Intermediate Information: May 2007 Archives

With many people pushing various "cash back to the buyer" schemes in real estate, a note of caution is needed. Actually, it's more like an entire symphony of caution. Because if there is a loan involved, you run the risk of committing fraud.



Some people reading this won't care. "What the lender doesn't know won't hurt them," is something I've heard and seen too many times to count. After all, that lender is just some nameless faceless megacorporation, not anybody they care about.



To those people, I say, "The FBI will make you care." Given the spate of abuses, and the current level of panic at many lenders and investment houses, even if your transaction comes off without a hitch and the lender gets repaid in full, you may find yourself on the business end of an investigation. The kinds of real estate and loan places that are willing to pull so-called "harmless" fraud are also willing to pull no holds barred fraud where the entire idea is to defraud the lenders. Where you have the lenders losing money, and a pattern of abuses, you have potential for the FBI to become interested in all of a businesses transactions, and once the FBI starts looking, rebate fraud is so easy to spot that my seven year old could probably do it. They find a known shady brokerage, and it becomes what military pilots call a "target rich environment." It's worth the resources to investigate all of that brokerage's transactions.



Here's what happens. A wants some cash to fix the property up, and so arranges with B to jack the price enough higher so that B can rebate the difference to A. A then procures 100 percent financing on the increased price, B gets the increased price, and rebates it to A.



Alternatively, A writes an offer with a real estate licensee who rebates part of their commission, while providing lesser "services". Usually, the question I want to ask those rebaters I encounter is "Why do you make more than minimum wage?" The answer is because suckers who think in terms of cash in their pocket don't understand what they're getting into.



In either case, this cash back somehow doesn't get disclosed to the lender, and it needs to be. Because if the official purchase price is $X, but B is giving A back $Y under the table, the real purchase price is $X-Y. If the lender knows about the cash back, they will treat the purchase price as being $X-Y. At the very most, for 100% financing, they will only lend $X-Y. Since this defeats the purpose of the cash back, the sorts of people who do this predictably will not disclose it to their lenders.



This is fraud. Even so-called "harmless" fraud where the people fully intend to repay the entire loan (and eventually do) is still fraud. The lender doesn't have to lose a single penny in order for you to have committed fraud. The definition of fraud is "An act of deception carried out for the purpose of unfair, undeserved, and/or unlawful gain, esp. financial gain." The legal definition is a little more complex, "All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprises, tricks, cunning or dissembling, and any unfair way which another is cheated," but essentially similar. Had you told that lender about the cash back, they would have treated the purchase price as being less than the official price. Hence, fraud.



Now there are all manner of crooks out there encouraging people to do this. I've seen numerous advertisements for various "real estate investment systems", and people who represent themselves as real estate professionals and real estate investors and real estate authorities and even real estate licensees who urge people to commit federal felonies for various reasons on the surface that always reduce to "So the crook can make money." Whether it's through a commission they wouldn't have because the client can't be persuaded to do it the legal way, or money they intend to make selling their "Foolproof System!" to thousands of pure deluded fools, they do a lot of damage. Nor does it get you off the hook if you were following the advice of alleged professionals, as lots of people in federal prison can testify. Even if you didn't know it was illegal, even if people you had reason to trust told you it was legal, you are still responsible.



The rebate itself is not illegal, according to my best understanding. Once again, I'm not a lawyer and I don't even play one on TV, so check that out thoroughly, but it is my best understanding. The illegality happens when you deceive the lender, either by omitting information a reasonable person would agree is relevant, or by actively saying something that isn't true.



It's more than possible to get cash back and be compliant with the law - it just defeats the purposes most people have in mind with cash back, which is to make the lender think they paid more for the property than they really did, and so lend a greater amount of money or on more favorable terms, or both, than the lender otherwise would have, had they known about the cash back.



If you inform the lender, they will treat the purchase price as being the official price less the rebate. So if the official price is $400,000, but you're getting $20,000 back, the price the lender will lend based upon will be $380,000, and it doesn't matter if the appraiser says it's worth $400,000, or $400 million. $380,000 will be 100% financing, not $400,000, $360,000 will be 95% financing not 90%, and I'm certain you can figure the rest. Lenders evaluate property based upon the LCM principle, which is Lesser of cost or market. You only paid $380,000 in real terms, which makes it a $380,000 property at most. It doesn't matter whether this rebate is direct from the seller, or some third party. They look at it in terms of "How much of your hard earned money are you actually going to part with?" If some cash is coming back to you, you aren't really parting with whatever number is on the purchase contract, are you?



Where most lenders will cut a certain amount of slack is in closing costs. If the money is not actually coming back into the buyer's pocket, but instead being used to pay for costs of the purchase transaction or costs of the loan, most lenders will give that their reluctant blessing. Because all parts of the transaction are subject to negotiation as to who gets what and who pays what, the lender will usually understand that in order to get that price, the seller agreed to pay this cost or that cost. I don't expect this to last forever because I can point to a lot of abuses that are happening, but it happens to be the case right now. I believe that sooner or later, lenders will clamp down on this practice and refuse to allow it, but for right now, most of them are still willing to do so.



Even the most forgiving of lenders, however, draws a bright and hard line if any of that cash finds its way back into the buyer's pocket. So make certain it doesn't. And make certain that the lender has been notified in writing of every penny that's paid on the buyer's behalf by anyone else for closing costs. Because you don't have to be directly involved in a conspiracy to get drawn into a fraud investigation, and once it gets started, you can never be certain you won't be sitting in a courtroom somewhere, charged with fraud and conspiracy and anything else they can think of to throw at you. Even assuming you win, it's going to be a big hit to your wallet and a bigger one to your reputation.



Caveat Emptor


The Appraisal and Appraisers

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Of all the issues having to do with a mortgage, the appraisal generates more overblown problems than any other part of the process. It's also one of the most critical areas to handle correctly. There are reasons for this: It (along with perhaps the relatively cheap credit report) is the only thing a consumer has to pay for, as in money out of their pocket, before the mortgage is complete. Everything else is (or should be) done "on spec" by the mortgage provider. It is also a weapon used against the consumer by many mortgage providers.



