Mortgages: June 2007 Archives

The short answer is "Because it costs less"



There is always a trade-off between rate and cost on a given loan type. If you want the thirty year fixed rate loan half a percent lower than everybody else is getting, you're going to pay for it in the form of discount points. The higher cost always goes with the lower rate. You might as well consider it a law of nature in the same league as gravity, because it is a law of economics. If you don't want to pay high costs, you end up with a higher rate. End of story. There are all kinds of games that can be played with loan quotes, but the fact of the matter is that of the tens of thousands of rate sheets I've seen from over two hundred different lenders from A paper all the way down to hard money, every single one of them conforms to this fundamental truth. A 6.00 percent loan will cost more from the same lender at the same time than a 6.50 percent loan of the same type. Some lenders have different trade-offs than others because they are aiming at different target markets. I could tell you about lenders that rarely have a rate below par on their sheet, and lenders that rarely have a rate above par, par being the point at which there are no discount points to get the rate, but no yield spread either. Some lender's par may be lower than others, or higher. The par on a completely different loan type, or loan program, will be different. Par varies with time, the qualifications of the borrower, the type of loan they desire, the type of documentation they are providing, and other concerns as well.



The cost of a loan is sunk. Once you have the loan, the money you spend to get it is gone, whether you paid it out of pocket or rolled it into your balance. If you sell or refinance before you have recovered it via lower interest costs, you don't get it back. Actually, if you roll it into your balance, the money isn't gone, because you still owe it and you're paying interest on it. If you sell, it will mean you get less money, and if you refinance again, your balance will still be higher. Paying it out of your pocket is no better, because you could be investing that money, likely at a higher rate of return than the rate on most loans.



Now here's a very old rate sheet I saved from a random lender. The rates are much higher now. All of the lock periods are thirty days. I'm going to presume a $400,000 total loan, as if you're doing a cash out refinance to a specific loan to value ratio, but the principles are the same no matter the loan size.







Rate

5.25

5.375

5.5

5.625

5.75

5.875

6

6.125

6.25

6.375

6.5

6.625

6.75

6.875

7

discount

3.898

3.221

2.6

2.01

1.452

0.963

0.615

0.252

-0.063

-0.381

-0.661

-1.039

-1.27

-1.511

-1.577

pts $

$15,592.00

$12,884.00

$10,400.00

$8,040.00

$5,808.00

$3,852.00

$2,460.00

$1,008.00

-$252.00

-$1,524.00

-$2,644.00

-$4,156.00

-$5,080.00

-$6,044.00

-$6,308.00

total cost

$19,092.00

$16,384.00

$13,900.00

$11,540.00

$9,308.00

$7,352.00

$5,960.00

$4,508.00

$3,248.00

$1,976.00

$856.00

$0.00

$0.00

$0.00

$0.00

net $

$380,908.00

$383,616.00

$386,100.00

$388,460.00

$390,692.00

$392,648.00

$394,040.00

$395,492.00

$396,752.00

$398,024.00

$399,144.00

$400,000.00

$400,000.00

$400,000.00

$400,000.00





Alternatively, If you owe $400,000 and roll the costs into the balance, it becomes the following. Actually, the costs are mostly higher because points are computed based upon final loan amount, while I was too lazy to recompute from the previous example. Also, the maximum conforming loan is $417,000 currently, so going over that would cause the rates to rise notably, but assuming you have a 7% interest rate now, this is how quickly you would recover the costs of the new loan:







