Searchlight Crusade

“Should People in their sixties take out a mortgage?”

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

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

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

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

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

Into this environment comes the guy with a Reverse Annuity Mortgage (RAM) to sell. This is a special kind of mortgage, with a special protection for the homeowner (here in California, and in many other states as well) that they cannot foreclose in your lifetime. You cannot be forced out. Well, what if you’re sixty-five and live to 100, as a far larger proportion of today’s 65 year olds will? That’s thirty-five years they are locking this money up for, and there is always the possibility that by the time they consider the cost of selling, etcetera, there will be no equity. The interest rates are significantly higher than a regular “A paper” mortgages, higher than most sub-prime loans, even, and the pay to the loan officers who do them is much higher than a typical loan.

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

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

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

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

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

Nobody can make you do this, and there are many reasons why you might not want to. But looking at it from a strictly financial viewpoint, it’s hard to find the justification for a Reverse Annuity Mortgage. In fact, I have never seen a situation where I would recommend it from a viewpoint of financial prudence. There might be family situations that make it the “least bad” solution, but that doesn’t mean it isn’t bad.

Caveat Emptor

I’ve said upon more than one occasion that the factors at closing are all in the loan provider’s favor. Unless they signed up for multiple loans, the typical consumer has no leverage to get the loan provider to play it straight at closing, and actually deliver what they said they would back when you signed the application. Many people never notice that their lender has taken advantage of them until they get the first payment notice, which is far too late to do anything about it. Furthermore, others never notice at all, and of the ones who do notice something is wrong in a timely fashion, eight to nine out of ten are so fed up with the loan process that they sign the documents anyway. I keep hearing sworn oaths from people who signed up with my competitors that they won’t sign the documents at closing if they’re not what they were promised, yet when I follow up the vast majority of them did. I can only conclude that these people actually enjoy being led on like the rats by the Pied Piper of Hamlin.

Assuming that you are not one of those people who enjoys being treated like a disposable rat by someone who’s making a goodly sum of money from your business, what can you do? The first thing used to be apply for a back up loan, but the new lending environment stopped that. The loan isn’t real until it’s locked, and lenders have made it far too expensive to lock loans before there is an underwriting approval. If it isn’t locked, the rate/cost tradeoff will change with the market’s daily movements, but closing costs don’t change like that. There is no excuse for not correctly disclosing all closing costs – and that includes escrow title and appraisal – at loan sign up. Rate and discount are the only things that should be able to change.

How can you tell if you’ve been treated right by the loan officer? There are dozens of pieces of paper that get pushed in front of you at signing. Disclosures for this and disclosures for that. Truth in lending statements. Yet more disclosures. Certificates good for a discount here and a discount there. This is partially legal requirement, partially intentional on the part of loan providers. There really is a legal requirement for most of these disclosure documents, but the loan provider likes that they are there because they all distract your attention from where it needs to be focused.

There are three documents at the heart of every loan closing. They are the Trust Deed, Note, and Department of Housing and Urban Development form 1 (HUD 1). I advise reading everything, especially any title transferring documents (Grant Deed, Quitclaim Deed, Deed of Special Warranty, etc), so the lender cannot easily throw a curve in amongst the auxiliary documents. But most don’t bother trying. The three main documents are where you should be focusing your attention.

Sometimes, the Note is included in the Trust Deed, but most of the time they are separate, stand-alone documents. The Trust Deed gets recorded with the county, while the Note usually does not. Some states that I haven’t worked in may use other systems (A Mortgage Note, for instance, which needs an actual court action in order to foreclose, and which California along with most other states have gotten away from because it is more costly).

The Deed of Trust is simple enough. Look over the Deed of Trust enough to see that it properly references and does not contradict the Note.