In order to understand appraisals, you need to understand where everybody is coming from. An appraisal is a necessity for lenders. It tells the market valuation of the property in neutral terms. It is one of the essential anti-fraud steps of the process, as well as telling the lender how much the property might sell for in ideal conditions (which a foreclosure most certainly is not). It is the "market" part of the "lower of cost or market" valuation, which is driven into accountants and bankers starting with their first classes on the subject. Think about it. Just because you might be willing to pay $700,000 for the house next door to your parents (or for your parents old house itself) does not mean someone else will if you fail to make the payments. I have encountered at least two instances where a prospective borrower was definitely attempting to defraud a lender - and an appraisal caught it. There have been others where a reasonable person would have been less certain, but some of those instances were likely attempted fraud. Because of these, anytime somebody wants me to press for a drive-by or computer appraisal, a little blip goes off in my little bank of warning signal detectors. The lenders aren't stupid. They know that lesser appraisals are cheaper, and employing the more expensive alternative requiring the consumer to write a check for several hundred dollars is going to cause some people to go elsewhere. It is the judgment of these highly experienced people who have been trusted to loan hundreds of thousands of dollars at a blow that an appraisal costs them less than an increased probability of the things it is designed to prevent. And when a loan officer like me presses them for a lesser appraisal, a little blip goes off on their radar screen, also. I can't read minds, but I've had more success in getting lesser appraisals by keeping my mouth shut and letting the lender decide it's safe enough on their own, then I have by asking for one.



You should not expect a mortgage provider to pay for an appraisal, like many will for a credit report. Unlike a credit report, an appraisal is several hundred dollars, and they don't it get back if the loan doesn't fund. My attitude, born of experience, is "If this customer is not sold enough on the benefits of the loan to front the money for the appraisal when I'm putting in a much larger investment of my time and administrative and support costs, then this isn't a good investment." Other people you may never meet such as the title company, escrow company, underwriters, processors, etcetera are also working in the background - and nobody gets paid if you change your mind, aren't qualified, find a better deal, whatever. If they are hourly or salaried employees that do get paid, somebody else is investing the money to pay them. I may not have a fiduciary responsibility to all of them, but that doesn't mean I don't have any moral responsibility to see that their work is rewarded.



Furthermore, some lenders actually do prohibit brokers from paying the appraiser directly as an anti-fraud measure - and that's one pointless piece of information I can ignore by having the necessary attitude to succeed in business. This does not mean that your mortgage provider isn't doing their best to balance the competing interests - that of an appraiser's right to get paid for what they do, versus a consumer's desire not to pay for something that doesn't help them. And twice in my career I have refunded appraisal fees out of my own pocket to customers who told me the truth as they knew it, but didn't know to tell me something else (both fairly obscure points) that prevented the loan from going through. Because I didn't ask, I felt morally obligated to compensate their loss. (This is not a legal requirement, and is not common - I've asked literally dozens of loan officers from all kinds of loan providers whether they've ever rebated an appraisal fee for any reason when a loan didn't go through. So far, two others have said yes. Most look at me and answer "no" as if I'm some kind of alien from another planet. So go into the appraisal with a clear idea that if the loan fails, you're not getting the money back. Period. That way you may be pleasantly surprised, but you won't be expecting something unrealistic)



You should not expect an appraiser to work for free. It may not be rocket science, but it is an exacting field where in order to become licensed you must spend at least two years of your life as an apprentice, with an income of basically nothing. As a result, there is usually a shortage of appraisers. I'm often amazed that appraisals aren't more expensive. On the other hand, many of them want to get paid for work that sabotages the loan it's supposed to support. There is a Big Thing in appraiser's association circles about how they hate loans with a minimum appraisal required, and explicit minimum appraisals actually are illegal. The appraisers, being normal humans, ideally want to be able to run their appraisal off the easiest comparable property values and let the chips fall where they may. On the other hand, there have been literally dozens of cases in my experience where choosing different but still comparable properties for comparison and doing a little more work netted the value necessary to make the loan work - the appraiser just didn't want to be bothered, something that is against the grain of good business practice - and they are supposedly businesspeople. I have also seen this abused by a broker who wanted to make more on loans - if the appraisal came in for $40,000 more, this broker got a bigger rebate from the bank, and thus, made another $1200 on the loan. Lenders for their part do not want appraisals ordered where the appraisal is going to come in at a certain minimum no matter what the property is worth. But it isn't a sign of good business practice to expect to be paid where your work is going to sabotage a substantial investment that others have already made in a project, as a below value appraisal does. It is naïve to expect that loan provider to continue to supply you with business, when you've just cost their former prospect several hundred dollars and kept that prospect from getting their loan, as a result of which the loan provider's investment is lost, and furthermore you have left the loan provider to face all of the negative ramifications of an unhappy consumer. So some sort of compromise needs to be worked out among the competing interests of a consumer that doesn't want to pay for something he doesn't have to or that does no good, an appraiser that wants to get paid for the work, a lender that wants an honest appraisal, and a loan provider that wants an investment to pay off.



The one that I have found that works best is not a minimum appraisal. Besides being illegal, asking for a minimum appraisal is a violation of my fiduciary duty to the lender. Instead, what I'll do is write something along the lines of "If comparables do not support a value of $X, please re-confirm the order prior to performing the appraisal." It isn't bulletproof, by any means. But it gives everybody the best shot at a fair shake without giving anybody carte blanche, and it prevents the vast majority of the problems. The appraiser does most of his or her work before going out to the house in question, checking sales of comparable properties in the Multiple Listing Service that they subscribe to. If the "comps" don't support $X, and the loan collapses, he's lost some work time. For a businessperson, this should be no big deal, and what they've lost is a small fraction of what other people working on this loan have lost. Furthermore, I'm going to keep sending business to that appraiser. If the comps support $Y, which is less than $X, and I can re-work the loan or find another loan and get the consumer to sign off on it based upon $Y (something that is far easier to do before the consumer gets angry at writing a $400 check and not being able to get the loan on the terms promised), the loan proceeds and the appraiser gets paid, and everybody is happy. If the comps support $X and the appraiser gets paid, everybody is happy - unless the actual appraisal comes in lower, and this does happen where a property is not as well cared for as most, doesn't have standard features, etcetera. There's nothing that can be done. You thought your home was worth $X, and it isn't. End of story. The loan provider took every precaution they legally could. The appraiser took every precaution to protect you that they legally could, and now they're entitled to be paid. It's no fun for anybody - consumer, loan provider, or appraiser. I will put up with this a few times for an appraiser who makes a habit of calling me when the comps are low. I'll keep sending them business. Chances are it's not their fault. On the other hand, every so often I'll get a call from some appraiser who gave me three "hop, pop and drops" (as in "hop on over, pop the consumer for the bill, and drop a uselessly low appraisal on them") in quick succession, and wonders why his phone isn't ringing. And of course, the various appraisers organizations are trying to pass legislation or regulations that basically give them the right to come back with any old appraisal they want to, and make it even more difficult to ask them to perform in accordance with good business practice.



