Beginner's Information: October 2007 Archives
The question that inspired this was
can a mortgage company use the flood insurance claim money towards homeowners mortgage loans?
This is equally applicable to every other form of insurance on your home - earthquake, regular homeowner's insurance, and any others that you may have or require.
The short answer is yes.
The reason that the lender requires being added to every policy of insurance you have on your home is so they have a claim on the policy proceeds. Let's say you buy a $500,000 home for nothing down, and the value of the structure is $150,000 while the value of the land is $350,000. Let's say the house burns down next week. If they weren't on there as beneficiary, you could theoretically take that check for $150,000 and split, leaving them with a $500,000 loan that they're maybe going to net $270,000 for by selling the property that secured it - after all the time for foreclosure, et al, which means they're out all those costs plus thousands of dollars in interest. If you're a lender, you're going to suffer this loss once at most before you decide not to trust anybody.
On the other hand, the lender doesn't want the property or a partial repayment. They want the loan repaid in full. What they're going to do is sit on any funds they get and make certain they're used to rebuild, unless they have some reason to believe that rebuilding is a bad risk. Banks don't throw good money after bad, so if this is the case, they're going to keep the money. On the other hand, if you've been keeping your payments up, they're going to want you to rebuild. Their taking custody of the money is a way to make certain that you do.
No, I'm not turning into a country western singer. Just got a search for "no closing costs no points loan cheapest rates loan". The visit (to this article) lasted less than a full second. The obvious implication was that it wasn't what that person was looking for.
As I have said before on many occasions, cheapest rates or lowest rates do not go with no points or no closing costs loans. Period. One of these things does not go with the others. Rate and total cost of the loan are always a tradeoff.
This is not to say that one loan with no closing costs may not be cheaper than another loan with no closing costs. The point is that there will be lower rates available with some closing costs, progressively more as you get higher closing costs. Then if you start paying points, there will be still lower rates available. There is a reason why they are paying all of your closing costs - you're choosing a loan with a higher rate than you otherwise could have gotten.
No cost loans can be and often are the smart thing to do. Because they are the only loans where there are no costs to recover, they are the only loan that can possibly put you ahead from day one. Consider the zero cost loan as a baseline, and compute what lower rates will cost you in closing costs. Consider: If the zero cost loan is 6.75 percent at $270,000, your new balance should be $270,000. If you can get 6.5 at par with closing costs of $3500, your new balance is $273,500. Your monthly interest in the first instance is $1518.75 to start. Your interest charges in the second case are 1481.46. The lower rate cost you $3500, but saves you 37.29 per month. Divide the cost by the savings, and you break even in the ninety-fourth month - not quite eight years. So in this example, if you think you're likely to refinance or sell within eight years, you'll be ahead with the zero cost loan.
If the loan has a fixed period of less than the breakeven time, you also know that the costs are not a good investment. If this loan were only fixed for five or seven years, well even if you decide to hang onto the loan after it adjusts, the rates go to precisely the same rate after adjustment. If you haven't broken even by then, you never will.
So whereas a true zero cost is often the best and smartest way to go, it will never be the lowest rate available.
Hello, I've been reading your website for awhile now, and have found it very helpful as I'm learning to navigate this crazy loan process! I had a question I was wondering if you could write about/answer.
We currently have a mortgage and a secondary line of credit on our condo (we didn't have a down payment, so we had to do it like this). We have been here one year, and the home values in our complex have gone up about $70,000 - $100,000 in that time period. (We live in Southern California.)
Recently we got a notice in the mail telling us that they can reduce our monthly payments ("by as much as $1,500!)" if we refinance with them. Frankly, it sounds way too good to be true, and I have a feeling they're not really telling us the truth in this notice. But it did raise a question in my mind: would it be wise to attempt to refinance, in the hopes that our higher valued home would allow us to refinance with only one mortgage, instead of two? I'm not even sure if that's possible...I'm having a hard time understanding how refinancing works. I should mention that we are currently in an interest-only loan, with no prepayment penalties. Our first loan is 4.75%, and our secondary line of credit is 6.375%.
Any help would be greatly appreciated.
Your feelings that they aren't telling the whole truth are justified.