The Note requires more attention, and cross referencing between it and the HUD-1. Is the amount borrowed consistent with what you were lead to believe? Is the rate correct? Is it fixed for the correct amount of time? Is there a prepayment penalty, and if so, for how long? Check out the repayment terms, and make certain there are the payments are what you were lead to believe. The Note is a legal contract detailing what you are agreeing to by signing all of this paperwork. Make certain it reads the way it is supposed to. Take your time, read it over, do not allow yourself to be rushed. Do not think to yourself, “I’ve got three days to call it off” because once you are done signing the odds are long that you will not think about your loan further until your first payment becomes due, and that is too late. Read it now. If there is anything that you do not understand, ask for a clarification. Good clarifications start from a point of the wording that’s on the paper, and make easy sense in English. Do not accept a clarification that you do not understand. Do not sign hoping to get a better clarification later. Do not sign period if you aren’t certain you understand.

Check out the HUD-1 carefully. It is the only form that’s required to give an accurate accounting of the money. Make certain the costs are what you were led to believe, and that it all adds up correctly. The numbers should start with the Old Loan (if Refinance) or purchase price, plus costs, plus reserves if you’re doing an impound account, plus prepaid interest, minus any money you’re bringing in (down payment, etcetera) or the seller or your broker is crediting you, and that should be the balance of the new loan. Take your time with the HUD-1 and the Note, and do not allow yourself to be rushed. Do not sign until you are certain that you understand and agree. If this takes a little longer than the signing agent planned for, tough. Many loan providers are adept at distracting you with this disclosure or that disclosure. Some companies actually provide them with training in how to distract you, and how to gloss over thousands of dollars that you didn’t agree to. Stick to your guns. The Note is what you are agreeing to, the Trust Deed is there to enforce it, and the HUD-1 is the only form accounting for your money that is actually required to be accurate. The Note, Deed of Trust and HUD 1 are what the lender is going to force you to comply with in a court of law. Make certain that they are what you agreed to before you sign them. If they’re not, it’s probably time to start the process over with someone else instead.

Caveat Emptor

Supply and Demand.

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

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

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

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

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

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

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

Now, let us consider the money supply here in this country, and thence the state of likely interest rates. We have increased government borrowing. We have the social security trust putting decreasing amounts of money into the government. We have a national savings rate that’s negative (and it is the overall rate, not just working adults that we’re concerned with, here). More and more people are becoming comfortable with foreign investment. And mortgage bonds are looking jittery right now, with foreclosures the way they are. Finally, no matter what the government propagandizes, we see the real inflation rate is substantial. Supply and Demand, remember?

Therefore, in my judgment, we are likely to see raises in the interest rate, at least in broad. If you’re on a short term loan that is likely to adjust in the next couple of years, the time to refinance is now, unless you’re planning to sell before it adjusts.

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

Caveat Emptor

My lender told me that there is an application fee?

He said an application fee of $250 and then we’ll need the appraisal fee and of course we’ll need an inspection. Does all this sound legit, is there always an application fee?

If they are asking for upfront money, they are trying to hold your money hostage to commit you to the deal. Most of the companies that do that know that 1) Better rates are available to the public and you’re likely to find something better if you try, 2) they’re going to hit you with a bunch of extra stuff they didn’t tell you about at the end.

Never pay for more than a credit report up front. You should want to choose the appraiser if you’re going to pay them – that way you own the appraisal, not them. You should also choose the building inspector if you’ve got to have one – most refinances don’t, but only a complete idiot wants to spend that much money to buy a property and doesn’t pay a few hundred for the inspection first. If the lender orders them, they own them. They have to give you a copy, but you can’t take it to another lender to use if this one hoses you.

Now, at closing, you can expect to pay some fees. How much depends upon a lot of factors. I tell people with entry level single family residences to expect about $3500 total in actual loan costs, plus whatever points are paid to buy the rate down, plus the expenses related to the purchase, which vary a lot. By the time you’re done with title and escrow and appraisal and lender’s fees, that’s what it really is. I’d rather tell the truth and guarantee the total, but since most people don’t realize how many games prospective lenders can play, quite often the person signs up with the person who talks a good game but won’t guarantee the quote. Usually you can choose a higher rate to get some or all of your costs paid (I love doing zero cost loans myself, and they actually are a good thing for most clients), but there is ALWAYS a trade-off between rate of the loan and cost of the loan.