An appraisal is not what your house will sell for. There are any number of subjective factors an appraiser cannot take into consideration, or cannot account for fully. The types of things they look at are objective. Size of the lot. Square feet of the house. Number of bedrooms. Number of bathrooms, and so on. These have all got measurable, objective answers. Cleanliness of rooms and condition of paint are hard to measure objectively. Nonetheless, potential buyers take them into consideration to a much greater degree than an appraiser.



One fact you should know about the appraisal: They're good for a maximum of three to six months, measured from the date of the appraisal to the date the loan funds, which is likely to be thirty days or more after you apply. Usually three months is the limit if no loan was actually funded based upon that appraisal. If it's older than the lender's underwriting guidelines allow, every lender in the known universe is going to require a new one, unless your loan is one of the fortunate few that doesn't require an appraisal.



The most important fact every homeowner or homebuyer needs to know about an appraisal: The entity that orders the appraisal, controls the appraisal. If you pay for it, you're entitled to a copy. That doesn't mean you're going to be able to take it to another loan provider and use it. The appraiser will require both a release from the previous loan provider (who after all, is responsible for giving them business), and a retype fee of about $100, possibly more. Whether the loan provider will release it is problematical. They are not required to. Some won't, no matter how good the reason. Some want to be paid, first. Even the most liberal and ethical aren't going to release it if you've simply found a better deal. Remember, they've invested some serious resources in making this loan happen based upon your representation that you wanted it.



In another essay, I advise you to apply for a back up loan every time you buy a property or intend to refinance. Now I'm going to tell you the second smartest thing that you can do: Make certain you're the one who orders the appraisal and owns it. Now some loan providers use only their own "in house" appraisers and require the appraisal to be paid for up front, when you fill out the loan application. They do this to make certain they keep control of the appraisal, so no other loan provider can use it, obliging you to pay a second appraisal fee if you want to go somewhere else. Unless you can get them to agree in writing to release the appraisal (they won't), this is a giant red flag not to do business with that provider. The appraiser should be someone you have the option of choosing, and should be paid at point of service when the appraiser comes out to the home. (Don't choose an appraiser who's a family member, however. Lenders frown on this. Expect some pointed questions or having to get another appraisal if your name and the appraisers names are similar.)



Even other loan providers will try to slip in and assume ownership of an appraisal. If you want to control the appraisal, you must order it direct from the appraiser yourself, and if your loan provider provided the recommendation, the appraiser still might consider themselves bound if they get a significant amount of business there. On the other hand, as I also state in another essay, time is always a critical factor in every loan. The appraisal holds the whole process up if it's not done promptly, and a reasonable appraiser is going to put his priorities on getting the appraisals done from the people he gets business from on a consistent basis. So if you're going to order it yourself, order it immediately, or even on your own before you start the loan process if you know the parameters. This is difficult in the case of purchases, but very possible in the case of refinances. On the other hand, purchases are less time critical. Warning!: There are different kinds of appraisals, and different qualification levels of appraisers. There isn't space here to cover them all. If you order the wrong kind of appraisal or order it from the wrong kind of appraiser, it's useless. Just because 90% plus of all appraisals are the same kind from the same grade of appraiser or better doesn't mean yours is one of them. The best way to handle this situation is to give the loan provider no more than two business days to give you the parameters for the appraisal, and be preparing the ground ahead of time by telephoning appraisers. Somebody that will charge $450 and do it within two days is almost certainly a better value than someone who will charge $350 and take two weeks. Immediately upon receipt of parameters from your loan provider, order your appraisal. That exact second. Don't even put the phone down. As I said, time is critical. Some loan providers will not allow you to do this, insisting upon being the one to order the appraisal. This is a red flag. You probably want to take your business elsewhere. Handling the appraisal correctly is not trivial for a consumer, who after all is not usually a real estate professional, but if you handle it correctly, you put yourself in a position of much greater leverage.





Caveat Emptor


If you haven't heard about the thirty year fixed rate mortgage, welcome to planet earth and I hope we can be friends.



The thirty year fixed rate loan seems to be the holy grail of all mortgages. It's what everyone wants, and what they're calling about when they call me to talk about refinancing a loan.



Well, it is secure, and it is something you can count upon today, tomorrow, and next week, etcetera, until the mortgage will theoretically be paid off.



The problems are three fold: First, it is the most expensive loan out there. It always has had the highest rate of any loan available, and always will (Except for the 40 year loan which is making a comeback for no particularly good reason, and the fifty year loan which is a brand new waste of money). This means you are paying more in interest charges every month for this loan. Second, according to data gathered by our government, the vast majority of the public will refinance or move about every two years, whether they need to or not, paying again for benefits they paid for last time, and didn't use. This is essentially paying for 30 years of insurance your rate won't change, and then buying another 30-year policy two years down the road, then another two years after that, etcetera. Finally, because it is always the highest rate and this is what everyone wants, many mortgage providers will play games with their quote. They will quote you a rate on a "thirty year loan", meaning that it amortizes over thirty years, not that the rate is fixed the whole time. Or they'll even call it a "thirty year fixed rate" loan, but the rate is only fixed for two or three years. Every time you hear either phrase, the question "How long is the rate fixed for?" should automatically pop into your mind and proceed from there out of your mouth.



The fact of the matter is that there are other loans out there that most people would be better off considering. In the top of the loan ladder "A Paper" world, there are thirty-year loans that are fixed for three, five, seven, and ten years, as well as interest only variants and shorter-term loans (25, 20, 15, 10, and even 5 year loans). The shorter-term loans tend to be fixed for the whole length, but of course they require higher payments.



