, they will know who to direct you to. They should lose their license and be barred from the industry for life over this. Unfortunately, your complaint alone probably won't do it, but people who get multiple complaints do lose their licenses, and sometimes, one is enough, if it's egregious enough.



The next issue is what can he sue for? I'm not a lawyer, but every adult in the United States should know the answer to that question is "anything at all," or even "nothing." The better question is where are you likely to recover money, and how much? Once again, I'm not a lawyer and you should talk to one, but I strongly doubt that you've got a good case for anything in civil court. He's got all of those documents you signed ("the weight of the evidence"), and even if you get some jury to agree that you are owed money, it's likely to be overturned upon appeal. This is why unscrupulous folks want you to sign all those documents.



What do you want to do? You indicate your interest rate is fixed, and it must have been low enough to be attractive. If this is the case, make your monthly payments on time, and make the fully amortized payment, usually the third payment option on Negative Amortization ("Pick A Pay") loans. However, I don't believe that is likely to really be the case. I have literally never seen one of these abominations where the real interest rate was fixed, or where the real interest rate was competitive with amortized loans. The attraction of these loans is low payment, and the real interest rate is usually at least 1.5% more than I could get the same person on a fully amortized 5/1 ARM, and right now thirty year fixed rate loans are about the same as the 5/1 ARM. People who don't know any better get the low payment, the bank gets your signature on a loan that's 1.5 percent higher than you could have gotten, and people who don't know any better will line up and fight for these loans! They are easier to sell than free beer to people who don't know any better! The hard thing is selling them something else when other providers are telling them about Option ARMs. So you're probably going to want to refinance, as over a three year period, 1.5 percent rate differential will save you a lot more than the pre-payment penalty.



I answer question emails directly. It may take me some time, but I do answer them, provided they don't get lost in the spam filter. If it's an issue I haven't covered before, or only tangentially, I do like to use questions as the basis for new articles, but I answer questions asked via email by return email. If there are already good answers on my site, I'll send you the link, because it was obviously too hard to find it. If there aren't, you'll get your question answered before any article appears.



Please ask if this does not answer all of your questions!



Caveat Emptor

UPDATED here