Nonetheless, the idea of money you pay before the loan is ready is to commit you to the lender. People understand checks that they write in their gut. That $1500 check for the deposit on the loan is more important to many people than the $450,000 loan that comes with it. As evidence, I have offered people loans that were more than $5000 cheaper on exactly the same loan type and rate, but people would not sign up for my loan because they didn’t want to “lose” that $1500 deposit. I’ve shown people better loans at lower rates on exactly the same terms that saved $1500 per year in interest, and they wouldn’t switch. Why? Because they are thinking about that money that came out of their checking account, that they scrimped and saved and set aside laboriously over a period of months, not the money in the loan, which is just as real, but they haven’t had to save it, and they don’t realize that it is real in the same way as that deposit check.

So lenders who want large deposits typically do so because they know that their loan will not stand the light of scrutiny, and competition from other lenders, so they want to tie you to them emotionally, with money you don’t get back if you switch lenders. Money that you’ve physically got in your checking account, money that you understand on the gut level. Be very wary of this sort of lender. Seeing as there are many loan providers who will do your loan without requiring such a deposit, I would suggest you find one of them (or better yet, two of them) to do your loan instead.

Caveat Emptor

I get the same junkmail and spam most of you folks do. They don’t know who I am when they send it out. It’s just that I know what’s going on behind the scenes with this stuff.

So I thought I’d get out my calculator and deconstruct what’s going on with the advertisements I’ve gotten in the mail.

The first one starts with “30 year fixed rate 5.125% (APR 5.42)” Well, computing that out, it converts to $10,100 of nonexcludable fees on a $300,000 loan (UPDATE: actually, I discovered later in light fine print that the APR is based on a loan amount of $359,650, the so called “maximum conforming” loan at the time, which means the imputed number of points are slightly higher). This works out to 2.71 points, assuming they get it done for the same $1700 or so of excludable fees everyone else has (Title, Escrow and appraisal charges are excluded from APR computation). I had that rate at 2.25 discount points at the time, so they’re making about half a point extra if there’s no prepayment penalty. So if there’s no prepayment penalty that’s not a bad loan, except that I called and found out there’s a five year prepayment penalty on it. That’s a good healthy (or unhealthy, depending upon your point of view) cha-ching of about two and a half or three points to the loan provider. Not to mention that the postcard was “old and the rates are higher now” according to the voice on the phone I talked to at the time, “so you should start the loan now before the rates go higher.” The lowest rate they could do as we were talking? 5.375, which I could do for 0.75 discount points as I was talking to them – giving them as a loan provider almost two points in their pocket without the 2.5 to 3 points for a five year pre-payment penalty.

Then, after a faint dotted line designed to be overlooked, they tell you all about payments. $250,000 is $632.14 per month, $300,000 is $758.57 per month, etcetera. Going over to the calculator (even though I can tell you what’s going on without it), I get a negative interest rate when I punch in thirty year amortization. I shouldn’t need to explain to adults that something is wrong with that picture. Well, what’s likely going on is that this is a forty year amortization, and indeed, when I punch in a forty year amortization I get an interest rate of 1%. So on top of being on a forty year amortization, the payments they are quoting are on a negative amortization loan. It is neither on the same rate nor term as the previously talked about loan. And that’s the purpose of that thin dotted line that’s designed to be missed. They want you to think payment B is connected to loan A, when in fact they are talking about a completely different loan. And indeed I can find that in small, very light print on the other side of the card, under some darker print about about $1000 “Best price guarantee.” Voice on the phone explained that, “If you close and subsequently prove you qualify for a better rate with someone else, we’ll pay you $1000.” Well, first off, if they pay you $1000 to make three points on the loan, they are still $8000 plus to the good, and if I were the sort to be giving that sort of guarantee I’d have no problem wriggling out of it on any of several fronts such as “rates are lower now – why don’t you refinance with us (so we can hose you again)”. And if you refinance or sell within five years, you’re out over $7600 in prepayment penalty. Since 95% of all clients sell or refinance within five years, if you’ve got to have the 5.125% rate, statistically you’re better off paying somebody honest one point of origination as well as the lender discount points for no prepayment penalty. One point of origination works out to a little over $3000 on a $300,000 loan. This is less than the difference between the loan they advertised and the loan they theoretically had when I called the day after I got the card.