I personally would probably not even consider a 30 year fixed rate loan for myself, and here's why. First, the available rates go up and down like a roller coaster. They are the most volatile rates out there. Given that I will lock it as soon as I decide I want it, it's still subject to more variations that any other loan type. Back when I bought my first place, thirty year fixed rate loans were running around ten and a half percent. Five years before that, they were fourteen percent and up. Second, having some mortgage history, I can tell you I refinance about every five years. Why would I want to pay for thirty years of insurance when I'm only going to use about five?



Even in the summer of 2003, when I could do a 30 year fixed rate mortgage at 5 percent without any points, I could do a 5 year ARM (fixed for five years, then goes adjustable for the rest of thirty) for four percent on the same terms. I keep using a $270,000 mortgage as my default here, so let's compare. The 30 year fixed rate loan gives you a payment of $1449, of which $1125 is interest and $324 is principal. The five-year fixed rate loan gives me a payment of $1289, of which $900 is principal and $389 is principal. I saved $225 in interest the first month and have a payment that is $160 lower, while actually paying $65 more in principal. What's not to like? If I keep it the full five years, I pay $51,549 in interest, pay down $25,791 off my balance if I never pay an extra dollar, as opposed to paying $64,903 in interest on the thirty year fixed rate loan, while only paying down $22,062 of my balance - and I've got $13,500 in my pocket, as well as the $13,300 in interest expense I've saved and $3700 lower balance. If I choose the five-year ARM and make the thirty-year fixed-rate payment, I cut my interest expense to $50,539 while paying off $36,426 of principal (remember, every time I pay extra principal it cuts what I owe, and so on the amount of interest I pay next month.). If I then pay $3500 to refinance, adding it to my balance, I have saved many times that amount. I still only owe $237,074, as opposed to the 30 year fixed rate loan, which has a balance of $247,938. That's over $10,800 off my balance I've saved myself, plus over $14,300 in interest expense, simply by realizing that I'm likely to refinance every five years. And the available ARM rates are more stable as well as lower. From the first, I haven't had one with a rate that wasn't in the sixes or lower. Finally, if I watch the rates and like what I see and so I don't refinance, I'm perfectly welcome to keep the loan. And all of this presumes that the person who gets the thirty-year fixed rate loan doesn't refinance or sell the home, which is not likely to be the case. Statistically, the median mortgage is less than two years old, and less than 5 percent are five years old or more.



At rates prevailing today, I can get the same loans at 5.75 and 5.125 percent (without points. Note: This was written a while ago, and rates are higher now), respectively - which is about the narrowest I've ever seen the gap. Assuming a $270,000 loan, for the 30 year fixed rate loan that gives a payment of $1576, which five years out means that I have paid just under $74,996 of interest, $19542 of principal and have a balance of $250,457. If I choose the 5 year ARM, my payment is $1470, so if I keep it five years I've paid $66,581 in interest, $21,626 in principal, and my balance is $248,373. Plus I've kept $6300 in my pocket, or alternatively, if I used the $106 per month to pay down my loan, I've only paid $65,713 in interest, have paid $28,826 in principal, and have a balance of $241,174. Even if I then add $3500 in order to refinance and the thirty year fixed rate does not, I'm still ahead $5700 on my balance plus the $9200 in interest I've saved, and the chances of the person who chose the thirty year fixed rate loan not having refinanced is less than 5%.



ARM mortgages are not for everyone. If you're certain you are never going to sell and never going to refinance, it makes a certain amount to sense to go for the thirty year fixed rate loan. And of course, if you're going to lie in bed awake every night worrying about it, the savings work out to a few dollars a day and my sleep is worth more than that to me, and so I'm going to presume it is to you, as well.



But what most people should be trying to do is cut interest expense while not adding any more than necessary to the loan balance. As I've gone into elsewhere, money added to your balance sticks around an awful long time, usually long after you've sold or refinanced, and you end up paying interest on it, as well.



So even though various unethical loan providers tend to quote you rates on loans that aren't really what you are looking for if you want a thirty year fixed rate loan, they're actually doing you a favor in an oblique and unintentional way, and somebody who is up front about offering you a choice between the thirty year fixed rate loan and an ARM is quite likely trying to help you. Consider how long most people are likely to live in their home (average is about nine years right now), how long they're likely to go between refinancings (less than two years), and your own mindset. It is quite likely you can save a lot of money on ARMs. Why pay a higher interest rate in order to buy thirty years of insurance that your rate won't change, when you're likely to voluntarily abandon it about two years from now anyway? Why not just buy less insurance in the first place?



Caveat Emptor



UPDATE: I had someone question the numbers in the paragraph comparing the 4% 5/1 ARM against the 5% 30 year fixed rate loan, both of which were available at the same time in the summer of 2003. Now I have had it pointed out to me that I made a mistake in calculations somewhere. The numbers for interest and balance savings are correct, but those for payment savings are $9623, not counting the time value of money. Your savings are not the sum of the three numbers. It depends upon your point of view as to which is most important to you. The interest savings and the dollars in your pocket plus lowered balance are essentially the same dollars. They are two sides of the same coin. It's just a question of what you're most interested in. Not that $13,000 plus is chump change, even on this scale, and no matter how you look at it, you're $13,000 plus to the good. You've either got $9623 in payment savings plus $3670 in lowered balance, both of which are "in your pocket" in one sense or the other. You wrote checks totaling $9623 less, and you've got $3670 in lowered balance, which translates to increased equity - not to mention that you're not paying interest on it any longer. Or you could look at it as simply 13,000 plus in interest you didn't pay. Most folks will lose some of the interest in the form of taxes they don't pay, but 1) That's never dollar for dollar and 2) I wasn't going that deep when I wrote this article.


Hi Dan wondering if you could help me out I'm getting a lot of different answers from a lot of people and I'm really searching for help I bought my house brand new (three years ago) for 550,000, and (the next year) I refinanced into a mta loan. which at that time was around 4.25% and now is 7.125%. I have a hard prepay of $12,000.00 which expires in (fifteen months) house just appraised for $775,00 balance on 1st loan 440,000 balance on 2nd 148,000. should I ride the next 15 months out to avoid pre pay or refinance now into a fixed. The rate on the second is prime plus zero.

