Games Lenders Play (Part IV)

I was approached by these folks a few weeks ago via email.



I attempted to get them to write up the experience themselves (and I would still like you to if you're reading this), but I wanted to write something about this before I completely forgot about it. This whole exchange is indicative of games loan providers play in order to make money.



I'm going to sketch this out chronological to the extent possible. What happened was Mr. and Ms. A got a postcard in the mail quoting low payments for their loan amount. They thought it looked great, and called the loan provider. The loan provider talked about these great payments on a loan that looked fairly real, and quoted an APR of 6.18. He told them that this was a great loan, and compared it to a 5/1 ARM in such a way that that was what they thought they were getting. No worries, because they were going to be transferred by his company in two to three years.



They asked my opinion about another item having to do with the loan, and something about what they said sounded funky to me.

Well, i believe what I'm getting is called a 5/1 ARM. Each month i have the 4 options of minimum payment, interest only payment, 30 yr payment, or 15 yr payment. (payments respectively would be either $A, $B, $C, or $D)



The minimum payment stays the same for every 12 months, then increases by about $90 each subsequent yr. I know minimum is not ideal, but i live in an area with high appreciation, and because of the ridiculous value of property in the area, & the school system in this county, it continues to appreciate regardless of trends elsewhere.



I'm told the loan comes standard with 3 yr prepay. I can pay the points I mentioned to make it a 1 yr, but it doesn't affect my interest rate coming down. That's at about 6.18%

Well, the part about property appreciating regardless of trends elsewhere is just plain wishful thinking. There is nowhere that is insulated from economic conditions. Nonetheless, it's not what we're talking about here. Does this loan sound like something I keep writing about?



Here's what I sent back:

That particular loan is actually a Negative amortization loan. I explain those here (same link as last paragraph - ed).



They are not wholly without redeeming qualities, but they are something to be done with a trembling hand and much looking over your shoulder. At the current rate, expect $725 to get added to your balance the first month - and rates are rising, so this is likely to accelerate, and your underlying rate is completely variable on a month to month basis. Even if they don't rise and you make the minimum payments, you will owe approximately $X after two years - an increase of $18,620 in your balance! Will it be an issue if you owe $18,600 more when you go to sell it? I think it likely that the answer is yes, but it's your call.



A 5/1 is something entirely different. It is a "A Paper" Thirty year loan with the interest rate fixed for the first five years, then adjusting once per year based upon either LIBOR or US Treasury rates, not COFI or MTA. As A paper, there is not an embedded pre-payment penalty. Right now, in California, I have them at about 6.25 no cost no points no prepay, or 6.5 interest only, and truly fixed for five years.

Furthermore, there was another issue with the loan quote:

If I do the math, the first payment gives a principal balance of $X+2000, the second payment gives a principal balance of $X, The third gets $X+500 and the fourth $X+1300. If these are the numbers your loan provider gave you, which of these numbers is correct? Any of them? Unless you're paying the 1.5 points out of pocket, your loan provider should give you a quote which adds them to the amount you are borrowing. Did they do this, or did they pretend it was going away by magic?

They responded:

oooh. sounding scary. So i left them a mssg asking which it was, a negative amortization loan, or a 5/1 ARM. I also asked for more info as I was sent spreadsheet which is missing some info. I am fwding the spreadsheet if you don't mind the attachment.

Well the loan provider had named the spreadsheet "2005_Pay_Option_Work_Sheet.xls" Pay Option is one of those "friendly sounding" names for a negative amortization loan. Well, I knew before what kind of scum bucket this loan provider was before I opened it, but doing so was confirmation, good enough to convict in court except that what he did isn't illegal, only immoral and unethical. Yep, it had all of the characteristics of a negative amortization loan as prepared by the worst kind of financial predator. Three or four payment options, including minimum, interest only, and 30 year amortized? Check. Prepayment penalty if you made any other payments (The so-called "one extra dollar" prepayment penalty I talk about here, which is not necessarily characteristic of negative amortization loans but certainly seems to occur there more than anywhere else). Check. Yearly minimum payment increases of about 7.5 of base minimum payment%? Check. Complete lack of disclosure that if you make the minimum payment your balance increases by hundreds of dollars per month? Check. About a 5 percentage point absolute spread between nominal rate and APR? Check. Complete failure to disclose payment based upon a "nominal" (in name only) rate of 1%? Check. Failure to disclose that the real rate was month to month variable from day one? Check. Failure to disclose that the index it was based on had risen in recent months and that unless said index went back down, the real rate would be rising? Check. Failure to include real and known closing costs in your loan quote? Check. That last is kind of minor as compared to everything else, but I'd be upset in a major way if it was the only thing wrong he did.



I sent Ms. A an email which said, in part:

"Option ARM" is a common, friendly sounding name for what is still a negative amortization loan. Everything about this loan, from the fact that it has a "payment cap" which is unrelated to a rate cap, screams negative amortization loan.



The 5/1 is a different loan provided for comparison, as the sheet tells you, and is a better loan for almost all purposes, as the second column of the comparison tells you. A 3/1 might have a slightly lower rate, or it might not. Ditto any of the 2 or three year subprime variants.



Intro period is telling you the period it is fixed rate for.



MTA loans are based upon a moving average of the treasury rate over the last twelve months. Since they've been going up, your real rate is likely to increase as some older and lower rates drop out of the computation in upcoming months.



Pay attention to the two footnotes on the payment options. "deferred interest" is characteristic of negative amortization.



(Name redacted for publication). They are not the only such company, but the translation into real english of their name must be "watch out for our piranha"



These loans are very commonly pushed because most people "buy" loans based upon payment, making them very easy loans to sell because unless you understand the drawbacks, you will think this is the greatest loan since sliced bread. These are up to forty percent of all new loans in the last year in some areas (including here), and are likely to contribute to a crash in housing values soon.

There are sharks and wolves out there, as this illustrates. Why people who would never buy a toaster oven without checking at least two vendors will sign up for a mortgage without shopping around is beyond me, but people do it. This is a trap that can be very hard to avoid unless you know what's going on, but if you talk to a few loan officers, and and go back and forth, chances become much better that you'll be saved by one of Jaws' competitors telling you what's really going on. Other, competing loan providers deal with this stuff every day. After a very short time, we get to the point where we can recognize it in our sleep. But we can't alert you to these kind of issues if you don't give us the chance.



Luckily, these folks gave me the chance.



They were in another state, and so I didn't get any business out of my good deed, but that's okay. I got this article. And now, you folks can read about it, and be forewarned.



Caveat Emptor