But the rate is voodoo magic to most people. Theoretically, you’ve got to be able to understand some mathematics to graduate high school, or at least be able to figure out how to get numbers out of a calculator. Nonetheless, what most people “buy” loans on is payment. This is well known factual information to everyone in the real estate industry. Very few people ever call saying, “Give me that rate.” What most customers want is the payment. And when the advertising apparently links the cheap payment on a negative amortization loan to the “Thirty year fixed rate of 5.125%”, most companies are doing what I call “lying by association”. Most clients want to believe that the one goes with the other and that the listed item is a pretty good bargain, when in fact I have shown that not only do they have nothing to do within each other, but also that they are both the sort of loan I would wish my worst enemy in the loan business would get for some enemy of civilization like Chairman Mao. Then when Chairman Mao gets a lawyer (and enemies of civilization never have a problem getting competent lawyers), I get to watch the whole thing blow up on both of them from safe on the sidelines.

Oh, and this postcard also talks about “skip one or maybe 2 payments.” As I cover in Prepaid Interest and Why You Never Really Skip a Mortgage Payment, you never really skip any payments, EVER. You can either pay them out of pocket or roll them into the costs of the loan. Anybody who represents otherwise is lying, with malice aforethought, unless they’re going to whip out a checkbook and pay it out of their pocket. How likely do you think that is?

To avoid this trap: First, don’t “buy” loans based upon payment. Second, get (or find) a calculator and use it, or even learn to do the calculations yourself. Third, ask the prospective loan provider the hard questions, and make sure that the question they answer is the one that you asked. Fourth, Shop Shop Shop around for a loan. And apply for a backup loan. Finally, always realize that with the kind of money loan providers make from loans, they will promise anything to get you to call, do anything to get you to apply for a loan, and even though they never have any intention of actually delivering what’s on the Good Faith Estimate (or MLDS in California) there is little chance of you being able to get any kind of legal satisfaction from them.

Caveat Emptor

The answer is a modified no. The same answer applies to property that is only structurally damaged, but not condemned.

That condemnation is a matter of public record. I’ve seen any number of them while perusing title records. It shows up kind of prominently on the title commitment, which every regulated lender is going to require.

Now it is a rule of regulated lenders that they will only lend upon the state of the property right now. If a house is condemned, you can’t sell it to anyone as a house. Furthermore, with a condemned house on the property, it really isn’t vacant land, either. It’s less valuable than bare land, as you have an expense that vacant land does not. You have to pay for demolishing the structure and hauling away the garbage.

In the case of structurally damaged but repairable property, regulated lenders won’t deal with it as a house either, although some may deal with it as if it were vacant land, less the cost of demolition and haul away. It depends upon lender policy.

The only place to get loans upon structurally unsound or condemned property is a hard money lender. They don’t have the Securities and Exchange Commission to answer to, and only much smaller responsibility to the Federal Reserve Board. Many of them are individuals holding the loans in their own name. They can do most anything they want. If one of them can be convinced that the property can be marketed for a given sum, they will typically loan based upon that sum. It’s all a matter of what they want to do.

Hard money lenders will loan a maximum of only up to about seventy-five percent of whatever the marketable value of the property is, and the rates are unfriendly, to say the least. However, they can choose to lend where a regulated lender can not. They can be your only option other than no loan at all. Most brokers will have at least a couple hard money lenders available to them, but your average direct lender cannot. As a final note however, before doing business with a hard money lender, you want to think long and hard and consult some experts as to whether you should – whether it’s a good idea or not.

Caveat Emptor

I recently closed a mortgage loan. The loan officer told me there would be no prepayment penalty. When the documents came there was none and the loan funded and closed.

Two weeks later I got an e-mail stating some documents had been missed and we need to sign and return them. They contained a new TIL, prepayment rider and addendum.

The original TIL states there is no prepayment penalty. I have not signed these and the lender is telling me I have to because of the compliance agreement.

Is this true?

Talk about scummy behavior!