Rate

5.25

5.375

5.5

5.625

5.75

5.875

6

6.125

6.25

6.375

6.5

6.625

6.75

6.875

7

total cost

$19,092.00

$16,384.00

$13,900.00

$11,540.00

$9,308.00

$7,352.00

$5,960.00

$4,508.00

$3,248.00

$1,976.00

$856.00

$0.00

$0.00

$0.00

$0.00

loan

$419,092.00*

$416,384.00

$413,900.00

$411,540.00

$409,308.00

$407,352.00

$405,960.00

$404,508.00

$403,248.00

$401,976.00

$400,856.00

$400,000.00

$400,000.00

$400,000.00

$400,000.00

int/month

$1,833.53

$1,865.05

$1,897.04

$1,929.09

$1,961.27

$1,994.33

$2,029.80

$2,064.68

$2,100.25

$2,135.50

$2,171.30

$2,208.33

$2,250.00

$2,291.67

$2,333.33

save/month

$374.81

$343.28

$311.29

$279.24

$247.07

$214.01

$178.53

$143.66

$108.08

$72.84

$37.03

$0.00

$0.00

$0.00

$0.00

breakeven

50.94

47.73

44.65

41.33

37.67

34.35

33.38

31.38

30.05

27.13

23.12

0.00

0.00

0.00

0.00



*over $417,000 kicks into non-conforming loan territory



People shop loans by payment. They shouldn't, but they do. Furthermore, a lot of people seem to get quite a stroke out of bragging that they have a low interest rate. But if you add $19,000 to your balance and only keep the loan long enough to recover $15,000 in interest, you've gotten a negative 20% return on your money - not including the time value of money. Furthermore, this money usually equates to the fact that you're going to have a higher balance and end up paying more money and higher interest on your next loan.



Now, it may be counter-intuitive, but it is easier to qualify for a loan with a lower rate, because the payments are lower, and therefore the Debt to income ratio is better. So any time somebody tells you that you didn't qualify for the same loan at a lower rate, you know it's nonsense. If you qualify for the program at all, you qualify more easily with a lower payment. This begs the question of whether you qualify for the program at all - your credit score could be too low, or it might not allow a loan to value ratio or debt to income ratio or any of many other situations you find yourself in, but if you qualify for the program, you will qualify at the lower rate. It may be smarter to want the higher rate, but that can be effectively eliminated by debt to income ratio.



So that's why low and zero cost loans are not popular. Most people focus in on either payment or interest rate, and when they discover that the low or zero cost loan means a higher interest rate, they're not interest. But if you don't keep the loan long enough to recover the additional costs, you're wasting money. Only a true zero cost loan can have you ahead immediately, but advertising or selling zero cost loans is like King Canute trying to command the tide to turn. Most people aren't interested.



There are other considerations. I've been telling people interest rates are going to rise for quite some time, and so rates gotten now are not going likely to be equaled for quite a while. This has now become quite apparent, for instance, if you've been pricing loans lately as opposed to when this rate sheet was valid a few months ago. If you're not intending to sell any time soon, it's likely to be a good idea to pay part of a point or even a full one, as you're likely to be keeping the loan longer, and the median time between refinancing is likely to rise. Nonetheless, there are limits on the size of any bet you want to make, and when you pay costs up front for a loan rate, you are betting that you're going to keep it long enough to more than recover those costs. For quite a few years now, the lenders have been winning the vast majority of those bets.



Caveat Emptor

Article UPDATED here

Two absolutely vile things in the mortgage field that I've heard with my own ears. The first, a radio ad, hyping a loan as a thirty year fixed loan. They quoted a rate that seemed way too low, so being a broker that's approved with them, I hauled out that lender's current rate sheet. Well the rate was for a thirty year loan all right, fixed for two years with a three year pre-payment penalty and with three points of discount. So yes, you could say that it is a thirty year fixed rate loan, but that's not what everyone thinks of as a thirty year fixed rate loan, and it definitely isn't the industry standard name for what they are selling (which translates into polite english as "feces").



The other thing was waiting in line, I heard the guy in front of me (who worked for Big Name Major Bank) bad mouthing brokers, saying "They can charge anything they want, where it's our policy to never charge more than two points." Well, they may not charge the customer more than two points, but they do put them in a higher rate that would get a broker a six point rebate - if the broker was allowed that after charging a customer two points up front, which would be illegal and also not every broker wants six points total compensation for every loan (Most don't. The average loan I work on is about one point total compensation, and less than that for purchases where I'm the buyer's agent). Then, because Big Name Major Bank is a direct lender they sell the note to a third party at even more of a markup. This guy was telling the truth, but omitting the most significant parts of the story, lying by omission. One hopes you see the extent of the mind games this guy was playing. I said, "Excuse me, but don't you hate it when someone slanders your profession by telling half-truths that give a completely false impression? Then why did you just do it to me?" I managed not to call him slimeball to his face, but he deserved it.



