Recently in X-Pert Information Category

Scapegoating, anyone?Brian Brady notes Barney Frank's misplaced quest for one.

1- Prohibition of "yield spread premium" as compensation to originators.

2- Mandatory licensing of mortgage originators by a Federal registry or state regulator. This Bill does direct the Office of Thrift Supervision to establish a registry for bank employees who originate loans.

3- Ability to repay the loan must be established. Limits on cash-out refinances and a determination of a net tangible benefit to the borrower will apply.

4- Mandatory "pre-funding counseling" for certain "high-cost" loans by a certified HUD counselor.

All of these are severely brain damaged. In Zero Cost Real Estate Loans, I talk about what a good idea for the average consumer that using yield spread to pay your loan costs can be. Yes, you end up with a higher rate. But if you refinance every two years, the money you spend in interest doesn't even approach the money you don't spend on loan costs. Provision 2 is just a sop to the big lenders, to make brokers lives more difficult, while allowing them to scapegoat their bottom level employees who also take loan applications. I talk more a couple paragraphs down about the first part of provision 3, but the second part is another sop to big banking. If someone owns an asset, they should be able to manage their mortgage as they see fit. I can tell a prospective client that they don't appear to be able to afford something and advise them of such, but they're supposedly competent adults and my proper role, like that of an accountant, is advisory, not compulsory. But these sorts of loans lose a lot of money for lenders who over-compete for business in order to attract customers, whom they can hope to retain while selling them to marketers.

I went over the problems with the fourth proposal in Is This Supposed to be Helpful Legislation?, along with links to what others were saying.

Just this morning, Barry Campbell over at enrevanche pointed me to a new Business Week article that says North Carolina's infamous predatory lending laws may travel.

I don't do business in North Carolina and never have. But they have a 6% aggregate limit on total fees for a loan. When, even with negotiated discounts, it takes just over $3000 to get a loan done (closing costs), you tell me how many $50,000 loans are going to get done, with a 6% aggregate limit. Oh, and I I wasn't aware of this, but "The North Carolina Home Loan Protection Act bans penalties for borrowers who pay off their mortgages early," so that can't be used to cover the costs either, as I go over in Keeping Pre-payment Penalties Legal. One more factor: I believe North Carolina is a survey state, which adds something like $400 more to loan fees. I also believe it's a mortgage tax state, levying a tax on mortgages and refinancing. I don't know what that runs but I doubt it's less than hundreds of dollars.

I have to admit, the idea of nothing but full documentation loans has a certain appeal. Keeps me from having to compete with people who'd do every loan stated income, and sell everyone a house too expensive for them to afford. Furthermore, I'll bet that the entire difference between North Carolina and the national average in foreclosures would be due to this one difference. But self-employed people (with large amounts of deductions) and real estate investors (only get credit for 3/4 of rent, among other issues), both of which have problems qualifying under full documentation lending standards, might disagree with me.

So what's the issue? As I go over in Manufactured, Modular, and Site-Built Homes: How Lending Practices Drive the Sales Market, constricting the availability of loans constricts the price of housing. Were these practices to be mandatory elsewhere in the nation, that 25-30% deflation we've had in California would be just the beginning, and all of the other high cost areas as well (as what drives the cost of living up, except in DC and NYC, seems to be an abundance of successful entrepreneurs). Furthermore, real estate becomes a much less attractive capital investment, so it would have to become more of a "cash flow" investment, putting increased upwards pressure on rents just when some rental markets (like southern California) are set to explode upwards anyway.

Here's the REAL issue that politicians keep tap-dancing around, because they don't want to offend wealthy, campaign contributing lenders and real estate brokerages: There is no substitute for due diligence on an individual level. People have got to take the time to understand what they're getting into. They are legal adults, theoretically competent to manage their own affairs. If they're not capable of being responsible, why are they permitted to vote, drive cars, and sign loan Notes for hundreds of thousands of dollars? But there is no real financial education in the United States, except for those who make a career out of it, and all too often, that license is a cover for activities that would make any self-respecting shark shudder.

I read a posting just a few days ago on how one real estate practitioner built a very successful career at least partially upon a point he seemed inordinately proud of: Not asking people what their plans were. People don't like discussing their plans with folks. But it is precisely discussing future plans that enables a real professional to know what he or she should recommend to the client. Without that, even the most conscientious of us isn't much more than a sales person. You just want me to shut up and get you a million dollar home, I'm cool with that - but I am entitled to protect myself by asking you to agree that I have furnished you with no false promises of you being able to afford it, or that it's really worth what you paid in comparison to other properties at the time.

There is no substitute for real loan disclosure at the time of application, something the legislative branch has been expanding loopholes for for the last thirty years that I'm aware of, all in the name of "helping the consumer" but really in aid of campaign contributions from big chain brokerages and large mortgage lenders. Quite frankly, of the major household names in both, there's really only one that I haven't seen evidence of pervasive unethical practices that would amount to systematic fraud in any other industry, but legal loopholes, lax supervision requirements, and unwillingness to go for the real perpetrators keep these folks in business, occasionally sacrificing a few low echelon goats while those higher up make millions to hundreds of millions per year. That's why I finally got disgusted enough to start this website.

But it seems that comparatively few politicians really understood the lessons of Economics 101, or at least, they understand the benefits of campaign contributions more, and that's why you can't seem to keep a bad idea down.

Caveat Emptor

Read your article on negative arm loans, and for the person who only owns a residence and most real estate investors it will not work. I own several properties, and the parcel to be refinanced is ocean is going up in value more than the negative arm would be when refinanced after prepay penalty period. Cash out would be used to pay off other mortgages, thereby increasing my cash flow for a few years. Does your advice against negative arms apply in my situation?

I believe he's referring to this article.

This is actually an excellent question, and the answer is ... maybe. At least it is not a clear "no", unlike so much of what the Negative Amortization loan is misused for. This largely goes beyond the scope of what I'm trying to do with this site, but I'll take a swing at it.