First off, a disclaimer. A precise infallible answer depends upon the rates when your prepayment penalty expires, something that is not currently known. I think thirty year fixeds will be in the low sevens, but I might as well be sorting through animal entrails to get that answer. I also think that the five year hybrid ARMS will stay about where they are, or perhaps even decrease a tad once the fed announces that they are done with hikes. But I don't know; nobody does. It also depends upon what comparable homes are selling for then, which determine your appraisal, and how long you keep the new loan.

Your rate moving like that is one of the reasons I recommend so strongly against negative amortization loans. The person who did your loan at the time had to know that, due to the nature of the mta yours is based upon, the rates were already set to rise into the mid fives for certain, and likely further, as older months were dropped from the average in favor of newer. Were it fully explained, would anyone rational agree to take a loan where you get a lower rate for six months, but then the rate rises inexorably, as the treasury rates the loan is based upon had already been rising, to a level that is well above what is available on A paper three or five year fixed? And with a three year prepayment penalty, so you're in precisely this sort of situation?

"No points" thirty year fixed rate loans are sitting right around 6.75 right now, and you're at 75% Loan to Value. The bad news is you're definitely a jumbo loan, as the conforming limit is $417,000. This boosts your rate a tad, depending upon the lender, to 6.875 or 7.00 percent without points. I prefer to discuss loans without prepayment penalties or points, but it might be in your best interest to pay a little to buy the rate down if you refinance. I'm going to use seven, as it makes the math slightly easier.

The good news is your loan to value ratio. According to the numbers you gave me, you're below 80 percent, even with the prepayment penalty. You owe $588,000 (If you bought for $550,000, the turkey who did this negative amortization loan scammed you out of a lot of money), and the prepayment penalty boosts this to $600,000. Assuming you have enough liquid reserves to put up the money for interest and impounds, this means the costs of doing your loan are going to put you at about at $605,000 new balance (perhaps a bit below, but let's keep the math as friendly as possible).

Basically, it cost you $17,000 to save yourself an eighth of a percent on the interest rate. Under more normal circumstances, I wouldn't even put that one through the calculator. No way that's in your best interest. But your real rate on that MTA is going to keep rising - by at least another quarter percent due to increases already on the books, more likely half. I'll use 7.5 as your mean rate. Furthermore, the second is at 8 percent, likely to soon be 8.25. Monthly interest under the current loan at that rate: $2750 for the first, $987 for the second as it is. Monthly interest on the new loan, $3530. It saves you $200 per month in interest, albeit with a higher payment, $4025 as opposed to what you've got now. I am assuming you have documentation that you make enough money to justify the loan in the underwriter's eyes, and that your credit score is about average. On the other hand, divide $17,000 by $200 per month, and you get 85 months to break even on the cost of doing it.

However, this decision does not take place in a vacuum. You can't let that negative amortization loan go forever. In fifteen months, I think equivalent rates will be about 7.25, which translates to 7.5 percent for your loan. Furthermore, I believe prices will be a little lower then, so in order to refinance, you're likely to have to split into two loans. Assume prices are 10 percent lower. Any of these prognostications is an educated market guess, no more, and I could be way off. The appraisal would come in just under $700,000, but let's say $700,000. Your first, for $560,000, would be at 7.5%, and for your second, I'll presume you get a new HELOC on the same terms, on which the balance would be about $33,000. Interest on first and second, at 7.5% and 8.25% respectively, comes to $3500 plus $227. The payment on the first would be $3915, plus $227 (assuming interest only HELOC) for a total of $4142. So $12,000 saved if you wait, versus about $200 per month less in interest charges per month if you dive in. Divide that out and it comes out to 60 months. Five years. If you keep the new loan five years, approximately, or more, you'll be better off refinancing now. If you keep it less than five years, you're better off waiting is what the calculations say. Plus chop off the $200 per month you save starting right now for the next fifteen months, and the answer turns into forty five months or a little less, being your time until break-even.

I'm a reasonable risk taker. Were I plopped down in your situation, I have to tell you I would probably hang tight until the prepayment penalty expires. Roll the dice and bet on my personal ability to come up with a good loan. On the other hand, you may not be as much of a risk-taker as I am. The stuff I quoted you for refinancing now is available now, no suppositions about it. The rates could well be higher in fifteen months than I have estimated, perhaps much higher, or they could be lower (although I don't think so with increased federal borrowing). You need to decide what your level of comfort is. If you're the sort that is averse to risk, refinancing now could pay for itself just in peace of mind, because you're not worrying about it. That's why I always offer a 30 year fixed rate loan, no matter how wide the interest rate spread is between that and my favorite hybrid ARM. There are folks who just won't sleep nights. The difference comes out to about $7 per night, and my sleep is worth more than that, so I presume yours is, as well.

Caveat Emptor.

I've written a lot here about how to manage your mortgage so that you control it instead of it controlling you.



Let's consider what happens when that project fails.



If you don't pay your mortgage, on time, no big deal at first. The lenders don't like it, but there's a grace period built in. Fifteen days later, the first consequence is that you owe the lender a late payment penalty. It's a doozy, typically four to six percent, depending upon where you live. Here in California, it's four percent. Doesn't sound like so much, but four percent for fifteen days is the equivalent of ninety-six percent annualized interest, over three times the most horrible credit card I'm aware of. I don't like paying ninety-six percent interest, and neither should you. Don't get fifteen days late if you can help it. But once you've paid the penalty and brought yourself current, nobody knows and nobody cares.



Suppose you get to thirty days delinquent - one full month. At this point longer term consequences set in. First off, your lender marks your credit as being thirty days late on your mortgage. This is a big negative as far as everyone goes, and can easily make a difference of 100 points or more on your credit score. Additionally, if you are applying for a mortgage loan (or plan to), you just got a "1x30". For A paper, this means that if your credit is otherwise perfect, you barely slide through. For subprime, this makes a difference on your rate. It takes two years for this to work its way out of affecting your mortgage application, even if your credit score recovers.



Most people end up being thirty days late for several months in a row, each month hurting their credit score, before it goes to sixty days late. They missed one payment and struggle but manage to make several more before they miss another. Occasionally, they go straight to two months late. Either way, it's a Bad Thing. A single "1x60" might scrape through A paper if there's no cash out and your credit is otherwise perfect. Otherwise you are subprime for at least two years. In the subprime world, a "rolling 30" is generally not as bad as a 60 day late, but both are steps down from even a "1x30" and a "rolling 60" is worse. It gets worse yet if you pay your way current and then backslide again. And of course, you are paying penalties and interest is accruing on your loan and you're falling further behind every time you are late. This amounts to a notable chunk of change very quickly. So none of this is good.



