Beginner's Information: May 2008 Archives

Many people think that mortgage interest works like rent: paid in advance before you live in the property for the month.

This is not the case.

Mortgage interest is paid in arrears. As you begin the month, interest begins accruing. It accrues throughout the month, and the payment is due at the beginning of the following month. The reason for this is that the interest is unearned until you have actually borrowed the money throughout the month. You could win the lottery, write a best seller, sign a contract a with professional sports team, or any number of other farfetched but real possibilities for suddenly acquiring a windfall of cash enabling you to pay that loan off. You could also refinance, in which case that lender is only entitled to the interest from the days you had their loan.

When you refinance, however, or even when you take out an initial purchase money loan, you will generally be required to pay the interest for the remainder of the month on that new loan in advance. The reason for this is quite simple administrative - it gives the lender some time to set all the bookkeeping on that account up, gives them a full month at least between initializing the loan and the time any money should be hitting their account in payment of that debt.

So when you refinance, you make an upfront payment to the old lender for the part of the month they held your loan during the month, and to the new lender for the time they held your loan. Say the new loan funds and pays off the old loan on June 15th. You will pay the interest from June 1st to 15th to the old lender, and from June 15th though the 30th to the new lender. You never, ever, get a free month, because interest never stops, at least so long as you owe the money. In point of fact, I tell people to think of it as making their normal payment early, as in this case they're writing the check they normally would have written July 1st two weeks early on June 15th. It's really just the interest owed, but since most folks don't keep their loan more than a few years, there usually isn't a large proportion of principal in their regular payment anyway. Therefore, if you think of it as your regular payment, paid early, it'll usually be a little bit less. There are usually one or two days of overlapping interest, which is why most escrow officers won't request funds on a Friday. You don't want to be paying interest on two loans over the weekend to no good purpose.

So why do lenders use the "skip a month of payments!" come on? Some will even use, "Skip two payments!" Because a new loan is being originated, they can (generally) roll that money into the balance on your new loan where you not only pay the money, but you pay interest on it for as long as you owe that money. Make you feel all warm and cuddly? Didn't think so. Anyone who uses the "skip a payment!" promise to get you to refinance has just told you point blank that they're a dishonest crook. However, since most people don't know how to translate loan officer speak into English, they get away with it disgustingly often. The state of financial education in this country is a national disgrace. Of course, it's to the benefit of certain political groups to have voters believing that there is such a thing as a free lunch.

You never really skip a loan payment when you refinance. If you try, all you're really doing is adding it to your balance. You can decide to pay your balance down at loan inception and pay closing costs out of pocket, and while an accountant or financial planner will generally tell you there are better uses for the money, it can be a very smart thing to do if your circumstances are right for it.

Caveat Emptor

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

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

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

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

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

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

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

Caveat Emptor

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

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

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

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

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

Caveat Emptor

We aren't married. How do we buy a house together?

Basically, the same way that married people do. The qualifications are exactly the same, provided that you both will be living in the property. If not all of the people who will be buying will also be living in the property, they have to show that they can afford both the place where they are living and their share of the expenses of the property. The only real difference in the paperwork is that unmarried parties cannot submit a single loan application - they must fill out separate applications. Most lenders will require that all of the disclosures also be signed and submitted individually. But that's just to keep the lumberjacks happy killing trees.

Now it is highly advisable that you consult an attorney as to how you want to hold title, and that there be some kind of partnership agreement that gives the other parties rights to recover any extra they paid to keep the partnership out of trouble, if one or more of the partners can not or do not make their share of the payments on time. But that's not a part of the purchase process, and you can certainly buy a property with basically anyone. It's one of the most basic of rights here in the United States. Convicted felons, jail inmates, illegal aliens, and people who have never set foot in the United States can all buy property here, as long as they have the money or can persuade someone to lend it to them.

The fact that people are not married means basically nothing to the loan qualification process, either. The guidelines are exactly the same either way. Yes, there are complex variables as to how you qualify, and what loan you qualify for. But people who are married but aren't going to be living together are treated the same as two random business partners, except that they can put all of their joint information on one application. You can have any number of people on title to a property, or responsible for a mortgage. The major thing to watch out for is that they must qualify as a group, and almost always under the same set of qualifications. If one person has to do stated income, they all might as well be stated income, because they're not going to get full documentation rates anyway.

Caveat Emptor

When it comes to mortgage loans, people get distracted by the darnedest things.

Let's look at Wal-Mart. You think they got to be the largest retailer in the world by making less money than their competition? I assure you that is not the case. In fact, they're legendary in manufacturing circles for using their size as an inducement to get the lowest possible price out of their suppliers. With that leverage - the fact that whether or not Wal-Mart stocks your item will be a significant predictor of your success manufacturing consumer goods - they can get outrageously low prices out of their suppliers. To this, they add all of the economies of scale and function consolidation that they can possibly come up with, to the point where Wal-Mart makes more on the same item than almost any other retailer, let alone the mom and pop store that everyone complains Wal-Mart has driven out of business. How the heck do you think they can afford to build dozens if not hundreds of new "Super Centers" worldwide every year?