The fact is that I can construct a scenario that goes either way, and the implicitly high appreciation rate you mention has surprisingly little to do with it.

The positive is that your other loans are paid off! To use Orwell-speak, this is maximum plusgood.

The negative is that this loan now includes every dollar you previously owed. Furthermore, there may be negative tax connotations to the fact that all of your interest expense now comes from one property, as opposed to being able to directly match it against individual properties with individual incomes. If interest against one property is greater than the income for that one property, you may not be able to take it all. I'm not clear on the implications of the tax code here (and I'd like to be educated), so consult with a CPA or Enrolled Agent.

Furthermore, your new loan won't magically create any "lake" of dollars. In order to pay off the other loans, it's going to have to be the size of all of them combined, plus any prepayment penalties, plus all costs of doing the loan, plus potential pre-payment penalties for the Negative Amortization loan.

Now consider:
If you make payment option one (the "nominal" or "as if your rate was 1 percent" payment), you are allowing compound interest to work against you. This is the force Einstein described as "the most powerful force in the universe", and it's working on the whole dollar amount of every single one of your current loans and then some.


No matter which payment you're making, the rate you are being charged, (aka "what the money is costing you") is not fixed, but variable month to month. As far as most commercial property loans are concerned, this is no big deal. They're pretty much variable at "prime plus" anyway. However, I expect the MTA and COFI (upon which Negative Amortization loans are based) to continue rising as government borrowing increases, whereas I'm not so certain about prime, which for most banks is comparatively high by real and historical standards.

Now with all this said, it's still very possible to construct winning scenarios, depending upon a variety of factors. You mention short-term cash flow, and that is certainly one possible justification. If short-term cash flow is all you're looking for, and the money it will cost you later on is no big deal because you're planning to buy down the prepayment penalty and sell in a short period of time. Yeah, you've added to your balance but you've got plenty of equity and you'd rather have a few hundred per month now than multiple thousands later. Think of it as a cash advance.

One of the things that negative amortization loans can do for you is make it easier for you to qualify for more loans on more properties. Because in loan qualification, the bank will only give you credit for 75 percent of prospective rents while dinging you for the full value of payments, taxes, fees, maintenance, etcetera, this can make it much harder to qualify than is realistic, given that in many markets the vacancy factor is less than five percent. You actually pay more, but you're not obligated to. Particularly because many people own investment properties for the capital gain rather than the income potential (i.e. price speculation, rather than monthly income). On the other hand, just because a property has been appreciating rapidly does not mean it will continue to do so, beachfront or not. The market nationwide is entering a very different mode than it's been in for the last few years. I can point to beachfront property here locally that's lost a lot of value since early 2005. Price speculation is great when it works (which is most of the time), but is really scary when it doesn't. It's a reward for risk-taking, so don't lose sight of the fact that it is a risk.

One other factor of doing this is that it can cause taxes on a sale to exceed net proceeds. Suppose you intend to sell the beachfront property in a couple of years, and it doesn't gain any more ground from where it is right now. Many properties were bought for less than 10% of their current value. Let's say you bought for ten percent of current value. If your loan is for eighty percent, and you pay six to seven percent in sale costs, you're getting ninety-three to ninety four percent of value, leaving a net of thirteen or fourteen. But you owe long term capital gains of eighty-three or eighty-four times twenty percent - almost seventeen percent! This can force you to take another loan out, against one of those "free and clear" properties lest you owe the IRS penalties. Yes, 1031 and even a potential personal residence exclusion can modify or nullify this, but so can all the depreciation you may have taken over the years, and if you intended to 1031 the property that would tend to contra-indicate any reasons you had for the negative amortization loan.

Now, to be honest, my experience with commercial loans is limited, and I've never done a negative amortization commercial loan. What few clients I've had in that market have had different goals in mind, and being as I'm a sustainability type loan officer, I tend to attract sustainability type clients, where Negative Amortization loans are more indicative of a speculative ("risk taker") type. I understand what's going on, but it isn't my primary approach to the issues. There are circumstances on investment properties where, unlike your primary residence, it can be very appropriate. Unfortunately, without full specifics, including time schedules, goals, reasons for holding investments, other investments, risk tolerances, etcetera, it's difficult to tell if yours is one of them. My experience in dealing with people is telling me one thing, my sense of ledger evaluation is hinting at a different answer. But I hope I've given you a clear idea of the kinds of issues you need to look at with professional help.
What do the mortgage companies mean when they say they can not insure your house loan.? What is the danger to the homeowner?

I have been in the new home for over a year now and they just now told me that they could not insure my loan. They said they made a mistake and overlooked something in my credit. I do not know what dangers I face now because of this.

You say you've been in the property a year, so I'm going to presume you're talking about an existing loan, rather than a new loan. The loan you used to buy the property, and what they're talking about is that the PMI company rejected the application to insure your loan, and they just now realized the problem.

That Note is a contract binding to both sides. They accepted that loan contract with you. Once it's funded and recorded, they can't back out. Unless the contract has a call "feature" they can't pull your loan just because they feel like it after it's recorded, so the loan you've got now should be fine for you. It's no coincidence lenders are adding call features to more and more loans, to give them a bail out clause should they decide to. But if you don't have such a clause, as long as you keep making all your payments on time, keep the insurance and property taxes up, and all that, they can't force you to do anything. The lender can offer you incentives, as lenders did back in the late seventies and early eighties, such as offering you a reduced payoff if you'll refinance or sell, but they can't force you to do anything as long as you continue to hold up your end of the bargain. The time for them to talk about qualifications is before the loan is funded and recorded. Afterwards, they can't do anything about it, any more than they can do something if values drop (which they have, another reason why they want you to find another lender), if you lose your job, if you decide to change lines of work, etcetera. The qualification process is not open-ended.