The fact is that you need to shop around. Every profession has its scoundrels, and mine is unfortunately no exception. Many of them masquerade as your friend, but aren't. I suggest using my list of questions to ask prospective loan providers here, but remember that the stuff they quote to get you to sign up may be lies, so sign up for two loans. The way to avoid the problem posed by the smooth talker in the second instance is to evaluate all loans by the criterion that matters to you - which means by the loan you are getting, and what it costs you, not by what somebody else is making. If you can buy a widget at store A for $12.00, or at store B for $13.00, and they are in all other ways equivalent, why do you care that store A bought it for $9.50 while store B bought it for $11.00, and so store A is making more? The bottom line is you get the same widget for less money at store A, even if the store makes fifty cents more per widget. The principle is the same whatever you're buying.



Caveat Emptor

Original here

One of the things that most mortgage and real estate consumers get mixed up on is the distinction between low-balling and junk fees. Junk fees are when they add fees that really aren't necessary to what you're paying. Low-balling is when there's an essential cost (or the associated rate) that either gets underestimated or they somehow neglect to tell you about. This can also take the form of costs such as subescrow fees which happen because your representatives did not choose your service providers with your best interests in mind.



As I said in Mortgage Closing Costs: What is Real and What is Junk?, "The easy, general rule is that legitimate expenses all have easily understood explanations in plain English, they are all for specific services, and if they are performed by third parties, there are associated invoices or receipts that you can see." In my experience, the vast majority of what extra fees that appear on the HUD 1 despite not being on the earlier forms such as the federal Good Faith Estimate, California's Mortgage Loan Disclosure Statement, or a real estate agent's estimate of seller's proceeds, are not the result of junk fees being added for no good reason, but are the result of real fees that your agent or loan provider knew were going to need to get paid, should have known the amount, and chose not to tell you about them or chose to tell you they would be less than they are. In short, low-balling is a much worse problem in the industry than junk fees. I've had people tell me my closing costs seemed high, because despite the fact that I have negotiated for discounts from providers, other loan providers were quoting significantly lower costs. What's going on is not that my costs are high - in fact they're pretty darned low when you compare the fees my clients actually end up paying - but the fact that a large proportion of my competitors will pretend that a large percentage of those costs aren't going to happen. The penalties for this, in case you weren't aware, are pretty much non-existent.



The reason they do is is to make it appear for the moment as if their loan is more competitive than it is. What happens is that because it appears that their loan is cheaper for the same rate, people will sign up for their loan. They then invest the three to four weeks necessary to fund that loan working with that loan provider. By the time they discover the real costs and the rate of that other loan are going to be much higher than they were initially quoted, there's no time to go back and get another loan - and that's if the people notice, and industry statistics say that over half of the people do not realize even massive discrepancies between the initial quote and eventual loan delivered.



This is why most loan providers don't want to tell you what your loan is really going to cost. It isn't that the extra is junk or in any way unnecessary. It's that they want their loan to appear more competitive that it may really be. All of the incentives are lined up in favor of this behavior - they got you to sign up, didn't they? - and there is no penalty in law. Of those people who do notice discrepancies, eight to nine out of ten will give in and sign anyway.



This applies also to many agents' "estimate from proceeds of sale" form. Despite the fact that the default purchase contract and usual custom may have the seller paying for certain items, such as a home warranty plan and an owner's policy of title insurance, many agents will leave these costs off the estimate. Unless you're selling a fixer in utterly "as is" condition, you're going to end up paying for a home warranty plan. Unless the buyer's agent utterly hoses them, leaving that agent completely open to lawsuits, you're going to pay for an owner's policy of title insurance. Unwillingness to do so is a universal deal killer unless the buyers are getting a price more than good enough to make it worth their while to pay for it themselves. Even if they've deliberately chosen escrow and title providers such that you're going to pay subescrow costs, they'll likely leave those costs off their estimates. Why? To make it seem like you're getting a better deal from them than you actually are.



I've seen more than a few people who signed up with other agents or loan providers based upon ridiculous low-balls (and over-estimates of sale price). Without exception, these people end up paying every single one of those loan costs. It's not like the people who do the work are going say, "Oh well, it's not like we want to get paid for all this work we did." In the case of sales transactions, that's if it sells - and it's very unlikely to sell at all if it's overpriced. Nonetheless, this gives the person who gives the great line of patter - a supposedly "bigger better deal" - a large advantage in getting people to sign up with them. By the time the clients learn the truth, it's too late. Most people don't want to do the research up front to find out what's really going on. They wait until after they've already been hosed to do the research they needed to do in the first place.