On the other hand, depending upon the state you live in, until you get to ninety or 120 days late the situation doesn't become dire. Each state's foreclosure law is different, but once the lender has the option of marking you in default, the situation gets uglier. It is a common misconception that lenders like foreclosing. In actuality, only so-called "hard money" lenders will usually start foreclosure immediately upon eligibility, especially if you've been talking to them about your situation. If they have some real reason to believe yours will eventually become a performing loan again, regulated lenders will cut you significant slack, by and large. It costs lenders a lot of money to foreclose and there's always the risk they end up stuck with the property, so they'll usually give you as much leeway as they reasonably can. One thing I keep telling people who want a loan approved based upon the equity in the property alone is "The lender doesn't want your house. They want to make loans that are going to be repaid. The lender is not in the business of foreclosure. They don't make any money on it."



Nonetheless, even the most forgiving lender is going to eventually hit you with a Notice of Default. At this stage, things are starting to move towards a resolution that nobody likes, but you least of all. At this stage, you are now liable for a large amount in extra fees that was written into your contract to cover the lender's cost of going through the foreclosure process. At this point, the lender has the right to require you to pay the loan all the way current, with all fees, in order to get them to rescind the notice. Refinancing becomes almost impossible, except with a hard money lender, and unless something about your situation has changed from what caused it to get to this point, that is only delaying the inevitable and making it worse.



As soon as that Notice of Default is recorded, your situation becomes part of public record. You are going to get calls and letters and everything else coming out of the woodwork. One category is going to be lawyers, who will typically tell you they can keep you in the house a long time without payments by declaring bankruptcy. Well, this is true as far as it goes, but it's not going to make the situation any better. As a matter of fact, it will steadily get worse. Just because you go into bankruptcy doesn't mean that the penalties and fees and interest go away or stop accruing. They are still there, and they keep coming. I'm not a lawyer, and you should consult both a lawyer and an accountant if you are in this situation. Nonetheless, bankruptcy is not something I would even consider in this situation without something highly unusual going on.



The second group that will contact you are the "hard money" lenders, looking to lend you money at 15% with five points upfront and a hefty pre-payment penalty, to buy your way out of the situation. Once again, unless something about your situation has suddenly changed, not a long term solution, and it only makes it worse.



Another group that's going to call is investors looking for a distress sale. They want you to sell it to them for less than it would otherwise be worth. This is actually something I might consider. Yes, I lose some money, but that's better than going through denial with the lawyer for a year and a half while any equity I might have left gets frittered away in interest and fees and penalties, not to mention paying the lawyer.



The final category, and one with a significant overlap from the previous, is real estate agents looking to sell the property for you. Assuming you're not deep in denial, this is probably the best option as to least unfavorable resolution. The drawback is that it depends upon whether somebody will make an offer in a timely fashion, a factor which is not under your control. No matter how great the price, no matter how hard my agent works, there might not be an offer. It happens.



If you do nothing, eventually a Notice of Trustee's Sale will follow the Notice of Default. In California, seventeen days after that happens, the property gets sold at auction (unless you've somehow brought it current). There are some protections in place here in California. The lender must perform an appraisal, and for the property to sell at auction, the minimum bid is ninety percent of this amount. Nonetheless, these are typically very conservative appraisals by design. At this point, the lender wants the property sold at auction, because if it doesn't sell, they own it, and they don't want to own the house. They are in the loan business, not the real estate business. So a house that may be actually worth $500,000 on the open market gets appraised at $400,000, and sold for $360,000. If the loan was for $250,000, that's $140,000 of equity you allowed to be taken from you because you were in denial, when you probably could have saved most of it. And if the loan with penalties and fees and interest was $450,000, that's worse, and not only because you forfeited $50,000 you could have gotten, and not only because they may be able to go after you in court for their loss in some states.



You see, because the lender took a $90,000 loss, they want to write it off on their taxes. And in order for them to do this, they have to hit you with a form that says you got away with $90,000 from them. This is taxable income!. So the IRS comes after you for the tax on the $90,000. IRS liens are one of the things that is not discharged by bankruptcy, and it stays with you forever. Ten years absolute minimum for any purpose. Sometimes your lawyer, CPA or Enrolled Agent will get you an "offer and compromise" that cuts your liability, but that's technically taxable income also and may be subject to another round of this crud. It it seems like to you the system is rigged so you can't win, you're right. The loan was an obligation you agreed to, and took the money for, and taxes are on obligation of anyone who is a citizen or resident.



The smart thing to do? As soon as you realize that you can't make your payment, take a long look at your situation and decide if this is something that's going to get enough better to make a difference, or not. Then figure out how much equity in the property you have.



If the situation is likely to improve, and you'll start making your payments in thirty days because hey, you just started your new job, that's one thing. Most of the time, however, most folks lie to themselves on this issue, for a variety of reasons. Remember: Denial Digs Deeper, and makes the situation worse.



Even if selling the property isn't going to net you anything, it's still worth doing as it gets you out from under the sitation. Your credit score stops dropping, you quit getting marked late by your lender, you quit getting socked with penalties and interest and fees you can't pay. The IRS obligations you are incurring stop.



Particularly if you have significant equity built up, the sooner you contact a real estate agent to sell, the better off you will usually be. You are going to lose the house if you don't sell. The sooner you sell, the lower the penalties and fees and extra interest you are charged by the lender will be. This translates into dollars in your pocket - dollars you are likely to need. If you can sell before the Notice of Default is filed, so much the better, as that's thousands of dollars right there. You don't have the luxury of taking your time about it, though. Taking the first reasonable offer is highly advised, and you have more time to get a reasonable offer if you start sooner. Once a Notice of Default is filed, it's a matter of public record and so your bargaining situation gets a lot worse because the buyer should know that you are over a barrel, metaphorically speaking, assuming their agent does their homework. Considering that it's two or three clicks of the mouse, it's easy homework to do and even the greenest new agent is going to catch it more often than not.