There is one more way they can get out of it. If you committed fraud or perjury or something else during the loan qualification process, and they gave you the loan based upon those false representations. Having a loan called is no fun. There's a reason I keep telling people to tell the truth, and nothing but the truth in loan paperwork. In addition to possible criminal charges, you'll have between 7 and 30 days to get the money somewhere when your loan is called for this reason. If the rate is higher, if the closing costs are huge, even if you can't get that loan, it's not the lender's problem. They are within their rights if you misrepresented yourself in a material way.

What they're likely trying to do in this case, where you haven't told me of such a reason, is stampede you into refinancing, since without PMI they can't sell your loan on the secondary market. Unfortunately for them, they're stuck at this point unless you let them off the hook, and they'll have to hold your loan themselves and hope you don't default.

There's a fair amount of this sort of thing going on right now, as the lenders that gave out 'warm body' loans suddenly realize the consequences. Don't draw any lines in the sand without talking to a lawyer first, but if I understand your situation, they can't force you to refinance or anything. It's more than a little slimy of them to do this, of course. But a certain percentage of borrowers will panic and do something they don't need to.

Caveat Emptor

We live in (A California city). In a 2 bedroom 1 bath home on approximately a 20,000 Sq. ft. lot. It is easily worth 500K to 600K with a current mortgage of $116,000. The mortgage/Title is in the name of my father and his wife 90% and myself and my wife with a 10% interest.

My father who is 75 and retired wants to take out about $80,000 cash which would create a new loan of approximately $200,000. He currently has a very small income from investments and lives in a paid off home in (out of state).

He would like to gift this (California) home to us and we would like that also.

Based on your expertise what is the best way to transfer the property to my wife and I and at the same time obtain a cash out stated income loan. How will a lender expect this to be handled? Do we all qualify together and the lender then allows my father to transfer/gift title at the close of escrow?

I realize that whatever lender wants to make the loan they will want to have my wife and I qualified to be on title. Since we have a 10% interest I would assume that we could all be asked to show assets and income. This might be complicated. I am a realtor but I haven't made much money in the last two years because I've worked on a business startup currently breaking even with no income.

My wife has a terrific long term (16 yr) job with a law firm. Gross income $85,000. All of our expenses are very low and the last time I looked our credit was a 785 FICO score. When I do the front end ratio 28 with only my wife's income it appears to be no problem at all. When I do the backend it's a little more snug but definitely doable. I've racked up some credit card debt funding the startup business. I can pay it off but I would like to retain working capital handy for my business.

I believe a stated income loan would be the best way to go.

Here are the assets and documentation I would be willing to show, and the lenders exposure to the property.

1. We would have approx. a 36% LTV at the end of the transaction. 300k+ equity
2. Assets in a 401K of $200,000 +
3. Approx. $30,000 in savings accounts
4. Approx. $40,000 in negotiable stocks
5. I will of course provide credit reports.
6. Employment documentation for my wife only.

I believe my father and his wife have approximately $200,000 in mutual funds plus social security and she has a part time job doing a water district's billing.

This one is fairly complex on the surface. Issues that I see right off:

-family transfer
-documenting current interest
-structure of transaction
-Will your father be selling you some of his interest as part of this transaction?
-likely the cash out quitclaim issue
-Who is going to be primarily or completely responsible for new loan
-verification of rent/mortgage.

You say that you are already on title of record, and that the desired end state is to have you and your wife owning the property outright.

The best way to structure this is probably as an actual sale
transaction. Your father selling you and your wife a larger interest. Because this is a family transfer, you still would likely qualify to continue having it taxed based upon original acquisition price, but that needs to be checked, either through the county or your title insurance company for the transaction. You also need to scrutinize the current owner's policy of title insurance to see if it will continue coverage. There have been changes in the industry since the property was bought. If it doesn't, you're going to want to buy a new policy.

Now there is a standard policy with every lender I've ever done business with. If someone is brought onto title via quitclaim, you can't get cash out for six months after that date. This prevents several sorts of fraud. I am going to presume that you've been on title longer than six months.

Now, there are three ways that suggest themselves to structure this transaction. Each have their potential advantages and disadvantages. First though, we need to take a look at another issue.

In all real estate transactions, and for all loans, the method of evaluating the property is the so-called LCM, or "Lesser of Cost or Market," method. Market is what similar properties around yours have sold for within the past twelve months, and that is what it is, and is computed by the appraiser.

Cost is the purchase price. In refinances, there is usually no purchase to consider, because the value has changed since purchase. In purchases, there usually is.

Whichever of these two numbers is less determines the value of the property, as far as the lender is concerned. It doesn't matter if similar properties are selling for four million dollars - if you buy yours for one hundred thousand dollars, the lender will loan as if the value was $100,000. It can't be any higher than that, because the seller willingly sold to you for that amount. If the property was worth more, they would have required you to pay more.

For family transfers (and indeed, any related party) this presumption goes out the window. Parents do all kinds of stuff for their kids that they wouldn't do for anyone else, and vice versa. Lenders still won't loan money based upon a number above nominal purchase cost, however.

Furthermore, there have been a sufficient number of scams over the years that they will take additional measures to protect themselves. The presumption of willing buyer and willing seller is violated on both ends of these transactions, and many times it has been A selling the property to B for an overinflated price for the purpose of getting a loan and departing at midnight, leaving the lender holding the bag. Remember, I told you in this article here, is that because the dollar values are so large on real estate transactions, every single one is heavily scrutinized for fraud. There's a reason for that. These additional measures differ from lender to lender, and some lenders will not undertake related party transactions at all. When I'm getting loan quotes from lenders, if it's a related party transaction, then words to that effect are the first words out of my mouth. It saves a lot of time and effort.

Now, I mentioned there being three ways I can see that make sense to approach the transaction?