Caveat Emptor

Article UPDATED here

One thing that is very common in the mortgage industry is masking loan costs by rolling them into your loan balance. People are less sensitive to being asked to roll this money into their loan balance than they are about writing a check out of their bank account. In the latter case, everybody understands that this is money you busted your backside to earn and save. In the former case, a lot of folks don't understand that the money is every bit as real.



Indeed, one of the standard ways to deflect questions about cost that seems to get taught to every loan officer by every loan provider is the phrase, "Nothing out of your pocket." Sounds like they mean there's no cost. That's not what it means. What it means is that they don't want to talk about what the loan is really going to cost, as they're going to have to do if you're writing a check. Therefore, they want to roll it into your balance on the refinance. Most people in most situations have had their property value increase since the last time they got a loan, which likely means there's plenty of equity to cover it.



For purchases, you can't really do this because your value is never more than the purchase price. There are only three places for loan costs to come from: Your pocket, your down payment, if you have one, which reduces to your pocket, and Seller Paid Closing Costs. Seller paid closing costs are an agent and loan officer favorite, because it makes it look like you're not paying them, even though you are. If nothing else, a smart seller would rather take $10,000 less in purchase proceeds than pay $10,000 of buyer's closing costs, on which they are going to pay commissions and taxes to boot.



This trick of making it appear like you're not paying closing costs is one of the best ways to get stuck with an awful loan, but most folks won't do the research until after they've already gotten burned. You are paying those costs in one fashion or another, I personally guarantee it. There is more than one way to pay them, but if you don't know how you are paying them, you are probably not paying them the way you want to, and you're almost certainly paying too much, to boot.



There is ALWAYS a trade-off between rate and cost in real estate loans. It can be very intelligent to pay some or all of your closing costs by accepting a higher rate, especially if you don't plan on keeping the loan very long. If you know you're going to sell or refinance within a few years, or think it likely that you will, it's likely to save you money if you accept a higher rate that has lower costs. On the other hand, if you're 100 percent certain that you're going to keep this particular thirty year fixed rate loan the rest of your life, sinking a couple of points into reducing the rate can be an excellent investment. However, be aware that if you later decide to refinance or sell after all, you're not going to get your previously sunk costs back.



People get talked into rolling multiple points into their loan because it reduces their rate, and therefore their payment, aka the check they're writing every month. Let's consider two rates and the associated costs I quoted earlier today, on a maximum conforming loan, thirty year fixed "A paper" (those rates are gone now, whether tomorrow's are higher or lower). 6.5 percent was 1.5 points, or $6255 in real money, plus about $3400 in total closing costs when you consider title and escrow and appraisal. You'll find a lot of loan providers will go a long way to avoid quoting you the actual cost of points in dollars. But at 7.00 percent, I could give them back about 15 basis points, or $625, towards reducing their closing costs of about $3400. So assuming a $417,000 loan, this person would really get:







rate

6.5

7.0

useful $

407,345

414,225

cost dif

+$6880

-$6880

int/mo

$2258.75

$2432.50

int dif

-$173.75

+173.75

breakeven

39.6 mos

39.6 mos







However, that's dodging the real purpose of this essay. Suppose a loan officer was to pretend that these costs didn't exist when quoting you their loan rate. Their loan would appear to be cheaper, so that you would be very likely to sign up with them, but when the facts became apparent later on - that those costs exist in reality, whether your loan provider tells you about them up front or not - you're likely to continue with their loan anyway, because you don't have time to get another loan for one reason or another, or you just decide to stick with what you've started.



Furthermore, by pretending you don't have to pay loan costs, that makes it easier to get you to accept outrageous ones. Suppose your choices were to pay that $9700 in points and closing costs to get that 6.5% rate in cash, or you could pay $15,000 by rolling it into your loan balance. It is a sad fact that most people don't understand that this is about a point and a half more in costs that are every bit as real as dollars coming out of their checking account. However, most people are a lot more careful with dollars in their checking account because they understand that those dollars are real money. They had to earn it, dollar by dollar - in the form of so many minutes out of your life per dollar if you earn an hourly wage. Then they had to not spend it right away, as soon as they got their pay! Most folks figure they have something to be proud of if they save ten percent of their pay, but if you make $5000 per month, it takes over a year and a half to save $9700 if you save 10% of your gross pay. They understand that $9700 in terms of the nineteen months of their life it took them to save it. If they're just rolling it into the balance of their mortgage where it's being paid for by the fact that the home increased in value, it may be more than half again as much money, but a lot of folks somehow think it's not as real, and they'll accept rolling it into their balance much more readily than writing a check. It doesn't matter if you're writing a check or putting the money into your balance - a dollar is a dollar. By accepting the higher cost loan, not only are you wasting over $5000 of your money, but you're paying interest on it in the meantime.