Refinancing is the process of replacing one loan for another on the same piece of property. The idea is that the terms of the new loan are more advantageous to you than the terms of the existing loan. There are three main issues that you need to be aware of, however. The first is that there are always costs associated with doing the new loan. The second is that there may be a prepayment penalty to get out of the existing loan. The third is to make certain the terms you are moving to are enough better, for your purposes, than the existing terms to justify the costs associated with the first and second issues.
You state that you're in California, which is where I work. Realistic costs of doing the loan are about $3500 with everything that is necessary. This doesn't include origination, to pay the loan provider for the work they do on the loan, or discount, to pay for a rate the lender might otherwise not offer. I explain those costs, the difference between them, and many of the games lenders play in my article on The California Mortgage Loan Disclosure Statement (MLDS) Part I. There will also be the possibility of you having to come up with some prepaid items, explained in The California Mortgage Loan Disclosure Statement (MLDS) Part II.
Note that not every loan has points. I actually think that, given most client's refinancing habits, it's usually better to pay for a loan's cost, and the loan provider's compensation, through Yield Spread. Yield spread can be thought of as negative discount points, and discount points can be thought of as negative yield spread. Discount points are a fee charged by the lender to give you a rate lower than you would otherwise have gotten. Yield Spread is a premium paid by the lender for accepting a rate higher that you would otherwise have gotten, and can be used to pay the loan provider and/or loan costs. Each situation must be considered upon its own merits, of course.
Now, let's take a look at your specific situation. Your current first mortgage is at 4.75% interest only. You don't mention what sort of loan this is (updated via email: it's a 5/1 Interest Only ARM), but there is no such thing as a thirty year fixed rate interest only loan. At most they are interest only for a certain period, usually five years, before they begin to amortize over the remaining twenty-five. On the other hand, you said you bought one year ago, and that rate didn't exist on thirty year fixed rate loans then and it doesn't exist now. (Via later email, the first mortgage is a 5/1 Interest Only ARM). Your second loan is a line of credit at 6.375. I'm also guessing that either you, or the person who sold to you, paid a good chunk of change in discount points to buy the rate down, and I'm hoping it wasn't you.
Now, there's no way that this is a loan that's going to serve you indefinitely at that rate. There hasn't been a 30 year fixed rate loan comparable to that available since Spring of 2004, with any lender I know of, no matter how many points you paid. So what you have is at most a hybrid ARM (Yes, 5/1 Interest Only). No worries; I love hybrid ARMs. They are the only loans I consider for my own property in most circumstances. But they do have one weakness. There is likely to come a time when it is in your best interest to refinance, because after the fixed period the rate on them adjusts every so often, based upon a stated index plus a contractual margin, and the sum of these two is likely to be significantly higher than the rate for refinancing into another hybrid ARM.
Now what are they offering you? They're talking about cutting your payment by $1500 or more. But there just aren't any rates that much lower than yours available. Nothing even vaguely close. I don't think I could get you a 4.75% rate, even fully amortized, right now. So how are they going to cut your payment?
The only hypothesis I can come up with that is not contradicted by available evidence is that they are offering you a loan with a negative amortization payment. I explain those in these articles:
Option ARM and Pick a Pay - Negative Amortization Loans and Negative Amortization Loans - More Unfortunate Details
There is more information on marketing games with this loan type in these articles: Games Lenders Play (Part II) and Games Lenders Play (Part IV).
Finally, there are a few more issues that may not be relevant to everyone in these articles: Regulators Toughen Negative Amortization Loans? and Negative Amortization Loan Issues on Investment Property
One thing to understand is that when lenders are sending out advertising, they are not looking for Truth, Justice, and the American Way. They're looking to get paid for doing a loan, and most lenders will do anything to get you to call, and then to get you start a loan. The Creative Fiction on many Good Faith Estimates and Mortgage Loan Disclosure Statements is only the start of this. If you find a loan provider who will pass up loans that they could otherwise talk you into because it doesn't put you into a better situation, keep their contact information in a very safe place, because you've found a treasure more valuable than anything Indiana Jones ever discovered. A valuable treasure that you can and should nonetheless share with friends, family, and anybody you come into contact with because you want them to stay in business for the next time you need them. Most lenders and loan providers could care less if they are killing you financially - what they care about is that they get paid. A negative amortization loan pays between three and four points of yield spread. Assuming your loan is $300,000, they would be paid between $9000 and $12000 not counting any other fees they charge you for putting you into a loan where the real rate is at least 1.5 percent higher than the rate you're paying now, and month to month variable. Warms the cockles of your heart, right? Didn't think so.