The first is a full price sale with upfront gift of equity. You buy the property for $600,000. They sell it to you for $600,000, but give you $340,000 in equity in addition to the $60,000 you already own. You get a loan for $200,000 (actually a bit more to pay for costs), the old loan gets paid off, your father gets his $80,000. This has the advantage of being a true picture of what's going on. The problems are that to the lender, this screams fraud. They're not likely to be too worried that its for below market value, but $340,000 is a lot of money. They are going to want to see evidence that there's not some loan going on under the table between you and your father, because that would affect whether or not you qualified for their loan. Furthermore, estate tax isn't completely dead yet and could be resurrected even if it does die, and this would have significant estate tax implications.

The second is full sale price with subsequent gifts of equity. Sell it for full price, from you and your wife as ten percent and your father and his wife as ninety, to you and your wife as twenty-five percent and your father and his wife as seventy-five. They can then give you a gift of forty thousand of equity each year. You can even combine this with the initial sale, making your interest thirty percent, which might make the loan easier. In this case, you are all four probably going to be on the new loan to get the best rates, as $200,000 is about thirty-three percent of $600,000 - a larger amount than the equity you and your wife currently have under this scenario. There is a further major difficulty with this lies in the possibility that the complete equity may not be gifted in your father's lifetime.

The third way is to sell the full property at a reduced sale price. Approximately $300,000 would probably be sufficient. Everything here is like the full price sale, but they're only giving you about $40,000 in equity upfront - which is within the IRS single year limits. The bank has less difficulty believing that (although they're still going to want a letter stating that it is a gift!). The downside is still that family transfer thing, and the fact that if you wanted to refinance within a year there would be appreciation issues on whether or not the bank would believe you.

All three ways have their bumps and walls which you very well might run into. Each lender has their own anti-fraud measures, and sometimes these run afoul of the best ways to structure it

Now, as to the loan itself, I have good news and bad news. I'm going to start with the bad. Verification of Rent/Mortgage is going to rear its ugly head no matter what you do. The bank is going to want to see some kind of evidence that you and your wife have been making rent or mortgage payments every month, and from all that I can see in the email, there's no evidence to support this. The only person who appears to be in a position to verify that is your dad - unless you've been writing the checks for the mortgage and can prove it. The lenders may or may not accept your father's word for it, and they are going to want evidence. If you're actually on the current mortgage, this would be extremely helpful.

The good news is that with an income of $85,000 per year which your wife alone makes and you should be able to document, you have a monthly income of about $7083. This means that the back end you'd qualify for on A paper, thirty year fixed rate basis, is about $3180 (about $2690 if we're talking about an A paper ARM). Picking a random A paper lender, I get about 6.25 percent rate thirty years fixed full documentation, which translates to a monthly principal and interest payment of a little less than $1232. With the yield curve inverted right now, the five year ARM is about the same rate, meaning there's no reason to do that instead.

Take $1232. Add $600 per month, which is about the worst case scenario for property taxes that I see (as I said earlier, you can probably preserve the current tax basis). Add another $150 per month for homeowner's insurance, which is a high estimate for most urban locales. This is still less than $2000 per month, leaving you almost $1200 of other allowable payments before you would not qualify full documentation. You can probably do stated income if you want, but that'd be giving the bank money that you don't need to.

Because of the multiple concerns, of which the most important are family transfer and verification of mortgage/rent, there are many reasons why the best way to approach this might change, but when you separate it all out, it certainly looks doable.

Caveat Emptor (and Vendor)

The negative amortization loan is a very popular loan with certain kinds of real estate agents and loan officers. It has two great virtues as far as they are concerned. First, it has a low payment, and despite the fact that people should never choose a loan - or a house - based upon payment, the fact is that most people do both, and the negative amortization loan enables both sorts to quote a very low payment considering how much money their client is borrowing. Furthermore, because it has this very low minimum payment, it enables these agents and loan officers to persuade people to buy properties that they cannot really afford. When someone says, "I'll buy it if the payment is less that $3000 per month," this brand of agent goes to a loan officer that they know will reach for a negative amortization loan, without explaining this loan's horrific gotcha, or actually, gotcha!s. Instead of someone ethical explaining that the real rate and the real payment are way above $3000, and this is only a temporary thing, they keep their mouth shut and pocket the commission.

This commission is, incidentally, far larger than they would otherwise make, and that's the second advantage to these loans from their point of view. When the pay for doing such a loan is between three and four percent of the loan amount, with most of them clustering around 3.75%, and they can make it appear like someone can afford a much larger loan, that commission check blows the one for the loan and the property that this customer can really afford out of the water. When they can make it appear like someone who really barely qualifies for a $400,000 loan can afford a $775,000 loan, and the commission on the $400,000 loan is at most two percent of the loan amount, that loan officer is making over twenty-nine thousand dollars, as opposed to between four and eight thousand for the sustainable loan, and that real estate agent (assuming a 3% commission per side) is making over twenty-three thousand dollars as a buyer's agent for hosing their client, as opposed to $12,000 for the property the client can really afford. Not to mention that if they were the listing agent as well, not only have they made $46,000 for both sides of the real estate transaction, but they have found a sucker that can be made to look as if they qualify for that property, making their listing client extremely happy - the more so because one of listing agents standard tricks is talking people into upping their offers based upon how little difference it makes on the payment. Ladies and gentlemen, if the property is only worth $X, it's only worth $X, and it doesn't matter a hill of beans that an extra $20,000 only makes a difference of $50 on the minimum payment for an Option ARM, as these loans are also called. Indeed, Option ARM (aka negative amortization) loan sales were behind a lot of the general run-up in prices of the last few years. By making it appear as if someone could afford a loan amount larger than they really can, this sort of real estate agent and loan officer sowed at least part of the seeds by making people apparently able, and therefore willing, to pay the higher prices because the minimum payment they were quoted fit within their budget. When someone ethical is showing you the two bedroom condo you can really afford, fifteen years old with formica counters and linoleum tile floors, these clowns were showing the same people brand new 2800 square foot detached houses with five bedrooms, granite counters, and travertine or Italian marble floors. Talk about the easy sale! Someone who's not happy about what they can really afford now finds out there's a way they can apparently afford the house of their dreams!