If it's an expensive loan, it's an expensive loan, whether you're rolling it into your balance or out of your checking account. If you're paying too much money by rolling it into your balance, you're still paying too much money, and it's at least as bad as if you wrote a check or even counted out the cash. Doesn't matter whether you're writing a check or rolling it into your mortgage balance. So before you sign that loan paperwork, ask yourself if you'd be as happy with that loan if you had to write a check for every single dollar, or even count it out $20 at a time like an ATM machine. Chances are you'll be a lot more careful with your hard earned money.



Caveat Emptor

Article updated here


Hello,

When my husband and I bought our home 2.5 years ago (two bedroom condo) we qualified for the loan ($250,000) based on both our incomes. Then I had a baby and stopped working. We've never missed a payment or even been late, and we're getting by just fine by being frugal. However, our loan is a 5/1 ARM, and I'm skeptical of our ability to pay the adjustable rates once our fixed years are over. Our original plan (when we got the loan) was to
see about refinancing at the end of those five years. (Five years worked well for us because my husband was still in school and we knew we'd be here about that long, if not longer.) However, now that we no longer have
my income, all the mortgage calculators online are telling us that we can afford a loan of just about half the value of our home. What do we do in a situation like this? Is it possible to do anything other than sell our home once our five years are up?

A few other (maybe) pertinent details: currently we're paying interest only on our first mortgage (4.75%) and a principal and interest payment on our second mortgage (8.75%) Our home has gone up in value since we bought it, and we've made some improvements as well. Likely selling price right now (based on comparable properties that just sold in our area) is $325,000 to $340,000.

What do you think?

The first thing I want to ask someone in this situation is "How long do you have until reset?" The second would be, "Are you going to be able to afford the payments when it hits reset?" These two answers I'm fairly certain of, looking at the information provided. The third would be "Do you intend to change something about the situation before that time?" and "What's your market trends?" would be the fourth. In San Diego, I know the answer to four, but three is a guess, and you're not in San Diego or close to it.

You have the loan. It is already funded. You have lived up to all the qualifications you agreed to in order to get it funded. You don't have to do anything other than make the payments in order to keep this loan. If this were a 30 year fixed fully amortizing loan that you were already making the payments on, there would be no reason for you to do anything, because I certainly can't beat that rate today. Nobody can. If you have already got the loan and you can afford it indefinitely, you don't have a problem.

Unfortunately, that's not the case here. You're fine for now, but not forever. You have a known time approaching at which point you will be unable to make your payments. To make matters worse, there's no way to get that good of a rate now and it's not likely that there will be before your initial fixed period expires. That's the worst news.

The mildly bad news is that you're not paying your balance down much. Assuming you're not paying anything extra, you're not going to pay that $200,000 interest only first down by anything, and you've only paid the $50,000 second down by about $1000 now, and you'll only pay it down to about $47,800 by the end of the fifth year.

The mildly good news is that you've got 2.5 years left to do something with. You could go back to work, and if you do so now, you'll have two years continuous same line of work before the 5 years are up. Assuming you make as much as you used to, you should be able to afford the property.

This 2 1/2 years is time on your side. I keep telling folks time makes a great ally or a horrible enemy, but it's never neutral. Right now, it's on your side - giving you time to do something to change the situation. Once the adjustment hits, or even gets close, time will become your enemy. Don't waste time, but right now it is on your side.

The really good news is that your market has gone up, and you have a good amount of equity. This is about as surprising as gravity, but it is still good news. You're under 80% loan to value ratio if the numbers you gave me are valid. I wouldn't touch your loan right now, if I were you, but if you were in a sub-prime situation to start with, chances are good that you'd be A paper by now. You've got a 5/1 A paper loan with plenty of the initial fixed period left - but there's a lot of folks out there with 2/28 C paper. Especially if your adjustment had already hit, moving from 8% adjustable to a 6.5% thirty year fixed A paper without points (as of when I'm writing this) makes a lot of sense. Even if you don't want to sell o refinance now, know that that kind of equity means you've got some breathing room if you've got to have it.