Trying the various delaying tactics with a lawyer is likely to end up costing you more than a quick sale. Even if you remain in bankruptcy for five years or more, within about a year and a half at most, the lender will almost certainly persuade the court to cut the home and loan out of the bankruptcy as a secured debt, and sell it. Since the loans and penalties and fees and interest kept accruing all this time, you end up with less money - or none, along with a little love note from the IRS that says "You owe us thousands of dollars! Pay up NOW!"



Every situation is different. At a minimum, consult a loan officer, lawyer, accountant, and real estate agent in your area. But when all is said and done, what I've talked about is the way most of these end up.



Caveat Emptor.



I've also got a "what happens next" kind of article called "Short Payoffs" up.

"How do I remove PMI?"



First off, a definition. Private Mortgage Insurance, often abbreviated PMI, is an insurance policy that the bank may make you buy in order to get the loan. It is a monthly surcharge based upon a percentage of your entire principal balance. You pay for it, but the bank is the beneficiary. It doesn't make your mortgage payments if you can't, it doesn't keep your credit from being screwed up, and it doesn't even keep you from getting a 1099 for income from loan forgiveness. Net benefit to you: it gets you the loan, and nothing more, ever again.



You can trivially avoid PMI by splitting your loan into two pieces, a first loan for 80% of the value and a second for any remainder. Yes, the rate on the second will be higher, but it will likely save you money starting immediately, not to mention that it's likely to be deductible, whereas PMI is not, in general, deductible. I do not believe that with all the loans I've ever done, I've ever seen one where PMI was preferable to splitting the loan in two, from the client's point of view.



"With all this against mortgage insurance, why does it still happen?" you ask. This is the critical question. Lenders usually pay yield spread to brokers or commission to their own loan officers based upon the amount of the first loan. Pay for a second is typically (not always) a small flat amount or zero. Your loan provider makes more money by doing it all as one loan. The loan provider wants to make more money and sticks you with the bill. Doesn't that make your heart glow with gratitude? Didn't think so.



There are two ways PMI is collected. One is as a seperate charge, supplemental to your loan. The second is as an addition to the rate.



The seperate charge is never deductible, but is easier to remove. Most states, including California, have laws requiring the bank to remove it when a Price Opinion or appraisal say that the Loan to Value Ratio goes below 78 percent (or something similar). Depending upon your state, you may or may not be required to pay for an appraisal, a cost of approximately $400, in order to have it removed. Some states require only a price opinion, others, like California, permit the bank to require an appraisal.



Just because the law says that that the bank can require an appraisal doesn't mean that the bank will require an appraisal. If the loan to value is obviously there, they might just have someone drive by to make certain the house is still basically sound. On the other hand, if loan to value ratio is close to the line, the bank has a responsibility to its owners not to increase their exposure to loss unreasonably. So if you just wake up one morning with doubled property values, the bank will likely waive the appraisal. If your market is gradually increasing in value and you're watching it like a hawk and make your request the instant you think the value is there, be prepared to pay for the appraisal. Around here, with PMI on a 90 percent loan being a surcharge of about one and a quarter percent per year on a $500,000 loan, you pay for your appraisal by not having PMI in one month - if you're right. If you're wrong and the appraisal comes in lower, you're just out the money.



Suppose, instead that instead of choosing the surcharge option, you choose to have PMI built into the rate. So instead of a 6.25 percent loan rate, you have a 7.00 percent loan rate. Advantage: it's usually deductible, because it's actual interest on a home loan. Disadvantage: You have to refinance (or sell!) to get out of PMI, because the pricing is built into the loan itself as part of the contract you signed. It is to be noted that by itself, this method is usually cheaper than the monthly surcharge for precisely this reason, because in order to get rid of it you have to pay to refinance, and if there's a prepayment penalty in effect you're likely going to pay that also, and so on and so forth.



So if your loan is more than eighty percent of the value of your property, you can expect to pay PMI, although it is easily avoidable by splitting the loan into an 80 percent first and a second for the remainder, and you're likely much better off for doing so. If you're already stuck with it, contact your lender for steps to remove it providing you think the value has increased enough. If you suspect the lender is not abiding by the law, contact your state's Department of Real Estate, although lenders not abiding by the law is both stupid and, in my experience, rare. It's usually the consumer that doesn't understand the law.



Caveat Emptor.


I got a search result for how to get out of mortgage pre-payment penalties, although I've never really dealt with the issue.



Prepayment penalties on real estate loans are something some people, often with less than stellar credit, accept, either in order to either get their mortgage rate lowered or because they don't know any better, or because they didn't ask, were lied to, didn't stick to their guns, didn't protect themselves from unethical loan providers, or any of a dozen other reasons people end up with them. Standard prepayment penalties are six months interest on the outstanding balance, but many companies with "twenty percent" allowances only require eighty percent of that.



Prepayment penalties come in two major varieties, "hard" and "soft", with the vast majority being hard prepayment penalties. Hard means that if the prepayment happens for any reason, you will pay the prepayment penalty. Soft means that if the reason you pay early is because you actually sold the property, there will be no prepayment penalty due.



Prepayment penalties can be further sorted into "first dollar" and "twenty percent". Either can be in the contract for either a soft or hard prepay, but first dollar prepays are uncommon for soft prepayment penalties. If you have a "first dollar" prepayment penalty and you pay one extra dollar above your regular payment, you will be assessed the penalty. These are most common with Negative Amortization loans, and are somewhere between ten and twenty percent of all prepayment penalties, judging from my experience with the problems people bring to me. A so-called "twenty percent" penalty allows you to pay up to twenty percent of the loan balance in any given year without triggering a penalty.



Common terms for prepayment penalties are one, two, three, and five years, although I have seen ten. Since the median time between refinancings is less than two years, and ninety-five percent of everyone has refinanced or sold within five years, it's very much like a hidden fee to the bank in most cases, one that will not apprear on your loan costs summary of the HUD 1, and yet since most people who accept them end up paying them, I would certainly advocate a dollar value being mandatory if there is a prepayment penalty associated with a loan. This is not to say that they are never beneficial or never necessary, but in a large majority of all cases they are simply the result of a loan provider who wants to make more money, who hides the prepayment penalty until it is too late to avoid. They want to raise your cost of going elsewhere so that you will keep the loan at least a minimum amount of time. No matter whether they are a broker or an actual lender, this means they make more money when they do or sell your loan. A lot more money. A two year prepayment penalty is worth about four points (four percent of loan amount), more or less, on the secondary market. Longer penalties are more.