So now that the Option ARM has finally been generally discredited by all the damage it has been doing to people these past three to four years, and has become well known, and deservedly so, by the moniker "Nightmare Mortgage," among others, this type of agent and loan officer are jumping for joy and shouting from the rooftops that a couple of professors have done apparently some work showing that "the Option ARM is the optimal mortgage." It was reported in BusinessWeek, which would have reason to celebrate if this defused the mortgage crisis, and therefore the credit and spending crunch that comes with it.

The problem is that the "Option ARM" these professors are talking about has very little in common with the Option ARMs, or more properly, negative amortization loans that are actually sold for residential mortgages. If you read their research, the loans they describe actually look a lot more like commercial lines of credit secured by real property. There really isn't much more in common between the two than the name.

The characteristics the professors describe in their ideal loan include first, it being the lowest actual rate available. This is not currently the case. In fact, since I've been in the business, it has NEVER been the case - or even close to being the case. The nominal rate can't be beat, but the nominal rate is not the actual interest rate you are being charged. Ever since the first time I was approached about one of these by a lender's representative, I have always had loans at lower rates of interest, with that rate fixed for a minimum of five years. For the last year and a half or so, I've had thirty year fixed rate loans - the paranoid consumer's dream loan, which usually carries a higher interest rate than anything else - at lower real rates of interest than Option ARM. When you're considering the real cost of the loan, it's the interest you're paying that's important. The lender, or the investor behind them, isn't reporting the payment amount as income. They're reporting the cost of interest to the buyer as income, and that's what they're paying taxes on as well. But because people don't know any better than to select loans on the basis of payment, lenders can and do get away with charging higher rates of interest on these. The suckers pay a higher rate of interest than they could otherwise have gotten, and their balances are going up, which means they're effectively borrowing more money all the time, on which they then pay the inflated interest rate that is the real cost of this money. What more could you ask for, from the lenders and investors point of view?

Now there is a real actuarial risk associated with these loans, as well, which does increase the interest rate that the lenders need to charge. This is that because there is an increased risk that the borrower's balance will eventually reach beyond their ability to pay, a risk which is exacerbated by how these loans are generally marketed and sold, a larger number of borrowers will default than would be the case with other kinds of loans. So these loans aren't all fun and games from the lenders point of view, either - as said lenders have been finding out firsthand for the last several months as the loans go into default. This leads us to the second dissimilarity between these loans as they exist, and the loans said to be optimum by the professors research, and this one is a real problem from the lender's point of view.

You see, the professors' study assumes that the lender can simply foreclose as easily and as quickly as sending out an email. That's not the way it works. First of all, foreclosure takes time, and it costs serious money. The law is set up that way. To quote something I wrote on August 23rd, 2007:

It takes a minimum of just under 200 days for a foreclosure to happen in California, and we're one of the shorter period states. Notice of Default can't happen until the mortgage is a minimum of 120 days late. Once that happens, it cannot be followed by a Notice of Trustee's Sale in fewer than sixty days, and there must be a minimum of 17 days between Notice of Trustee's Sale and Trustee's Sale. Absolute minimum, 197 days, and it's usually more like 240 to 300, and it is very subject to delaying tactics. There are lawyers out there who will tell you if you're going to lose your home anyway, they can keep you in it for a year and a half to two years without you writing a check for a single dollar to the mortgage company. It's stupid and hurts most of their clients worse in the long run, but it also happens. Pay a lawyer $500, and not pay your $4000 per month mortgage. Some people see only the immediate cash consequences, and think it's a good deal.

So that loan is non-performing for a time that starts at just under nine months, and goes up from there. This costs the lenders some serious money - money which they expect to be actuarially compensated for, which is to say, everybody pays a higher rate so that the lender doesn't lose more money on defaults than they make on the higher rate. I checked available rates on loans this afternoon, and for average credit scores on reasonable assumptions, the closest the Option ARM came to matching the equivalent thirty year fixed rate loan was 80 basis points (8/10ths of a percent), and that wasn't an apples to apples comparison, as the Option ARM had a three year "hard" prepayment penalty, while that thirty year fixed rate loan had none, as well as the Option ARM had the real rate bought down by a full percent by a lender forfeiting sixty percent of the usual commission for the loan to buy the real rate down. How often do you think that's going to happen? Sure, the *bleeping* Option ARM had a minimum payment of about $1011 on a $400,000 loan, as opposed to $2463 for the thirty year fixed rate loan fully amortized, but the real cost of money was $2350 per month, as opposed to $2083 for that thirty year fixed rate loan, and the equivalent payment for the Option ARM was, that accomplishes the same thing $2463 does for the thirty year fixed (theoretically paying the loan off in thirty years, providing the underlying rate remains the same), was $2675. Not to mention that the thirty year fixed rate loan has the cost of money locked in for the life of the loan, where that *bleeping* Option ARM can go as high as 9.95%, and the prepayment penalty for that *bleeping* Option ARM starts out at $14,100, and is more likely to go higher than lower for the three years it's in effect. You can't just handwave $14,100 that the majority of people who accept a prepayment penalty are going to end up paying, for one reason or another.

Another characteristic of the Option ARM envisioned by the professors is a so-called "soft" prepayment penalty, where no penalty is due if the property is actually sold, rather than refinanced. That's not the case with the vast majority of real-world Option ARMs. With only one exception I'm aware of, they're all "hard" pre-payment penalties, and the one lender who offered the "soft" penalty has discovered it's not a popular alternative, because they had to charge a higher nominal rate in order to make it work. Since the minimum payment was higher, and it wasn't quite so easy to qualify people quite so far beyond their means, that particular lender had been contracting operations, even while the rest of the Option ARM world was going gangbusters. Indeed, their parent company sold that lender earlier this year, because they just weren't getting any profit out of them, and at one point, they had been a very major subprime lender (They were extremely competitive on 2/28s and 3/27s and their forty year variants, as well as versus other subprime lenders on thirty year fixed rate loans). Until I checked their website just now, I was not certain whether they're even still in business. I haven't heard from my old wholesaler in eighteen months now.