The bad news is that if you sell, you're going to sacrifice some of that equity. It costs money to sell property. Assuming yours sells for $325,000, you'd probably only net roughly $299,000, of which your loans would eat $249,000, leaving you with $50,000 in your pocket. Right now, a lot of places are in a world of hurt for trying to sell, so your could be out more than that and still have to take a lower price in order to get it sold. If your condo was in San Diego, for instance, you'd be doing extremely well to net $35,000 from an actual sale right now, even if your condo really was worth $340,000. The condo market is just saturated with conversions. I think this will change soon enough to surprise a lot of people, but I don't know for sure.

Let's assume that you don't intend to return to work. If your loan was adjusting any time in the next year, it would be time to sell. However, you've got some time. If your market doesn't look like it's in danger of collapse, I'd probably wait. I don't know about where you are, but here in San Diego, I'd bet the market is going to be better for sellers next year than it is now. Most likely, more than enough better to justify waiting. If your market is just peaking, however, you've got a real issue, and you might want to get out now before you've lost all of your lovely equity.

One final possibility is planning to wait and refinance, doing the loan "stated income", telling the lender that you make more money than you do. This is dangerous. Quite aside from the fact that you are intentionally defeating one of the most important safeguards for your protection as well as the bank's, this is not what stated income was intended for, and you need to be careful that you're actually going to be able to make the payments without going backwards (in other words, no negative amortization). Better would be a fully amortized loan, but since you're already in the property, interest only is acceptable. If the situation is at least stable, why incur the costs of selling while the property meets your needs? However, at this point we do not know what the rates will be two and a half years from now. I don't know what the maximum rate you could afford is. I think 5/1 loans are going to stay about where they are now, in the low 6s. Can you afford even an "interest only" payment on a 6% loan ($1250/month on $250,000), which is roughly 1/3 more than you're paying now? 6.5%? 7%

This isn't a situation that can be tackled using only numbers, but the situation is not likely to be sustainable as it sits. You do have some choices on the table. The three most obvious are that you can go back to work, your husband can start making more money, or you can start making plans to sell the property. Any of them beat the default option, which is "do nothing and let the situation ambush us when time is up." And if you decide it's likely you'll be able to afford to refinance, keep an eye on rates. I think 30 year fixed rate loans are going up to the low 7s, but that's just a projection of where I think the capital markets and our economy are going. I could be very wrong. There is a point at which you will be unable to afford your property. If rates hit that point, your choices become basically, "Start the sales process now or wait?"

Caveat Emptor

UPDATED article here

or


Figures don't lie, but Liars Sure do Figure!

With the loan rates being significantly higher than they were a couple of years ago, we've got a lot of people with loans in the low fives, interest rate wise. One of the tricks lenders are using to persuade them to refinance is Weighted Average Cost of Capital, which really does take a page out of corporate finance books, but ignores a lot of details and alternatives.

This was an actual example that someone put online as an argument to refinance:

Current situation:

$350,000 first at 5.25%
$100,000 second at 8.5%
$50,000 consumer debt at 12%

This person then used standard practice to compute a weighted average cost of capital of 6.575, and justify refinancing all of it into a new first at 6.25%. They also assumed a tax bracket of 40%, which is a little higher than most folks pay, even with state tax figured in. Furthermore, it just took for granted the fact that there's enough equity in the property to absorb the full amount of excess debt without PMI. Robert Heinlein introduced me to this kind of attitude in Stranger in a Strange Land, calling it "straining at flies and swallowing camels," which is an apt description of what's going on, which is basically theater.

What's really making the calculation work in favor of refinancing is that $50,000 at 12% without deductibility, and assuming a tax bracket higher than most people are in. Even the top federal bracket is 39.6%, so if you live in a state without income tax (quite a few), the article was overstating any possible current benefit. Furthermore, those states without income taxes tax mortgage loans on the basis of size, some of them pretty steeply. I just got an email from someone in one of those states back east, and for a mortgage under $250,000, the state was charging about $7000 in taxes. That's almost a 3% surcharge on the base mortgage, and if you're going to roll it into the balance, you're likely to be paying points up front. You're also paying interest on it basically forever.