Their main attractiveness to consumers is one thing. Price. They deliver whatever it is, from breakfast cereal to makeup to cell phones to automotive supplies at the lowest final price to the consumer. They've also got a huge selection of merchandise so you've only got to make one stop (thereby saving on gas, if you don't count the three gallons you waste getting in and out of the parking lot), but that's not why most consumers go there. They go for price. I may hate the thought of going to stores that are even in the physical vicinity of a Wal-Mart, but you've got to give them respect for what they accomplish.

People don't shop Wal-Mart because Wal-Mart doesn't make anything on the transaction. If that were the case, we'd all be shopping government stores. No, people shop Wal-Mart because the total cost, aka purchase price, is lower there even thought they may be making more money per transaction than the Mom and Pop store that used to be a couple blocks over. Lest anyone not understand, this is a good and rational thing, not just for Wal-Mart but (as far as it goes) for society as well.

The same thing should apply to loans. Shop loans by the lowest total cost of money . To know what that is, or even make a reasonable estimate, you've got to have some idea how long you intend to keep the loan. There is always a trade-off between rate and cost, because lenders have to work with the secondary markets, and that's the way the secondary markets are built. Know for a fact you're going to sell the property in two years? Then look at the costs of that loan over a two year period. In such a case, it probably doesn't make sense to choose anything with a fixed period longer than three years, and lowering the closing costs is likely to be more important than getting a lower rate, even if the payment is lower on a lower rate. That's pretty much a textbook case example of higher rate being better because it's got a lower closing cost.

If you're certain that you're going to stay in this property forever, and never ever refinance again, a thirty year fixed rate loan where you spend several discount points buying the rate down will verifiably save you money - if you're right. If you're wrong, and six months from now you're looking to sell and move to the French Riviera, all that money you spent on points and closing costs was essentially wasted. You're not going to get it back - it's a sunk cost, used to pay the people who do all the work to make a loan happen, and to pay the rich folks who work the secondary mortgage market to give you a lower rate than you could have gotten otherwise. It's not their fault you chose to let them off the hook from that contract you negotiated. You're essentially betting a lot of money upfront that future events will happen the way you believe they will, and if you're right, you reap quite a reward. However, most folks lose this bet, which is why the (rarely followed) admonishment not to pay points for a loan gets repeated so often. That's also why people hedge their bets most of the time, by choosing an alternative that costs less, and therefore risks less, while covering a lot of future possibilities in a decent manner, if not quite perfectly.

All of this is good information to have. But there is one piece of information required of brokers but not direct lenders that distracts consumers from what is really important: How much they're making for this loan. I think it's good information to have out there providing the consumer knows enough not to give it more weight than it deserves. And it really isn't important information, because it does not impact the bottom line to you, the consumer. It's really no more important than knowing where the airplane for your flight just flew in from. The point is that it's going to cost you $99 to get on that plane to where you're going, just like the important thing for consumers about their mortgage loans is that it's going to cost them $X total to get the loan done, and they're going to have an interest rate of Y% that they're going to have to pay for as long as they keep that loan. But if it's important for brokers to disclose how much they're going to make, why isn't the equivalent disclosure required of direct lenders?

The Federal Trade Commission prepared a report, The Effect of Mortgage Broker Compensation Disclosures on Consumers and Competition: A Controlled Experiment. The upshot? Consumers will choose the loan where the company providing it makes less money, or, even more strongly, choose the loan where the company's compensation isn't disclosed at all. I think it's reasonable information for someone to want to know, but if it's important to know the information when you're dealing with a broker, and the government therefore mandates such disclosure, then why isn't it required for direct lenders? (The answer is politics, to put brokers at even more of a psychological disadvantage as far as the average person is concerned. Lenders make a lot more money than brokers, so they have a lot more money to bribe politicians contribute to campaigns). To quote from the report:

If consumers notice and read the compensation disclosure, the resulting consumer confusion and mistaken loan choices will lead a significant proportion of borrowers to pay more for their loans than they would otherwise. The bias against mortgage brokers will put brokers at a competitive disadvantage relative to direct lenders and possibly lead to less competition and higher costs for all mortgage customers.

Focusing upon what the provider makes actually hurts you. If you just focus upon how much the loan officer makes, there's no incentive for them to shop around looking for a better loan. As I've written before, if I can find a better lender for that loan, I can both make more money and offer a better loan. But if you're just going to shop by how much I make, there's no incentive to do that. I make my $X, regardless of whether you get a 30 year fixed at 5% without a prepayment penalty or a 2/28 at 8% with a three year prepayment penalty. There usually isn't that much difference, but the principle is the same. You want your loan person motivated to find you a better loan, which shopping only by how much someone makes frustrates. And if you choose a loan at a higher rate of interest and higher cost just because the company offering it is not legally required to disclose what they make, it doesn't take a genius to figure out that you're doing nothing except hurting yourself. It's the equivalent of passing up the store with the lowest price because the law requires that store (but not their competition) to hang a big sticker on it that says, "The store makes $12.98 if you buy this toaster oven." Me, I like it when people make money from my custom, especially when the bottom line cost is as good or better. It means they're motivated to work hard and do a good job so they get my business again next time I'm in the market. The principal is the same whether it's a big box retailer, a mechanic shop, or a real estate loan.

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, and 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.