The Option ARM envisioned by the professors lacks the "payment recast" bug present in all current Option ARMs. Indeed, under all currently available Option ARMs, it is difficult to avoid this issue, because they recast in five years no matter what. Furthermore, they professors' assumptions as to the longevity of the loan were open ended - essentially infinite in theory, although no loan given to individuals can be open ended in fact because we're all going to die someday, and most of us are going to want to retire before that, at which point these loans would definitely not be paid down to a point where they're affordable on retirement income under anything like our current system.

One final crock to the whole Option ARM concept as envisioned by the professors seems to be that the borrower gets a reserve amount if ever they default. The obvious retort is "Not in the real world." That is contrary to every practice of lending as it currently exists. That is the very basis of the real estate financing contract - the lender gets every penny they are due, first, and the borrower/purchaser/owner gets everything that's left over. As the authors themselves note, this does create a moral hazard for the lenders. Furthermore, and I must admit I'm not certain I'm reading the relevant passage correctly, another characteristic of the "Option ARM" they propose is that the lender gets primary benefit of any gain in value, and at least under certain circumstances, takes primary risk for any loss. In case you were unaware, this would completely sabotage the benefits of leverage that are the main reason why real estate is a worthwhile investment. This would certainly make the communities that make their living off selling other sorts of investment happy. Lenders, and especially current owners, not so much. Furthermore, I'm pretty certain that if they think about the economic consequences of this, real estate agents and loan officers don't want this to happen, either.

Those aren't all of the differences or relevant caveats, by any means. I took quite a few notes that I haven't yet covered, but it's bedtime, and by this point it should be obvious to anyone who took the trouble to read through the above that there really isn't a whole lot in common between the Option ARM as the contracts are currently written, and it is currently marketed and sold, and the loan of the same name as envisioned by the professor's research, except that name. Any claim that said research rehabilitates the Option ARM aka Negative Amortization Loan aka Pick a Pay aka "1% loan" aka (several dozen words of profanity), is based upon nothing more than the similarity in labeling, as if claiming a Chevette was the same thing as a Corvette, because they're both Chevrolets. Someone reading the professors' research would not recognize anything like the loan they are promulgating in any Option ARM currently on the market, because those currently offered are not based upon any of the same principles.

Caveat Emptor

Postscript: Lest I be misunderstood, I had previously come to a lot of the same conclusions that the professors had, although I had never integrated it into a single article, here or anywhere else. A lot of what they conclude, while pretty much theoretical, has some significant real world applications. Indeed, I have said several times in the past that leverage works best when it's maximized, and when you pay as little as possible towards paying off the loan, although that one result has to be modified for real world considerations like mortality, morbidity, and various psychological factors, which the professors mention in passing but do not really address or answer. I think I have some real academic appreciation for the value of Professors Piskorski and Tchistyi's work, and what went into it, and the results they have achieved. I had to dust off some portions of my brain (and mathematical textbooks!) that I haven't used in almost twenty five years, which was a treat of a certain kind once I got into it. Nonetheless, the products that go by the same name in the current world of loans have nothing to do with what these two distinguished gentlemen are talking about. The loan product I'm aware of that comes the closest is, as I said, a line of credit on commercial real estate.

In an article on my other site somebody wrote in the comments about going upside-down on their mortgage:

What happens if the property value falls and becomes far less than the loan ammount? (POP) Lets say you get a loan for $280,000 on a home that was $330,00 and then three years later is is only worth $150,000, but you still owe $250,000 on it?

Now "upside-down" in the context of a mortgage is just slang for owing more than the property is theoretically worth. This is a tough situation to be in, and there's not much that can be done while you're in it except get through it. Before, yes. After, yes. During, no.

I've predicted that this is going to be a widespread phenomenon over the next few years, and it's going to cause a world of hurt, but it doesn't need to include YOU, unless this has already happened, and I thought Sandy Eggo, where I live, to be on the bleeding edge of bubble problems, and appraisers are still able to justify near peak values even here.

Surviving being upside down is actually pretty easy if you have the correct loan. I bought near the peak of the last cycle, and was upside down myself for little while. If you take nothing else away from this article, understand that the only time your current home value is important is when you sell or when you refinance. If you don't need to either sell or refinance, it does not matter what the value of your home is. It could be twenty-nine cents. It's still a good place to live. You've still got the loan you always did. You should be able to keep on keeping on until the situation corrects. Prices will come back sooner or later.

The key is to have a sustainable loan. I did. I had a five year fixed period, during which time the market recovered and I paid down my loan. By the time I went to refi, five years later, things were better.

This is the real sin of the local real estate and mortgage industry. Yeah, the bubble's ggoing to pop, and everybody knows it. Actually, it's already had significant price deflation. But if they had been putting folks into longer term sustainable loans, they'd be fine. Instead we've had about forty percent of purchase money loans being negative amortization and another forty percent being two year fixed interest only loans. The period of low payments for the former, and the fixed, interest only periods for the latter, are going to expire while prices are still down. That would be tolerable if the people could make the new payment, but if they could have made the new payment, they would have been in longer term fixed rate fully amortizing loans in the first place. What's going to happen next is kind of like when Wiley Coyote looks down.

I've been telling people there are no magic solutions to the problem for over three years now. If you borrow the money, you're going to have to pay it back. Make the payments now or make them later, and the later it gets the worse it will be. There is no such thing as free lunch, and those who pretend that there is are not your friends. The Universe knows how much more money I could have made by keeping my mouth shut and screwing the customer. $100,000 is a conservative estimate. Instead of struggling to convince people to do the smart thing these last eighteen months, I could have been glad-handing everyone in sight and making a mint off of ignorant people. But then there would be court dates looming in my future (those in my profession who were not so careful are going to be in for a hard time, and I hope you'll forgive my schadenfreude when it happens. Those con artists masquerading as professionals stole a lot of money from me and from the people who became their clients by convincing them they could afford more house than they could, or by not admitting to the tremendous downside of what they were offering the client. "No, he just wants you to do business with him and he can't do what I'm doing." I could have gotten the loans, as I informed more than one of the clients I lost, and on better terms, but I wanted them to know the downsides. So I lost the business to the con artist who pretended there wasn't one. There were downsides, but people want to believe the con artist).