In short, they're offering you a teaser no better than a Nigerian 419 scam for most people in your situation. My advice is not to do anything unless you're coming up on the end of your fixed period, in which case you need to talk with someone else, who might have your interests somewhere closer to their heart than the Andromeda Galaxy.
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?
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.
It may not come as a shock to you, but loan officers, along with many other salesfolk, speak a different language than the rest of the population. What will probably annoy you, however, is the number of times they'll say something that sounds like a phrase out of English, but really is from Salesgoodspeakian, a bizarre tongue in which the true meanings must be learned by osmosis from the particular subculture's dialect, while intending to communicate something entirely different to the poor schmuck who, after all, doesn't understand salesgoodspeakian.
This post is intended partially as humor, partially as education. I'm going to start it with a few of the most common ones, and update it by adding more and reposting from time to time. If you've got a good one, either with or without translation (and whether from one of my fields or not), please send it to me along with the context, if appropriate (danmelson at). Even if you don't have a translation, I'm pretty good at major dialects of salesgoodspeakian. It is to be noted that these phrases are not red flags, but more in the nature of yellow flags. If they just occur on a stand-alone basis, it's something that's likely to proceed from yellow to a red flag, particularly with repeated yellows. On the other hand, if the person uttering them proceeds to issue a clarification in plain English, issues an amplification rendering the translation void, or translates and explains the salesgoodspeakian, it's possible you've just been given a real world green flag that this is an ethical person. For instance, my absolute favorite loan to do is a true zero cost to the consumer A paper loan (and no prepayment penalty!), which I usually explain as "Nothing added to your mortgage. You've just got to do the paperwork with me, and come up with the money for the appraisal, which will be returned to you when the loan funds". And it's also possible you've been given a reinforced red because they lied.
And yes, I've had clients who came to me report every one of these. Some of the translations are a little exaggerated to make the point, but the spirit remains the same.
The salesgoodspeakian to English phrasebook:
"Stress free loans" two percent higher than you'd qualify for with better documentation and a little more work and less greed on the loan officer's behalf.
"Won't cost you anything out of your pocket" - Six points and $5000 in well-padded closing costs added to your mortgage loan balance, though.
"Thirty Year Loan" fixed for the first two, if they're feeling generous that day, but it does have a thirty year amortization. With five year prepayment penalty of course!
"How does a 1% rate sound?" Like you're a misleading weasel trying to get me to do a loan that digs me in deeper every month with a three year prepayment penalty that keeps me trapped even after I figure it out (See Negative Amortization Loans)
"Industry standard" - Everybody else at this company does it that way, too, because the boss says to, and I don't know any better. (This is very much the "G" rated translation. Please note that there are industry standards - things that pretty much every company in the industry does. Some of these standards need to change, some just are, and some are actually beneficial).
"Everybody knows there's 2% origination fee." Actually, everybody knows no such thing. But if I told you about it in the first place, you might have gone with somebody honest.
"Brokers can charge you anything they want" - so can I, but brokers have to disclose their compensation and I don't.
Found on the same billboard:
"Rates as low as 4%!" on an "adjusts every month" loan that's going to 6% next month and who knows what thereafter. With five points. While I have you on the phone, let's sign you up for it.
"No Points!" we've got no points loans. Not on the loan we quoted above. I'm really so terribly sorry you misunderstood. Now, about that 4% loan, what's your name?
"Low Fees!" compared to the multimillion dollar Oil For Food bribes, $23,000 is low. Now about that 4% loan, what's your social?
"Easy paperwork" but the start rate goes to 6% for the first month, adjusting to 8% next month. Still five points. Not for the rate we quoted above. I'm really so terribly sorry you misunderstood. Now, about that 4% loan, when can you come in to sign?
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