Doing the calculation on the basis of pure interest rate calculation, like the manuals teach (I've got an accounting degree) ignores the costs of consumer loans. For corporate transactions, the costs are built into the the interest rate of the obligations. For consumers, this is not the case. You're going to be paying thousands of dollars for the privilege of refinancing - points and fees, and in many states, taxes. As I've made clear in the past, there is ALWAYS a Tradeoff between Rate and Cost in Real Estate Loans, and the standard WACC computations do not include cost of the loan in whether it's worthwhile, only the rate. This makes it seem like the rate with three or four points is necessarily better than the rate with none, when in reality it's likely to take eight to ten years before the lower rate pays for its cost in terms of interest savings. Most people will never keep a given real estate loan that long in their lives.

Now just for a moment, let's give the author of that article everything they're asking for. In order to be able to absorb this debt without PMI, the property has to be worth $625,000 minimum, plus 125% of whatever fees and prepaids get rolled into the balance.

What this means is that I could, without touching that 5.25% first, refinance that second into a 30/15 at around 7.25%, and still get paid half a point yield spread to do a very easy loan that costs the consumer less than $1000 all told. You see, not only do we get a price break for the bigger equity loan, but because it's only 80% Loan to Value Ratio (actually CLTV), and so we get a price break of

$350,000 at 5.25%, 40% aggregate tax bracket, 70% of the loan, =2.205% contribution from this
$150,000 at 7.25%, 40% aggregate tax bracket (on 2/3) 20% of loan = 0.870% contribution
$150,000 at 7.25% non deductible on 1/3 10% of amount =0.725%
2.205%+0.870%+0.725%=3.8% weighted average cost of capital, which essentially ties the projected 3.75% on 6.25% which is 40% deductible, but the lowered cost more than covers the difference in interest - $250 per year - for ten full years, just based upon the difference in closing costs, never mind points or cost of interest on the increased balance.

So why do loan officers push a full refinance when there are better options? Quite simply, they make a lot more on first mortgages than second, so it's in their best interest to make it seem like refinancing a first is in your best interest, even when it clearly is not. Second mortgages are something I'll do for existing clients, but it's not business I chase because I just can't make enough to make it worthwhile, and chances are that a credit union is going to do about as well as I can. First mortgages, however, are a different matter - and not just for me. The projected first mortgage would make me roughly 7 times what that second does, and my margins are low by comparison with the rest of the industry.

Because of facts like this, you need to know enough to think about alternatives like refinancing a second and leaving a low interest rate first untouched. This is also why you need to talk to more than one potential provider, to increase your chance of getting one of them to give you a better way of doing things.

Caveat Emptor

Article UPDATED here

Note: This article has been updated to more accurately reflect changes in the market since originally written. The update is here


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

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

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

For the last two years, rates have been slowly climbing. People don't like refinancing when it will raise their rates, and quite often, they can't afford to refinance, even if they have to, if the payment is going to go up. This has caused many lenders to get desperate, and is certainly one of the reasons for the way the negative amortization loan has been pushed. Loan Officers don't get paid unless they are originating new loans this month, and negative amortization loans look wonderful on the surface, when all you know about is the minimum payment. (I'm also working on a post debunking the Weighted Average Cost of Capital scam some lenders are also using to persuade people to refinance out of low rates into high ones).

Furthermore, values have been declining, at least here local to me and in most other major urban areas. The problems this creates are far deeper than the benefits that arise when prices are rising rapidly. When the loans total $500,000 and the property is only worth $420,000, that's a problem. That's a real problem. Lenders do not want to lend more than a property is worth. The highest financing regularly available is 100% of value. The situation I have just illustrated is a 120% financing situation. On a straight refinance, that's not going to happen. Period.

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

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

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

There second option for refinancing is a 125% equity loan piggybacked onto an 80% first loan. The problem is that the terms on these are ugly. It's not likely to cut your interest rate or your payment, and they are all full recourse loans, where purchase money loans are mostly non-recourse. This won't work for a lot of people, not the least of the reasons for which is that the lenders that were offering these when prices were increasing rapidly have largely withdrawn them from the market now that prices have been decreasing. I can't remember the last time I had a wholesaler offer me one. Still, if you're in trouble it can be on option worth asking your current lender about. If you can't make your payment now and go into default, they lose money. If you can afford the payments on the 80/125 combo loan, and don't go into default, they won't lose money, not to mention they potentially move you from a non-recourse purchase money loan to a full recourse refinance.

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

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

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

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

UPDATE: You may want to consider reading my new article on Mortgage Loan Modification


Caveat Emptor

Article UPDATED here

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This page is a archive of entries in the Mortgages category from June 2007.

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