What to do if it has become obvious you're headed for the canyon? Figure out what your payment is going to do for the next several years. Determine if you're going to be able to make that payment before it happens to you. If not, refinance now if you can, sell if you can't. Pay the prepayment penalty if you have to, because given a choice between a prepayment penalty and foreclosure, the former is much better.

If you want to refinance, find a long term fixed rate loan. Minimum of five years fixed, fully amortized. Since thirty year fixed rate loans are actually about the same rate as 5/1 ARMS right now, I've been recommending the thirty year fixed for almost everyone. This is a loan that never changes, and you never have to refinance because the payment is going to jump.

The critical factor for refinancing is the appraisal. The Critical factor for the appraisal is how much value can be justified by the appraiser. In order to justify the value, there have to be comparable sales in your neighborhood. The appraisers don't always have to choose the most recent; they have the option of choosing better matches for your home. May the universe help you if there are model matches selling for less in your condominium complex, because there the lender is going to insist on the most recent sales. All the more reason to act now, while you can, rather than wait and hope.

If you're already over the chasm and prices have fallen, consult some local agents about selling. Short payoffs are no fun, but in the vast majority of cases, they're better than foreclosure if you're not going to be able to make your payments. At least when they're done, they're done. Foreclosure is a hole that keeps on draining you long after you've lost the house, and after it's cost you thousands of dollars more than a short sale (and if sale prices continue down, that 1099 love note from the lender after the foreclosure is going to be worse). As for waiting, well, if it's an honest concensus that things are coming right back, but here in San Diego the Asssociation of Realtors had not yet admitted there's price deflation despite it going on for almost a full year. They've been playing games with reported figures to make it seem like things are rosy. There are obvious motivations for this, not all of which are explained by self-interested greed, but it's not something you can paper over and ignore indefinitely.

Who's to blame for the impending trainwreck? I'm not really into blame, but here are several targets. Unscrupulous lenders and agents bear a lot of blame, but not the exclusive burden. Panic and greed on behalf of the buyers is certainly a significant part. And if several folks are telling you that the best loan they have is five and a half or six percent or even six and a half, shouldn't a normal, rational adult be suspicious of an offer that's theoretically at one percent? I can maybe believe somebody who offers something a quarter of a percent better than the competition. Half a percent might be just barely possible. Somebody who offers money, of all things, that's less expensive by an interest rate factor of five isn't telling you the whole truth. (Unfortunately, in this case, these loans are so easy to sell on the basis of minimum payment and nominal rate, it got to the point where these loans were what the vast majority of agents and loan officers were talking about)

As a final note, 125% loans do exist, but they are ugly. Very ugly. Not as ugly as Negative Amortization, but ugly, and the payments and interest rates aren't any more stable than the real terms on those Negative Amortization loans. They don't do stated income, either, or nonrecourse. You stiff those folks, they will get the money out of you.

Prices are going to come back up. It's as predictable as the fact that they were going to fall. Can't tell you when, anymore than I could tell you when exactly they would start falling. Doesn't mean it won't happen. The trick is to have a sustainable situation in the meantime, and this means a loan with payments you can make every month, month after month, indefinitely until the loan is paid off or you have the ability to refinance or sell. If you've got this, someday you'll be telling yourself how happy you are that you bought that property. If you don't have it, get it. If you can't get it, get out.

Caveat Emptor.

I've been looking around for an answer to this but my searches haven't returned anything useful.

Say you buy a house and with that house you finance in a pool. House was $210,000 and pool is $40k. $250k mortgage. Okay, so two years later (the average!) you decided to refinance. Especially since you didn't get a good deal in the first place because you wanted a new house and to get the incentive you decided it was okay to finance with the company the builder tells you to finance with. Anyway, in those two years the housing market slumps a bit but for the most part after that time your house doesn't loose value. At the same time, the pool does not add value to your house. Comps in the area put your house at $220,000 but you still owe $245k. Is it possible to refinance? Was all the refinance hype only because the markets kept going up? Is this the reason why people who got an bad loan, maybe thinking they could refinance, are going to loose their house because no one will refi a house that isn't worth more than it was when you bought it?

No, the refinancing craze was only partially because values kept going up. Rates kept going down as well. What this combination meant was that not only were better rates coming along all of the time, but that people who were stretching to the utter limit for 100% financing could refinance into more favorable loans as their equity picture improved. If you bought for $180,000, and comparable properties are selling for $360,000 now, that's 50% equity even if you didn't have a down payment. So people who bought for $180,000 were refinancing into single loans without PMI once values hit $225,000. Let's use today's A paper as a comparison. Instead of a first for $144,000 at 6.25% and a second for $36,000 at 9%, with payments of $886.64 and $289.67, even if the rates are absolutely the same and you refinance after 18 months for the $177,000 you owe (paying closing costs out of pocket), when your appraisal says $225,000, that's one loan at 6.25%, with a payment of $1089.82. This cuts $86.49 off the monthly payment, which is how most people think, and cuts your monthly cost of interest by $81, which is how smarter people think. It probably isn't worth refinancing at anything like par for such relatively small savings, but rates were dropping at the same time. This led a lot of unethical agents and loan officers to lead a lot of clients down the primrose path by saying things like "real estate always increases in value," and "You can hold on for a year, right? You'll have equity and we'll be able to refinance you." Lots of folks have a tendency to assume trends of the moment are going to continue.