Now, the answer to the question. I know of precisely four ways to get out of paying a prepayment penalty, and three of them are trivially easy to describe.



The first is not accepting a prepayment penalty in the first place. No matter how bad your credit is, you do have this option. Your interest rate will be higher, or they will charge you more for the loan, but you won't have a prepayment penalty. In general, my experience has been that the higher loan rate is worth not having a prepayment penalty. If your loan amount is $300,000 and your rate is 6 percent, your prepayment penalty will be about $9000. Nor is it, in general, deductible if you have to pay it. In this case, if you had to accept a rate one full percent higher to avoid a three year prepayment penalty, you'd be breaking even.



The second is equally trivial. Wait to sell or refinance until the prepayment penalty has expired. Let's say your loan amount is that same $300,000, and that you have a year and a half to go. In order to be worth refinancing, you would have to save two full percent on your new rate, and that's not counting anything you pay, costwise, to get the new loan.



The third way involves something not under the personal control of the borrower, in that it requires legal intervention for perceived legal wrongs done you, the borrower. It has happened in the past that courts have ordered prepayment penalties waived in such cases. It has also happened that companies have agreed to waive a prepayment penalty as part of a settlement. Both events, however, are quite rare, and require you to have gone through something bad enough to merit this. The one I'm personally familiar with involved the lender playing games with payments that were being made on time to the point where they actually marked the people as being in default. I got them to a lawyer specialist and did exactly what that lawyer told me to, when he told me to, and nothing else. They went through something worse than purgatory at the hands of this lender and ended up paying thousands of dollars in attorney's fees, which they didn't recover, but at least they kept their home. Getting out of a prepayment penalty this way is a cure that's worse than the disease.



The fourth and final way to avoid a prepayment penalty is to refinance with the same company. Most (although not all) lenders will agree to swap the old prepayment penalty for a new one if you do your refinance with them. This does not mean that if you've got eighteen months to go on a three year prepayment penalty, you've got eighteen months under the new loan. This means you've got a whole new three year prepayment penalty. It's like putting a problem off for another day, allowing it to fester. Far superior in most cases to just wait until the penalty is gone, because in the vast majority of all these cases your balance under the replacement loan will be significantly higher, and thus, the amount at risk due to a prepayment penalty will be more.



There you have them. The four ways to avoid paying a prepayment penalty. None of them is exactly wonderful, I know. But consider that the borrower agrees to the penalty when they accept the loan. It's part of the terms, and they do have alternative loans without prepayment penalties. It's just that most people jump to conclusions that this is a loan they want as soon as they hear the payment, and, if they're more cautious than average, the interest rate. Which is why you should be one of those who asks every potential loan provider about them, before you are stuck with one. An ounce of prevention is worth many pounds of cure.



Caveat Emptor.


Been reading some of your informative tips. I am looking at refinancing and getting a $378000 mortgage. Now in the case of having a 3 yr prepay penalty, vs paying 1.5% in points to make it a 1 yr prepay, am i right in assuming it's wiser for me to pay the points than accept a three yr prepay when i know I will sell/move within 2 yrs? Any info you can provide would be great. I'm wondering if I'm missing something here.

I think they points would cost me around $5800.


I compute 1.5 points on $378,000 as being approximately $5756.

Here in California, the maximum pre-payment penalty is six months interest, and that is the industry standard nationwide for when there is a pre-payment penalty. A few lenders will pro-rate it, but for the vast majority, they will charge the same penalty on the day before it expires as on day one. This is pure profit, and they're generally not going to turn down pure profit any more than most people will turn down a bonus. So if your interest rate is 6 percent, you're going to pay a 3 percent pre-payment penalty if you sell or refinance before the pre-payment penalty expires. For Negative Amortization loans, the pre-payment penalty is based on the real rate, not one percent, of course.

On some loans, the pre-payment penalty is triggered by paying any extra money. One extra dollar and GOTCHA! But probably eighty percent or so give you the option of paying it down a certain amount extra each year, usually 20 percent, without triggering the pre-payment penalty.

Assuming that it is a case of you won't move in less than one year, this is equivalent to the prepayment penalty on a loan with interest rate of between 3.05% (100 percent prepayment penalty) and 3.81% (80% prepayment penalty). Since even the 1 month LIBOR is a little over 3.8 percent right now, this seems like a cut and dried case of pay the point and a half.

Of course, if there is a possibility that you will need to move in less than one year, paying these 1.5 points could well be a costly exercise in futility. I can't begin to gauge that risk without more information. But if you're in any number of professional situations ranging from the military to corporate executive, this is common.

Given that you're talking about pre-payment penalties, you're likely in a subprime situation. Subprime has a fairly uniform rate of 1.5 points of cost equals 3/4 of a point on the interest rate. I'm going to assume you're getting about a 6.25% rate. If you decided to buy it off via rate, you'd be looking at a 7% rate.

Let's punch in the two loans. $383,750 (balance with 1.5 points) at 6.25% gives you a payment of $2362.81. Running it out 24 months gives you a balance of $374,467. You have spent $56,708 on payments.

378,000 at 7% gives you a payment of $2514.84. Running it out 24 months gives you a balance of $370,043.00, and you've spent $60,356 on payments, while paying your balance down $7957.

Now, assume you sell the home for $X at the end of this period. The first loan saves you $3648 in interest. The second loan gives you $4424 more in your pocket in two years. The second loan, with the higher interest rate and higher payment, as opposed to the higher balance, nonetheless saves you $776 as opposed to the loan with the lower interest rate, and also leaves you more money with which to buy your next home, which means lower cost of interest on your next home loan, as well. Of course, this is subject to some pretty significantly naked assumptions as I don't know anything more about your situation. Furthermore, it assumes that your income is not marginal, and that you would qualify for both loans. It is perfectly possible that you would qualify for the lower payment, and hence the lower rate would be approved, but not be able to qualify for the higher payment associated with the higher rate (The reverse is not the case). Finally, I assumed that because you know you're going to have to move in two years, you are looking at a two or three year ARM in the first place, as opposed to a longer fixed term.

I hope this helps you. If you have any further questions, please let me know.

Caveat Emptor.
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This page is a archive of entries in the Intermediate Information category from May 2007.

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