I wouldn’t sign the new documents. As a matter of fact, talk to your state’s department of real estate about this behavior immediately. I hope that whoever is responsible for this loses their license to do loans in your state. You also will likely want to consult an attorney, as a precaution. A lender attempting to modify the contract after funding requires your consent. This strikes me as a a good candidate for fraud, depending upon the particulars of the contracts. Explain to them that you would not have signed the documents had this been presented as a condition of your loan funding, and so to attempt to alter the contract ex post facto (after the fact) is, in some cases, grounds for a prosecution based upon fraud.

That contract is a two-sided document, freely agreed to as it originally was by both parties. The fact that the loan funded is evidence of this. I have never heard of needing to sign a pre-payment agreement as a compliance procedure after the fact – except to comply with getting that lender paid more.

If lenders could require this sort of thing, they could unilaterally change the agreement any way they want to after funding. So what if you signed a thirty year fixed rate loan at 5.5 percent and paid three points to get it? You new rate is eight percent, “for compliance”! According to everything I know about contract law – which is limited, because I’m not an attorney and you should talk to one – they have no legal grounds to demand this of you.

At the very least, it would be the case that signing these documents is what starts the clock on the the three day right of rescission. That the lender funded the loan before then is evidence of a severe error on their part, and they would have to restore you to the situation as it existed prior to you signing the original documents. If you get a sharp enough attorney and help from your state’s regulators, it’s possible that you might get yourself some concessions or even a settlement from the lender.

Every state’s laws are different, so you need to talk to your state’s department of real estate, and I do suggest consulting an attorney before you draw any lines in the sand, but this is my best understanding of the situation.

Caveat Emptor

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

At the bottom-most level, all mortgage money does come from basically the same place. It’s all investors looking for a return on their money in a historically well secured market where they are somewhat protected from taking a loss. It is the ugly surprise that this security isn’t perfect that has a lot of investors in panic meltdown mode after they took it for granted for years, and now they are refusing every loan that’s not essentially perfect because of the rude awakening.

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

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

I’m not going to get into all the details of CMOs and MBSes- Collateralized Mortgage Obligations and Mortgage Backed Securities – how they are sold, how to price them, yada yada yada. It’s something I am not involved in, and I don’t need to know as much as I do. Even when I was financial planner, the nuts and bolts just aren’t that important to most investment portfolios. Two important things to note: The higher the interest rate of a loan, the better the price the lender will get from the investors, and the lower the rate, the lower the price. The higher the default and loss rates is expected to be, the lower the price, and the lower the default and loss rates are expected to be, the higher the price. Default and loss rates translate to “How tough are the underwriting standards?” As with all other things economic, it’s a trade off. Low interest rates at a lender usually means very tough underwriting, and fewer people qualify. High interest rates means relatively easy underwriting, and more people qualify. However the former means that there will be a lower default rate, while the latter translates into a higher default rate. In the end, the price they get for their loan packages will be comparable as higher rate translates into more money when the lender sells the loan but higher default means less.

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

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

This phenomenon expands out progressively farther in the A minus, Alt A, and sub-prime lending worlds. A paper has noticeable differences between lenders, while the further down the loan quality ladder you go, the more differentiation you get between lenders. Almost all of them have their own niche, or niches, that they will underwrite to, trying for a mix of rates to borrower and underwriting standards for approval that results in fewer of their loans defaulting, and thus the ability to command a premium price in the bond market over and above what mostly equivalent lenders will give.

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

No lender has the capability of running programs that are good fits for everyone. Some of them have a few dozen, some have only ten or twelve. This sounds like a lot, but it isn’t. Every single loan type is a different program. Just to cover the most standard loan types for their market is usually between twenty and thirty different programs. Back when I originally wrote this, I could point to lenders with twenty-five or more different Option ARM programs. They’re gone now (quite predictably) but they sure looked like they were doing well for a while on the surface.

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

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

(Correspondent lenders are brokers with one difference: They initially fund the loan before selling it to the lenders whose standards they met. The loan is still written to the real lender’s standard, underwritten by their underwriters, etcetera)

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

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

So you see the partial truth of the title statement, and the utter falsehood. All mortgage money pretty much does start out in the same place, if you want to look at it that way: the pool of investors looking to loan money. Nonetheless, what happens to it after that, before it gets to the consumer, renders the statement “All mortgage money comes from the same place” incredibly dishonest.

Caveat Emptor