For the last two years, rates have been slowly climbing. People don't like refinancing when it will raise their rates, and quite often, they can't afford to refinance, even if they have to, if the payment is going to go up. This has caused many lenders to get desperate, and is certainly one of the reasons for the way the negative amortization loan has been pushed. Loan Officers don't get paid unless they are originating new loans this month, and negative amortization loans look wonderful on the surface, when all you know about is the minimum payment. (I'm also working on a post debunking the Weighted Average Cost of Capital scam some lenders are also using to persuade people to refinance out of low rates into high ones).

Furthermore, values have been declining, at least here local to me and in most other major urban areas. The problems this creates are far deeper than the benefits that arise when prices are rising rapidly. When the loans total $500,000 and the property is only worth $420,000, that's a problem. That's a real problem. Lenders do not want to lend more than a property is worth. The highest financing regularly available is 100% of value. The situation I have just illustrated is a 120% financing situation. On a straight refinance, that's not going to happen. Period.

Now before anyone goes too far off the deep end, being upside down is no problem at all if you don't need to sell or refinance. You just keep making the payments and everything is fine. It may be possible that real estate won't eventually return to the pattern of appreciation we've come to expect these last hundred odd years, but that's not the way the smart money is betting. I think that we're going to stabilize very soon and may even start seeing small amounts of appreciation. I was upside down myself for a little while after I bought in 1991. It was no big deal. I just kept making those payments, and the prices came back. By the time I had a reason to refinance, I was back at 80% loan to value. For those people who have sustainable loans, being upside-down is a non-event.

Where it becomes a serious problem is when you've got a non-sustainable loan. Whether it's negative amortization, or something somewhat less hazardous to your financial future such as a 2/28 or something short term interest only, you're looking at a time when refinancing is going to be pretty much mandatory. If you could have afforded the payment it's going to adjust to, you could have had a sustainable loan. But people have a tendency to stretch too far and buy more of a property than they can really afford.

There are some options and potential options if you need to refinance while you're upside down. The one involving the least amount of mental effort is to come up with the difference in cash. Most people don't want to do this even if they have it, but it's an option. Actually, it's a pretty good option.

There second option for refinancing is a 125% equity loan piggybacked onto an 80% first loan. The problem is that the terms on these are ugly. It's not likely to cut your interest rate or your payment, and they are all full recourse loans, where purchase money loans are mostly non-recourse. This won't work for a lot of people, not the least of the reasons for which is that the lenders that were offering these when prices were increasing rapidly have largely withdrawn them from the market now that prices have been decreasing. I can't remember the last time I had a wholesaler offer me one. Still, if you're in trouble it can be on option worth asking your current lender about. If you can't make your payment now and go into default, they lose money. If you can afford the payments on the 80/125 combo loan, and don't go into default, they won't lose money, not to mention they potentially move you from a non-recourse purchase money loan to a full recourse refinance.

In some circumstances, it is conceivable if highly unlikely that the holder of a second trust deed may agree to subordinate their loan to a new first. They're not going to agree if your payment or the loan amount on the new first increases, so you're going to have to pay all closing costs out of pocket. The amount on the new first is also obviously going to be above 80% of value, so you're likely to have PMI on it, but if it gets you from a 2/28 that's adjusted to 9% to a 30 year fixed at 7, it's probably worth doing. If the second goes from sitting behind a $410,000 first at 9% to sitting behind a $410,000 thirty year fixed at 7%, it has become more likely that second loan is going to be repaid in full, where if you default on the first trust deed that second is likely to be completely wiped out. Obviously, the holder of the second would rather not do this - they'd rather be refinanced out of their losing position. But nobody is going to come along and rescue them from their bad decision making if the property is only worth $420,000 and you owe $495,000. If you need to refinance your first in order not to lose the property, the holder of the second can either agree to subordinate, step up to the line themselves and be on the hook for the full amount, or be wiped out completely when the first forecloses.

The next option is the worst of all possible worlds: default and foreclosure. This is something you want to avoid if there's any way around it. Slightly better is a Deed in Lieu of Foreclosure, where you sign the title of the property over to the lender. Lenders may or may not allow this if you're upside down, though. Typically, they want to have at least a little bit of theoretical equity in order to agree to a Deed in Lieu. On the other hand, if they avoid the money that the whole default and foreclosure process costs, they may agree. A Deed in Lieu does hit your ability to get a future real estate loan, although it's not nearly so bad of a hit to that or your general credit as a foreclosure, particularly if you can see it coming and take action before you have a spate of late payments. Most folks won't.

Finally, if you need to refinance and can't, you can get yourself a good listing agent and execute a sale subject to a short payoff. This has potential consequences for your financial situation that start at 1099 love notes and might include a deficiency judgment. This is definitely not something to try "For Sale By Owner" or even with a discount listing agent. You're going to need an on the ball full service agent in order to make it happen, because the lender isn't going to listen to you as the owner, and a discounter is unlikely to be willing and able to devote the time necessary to get the lender to approve it. The big advantage to this is that it doesn't hit your credit nearly so badly as a foreclosure or Deed in Lieu, and if you want another real estate loan sometime in the next decade, you would probably rather do a short sale than go through foreclosure.

None of these situations where you need to refinance a mortgage you can no longer afford, but owe more than the property is worth, is a good situation to be in. But if you take action before you've got late payments or a notice of default, let alone a notice of trustee's sale, you can get away surprisingly little damaged. The worst thing that can happen, will happen if you don't do something to fix an untenable situation before it gets that far.

Caveat Emptor

All too often, these days, I have to tell desperate people who've found me on the internet some bad news.

Nobody can match the rates they've got at a price worth doing.

This is just a sample of what I've seen:

I bought a house in DELETED in Aug 04. It was my first house, and I was pumped about it. Now, it's become a liability. I want to leave soon, and pursue an (advanced degree). I've been extensively preparing for my (test), and I expect to qualify for some 'almost top-tier' schools out east. So what do I do with my house? Bad market = hard for me to sell.

I am looking to rent my house out. The largest hurdle comes from the fact that DELETED has very low rents, and very high housing prices. To give you an idea, a typical 4-plex has a yearly NOI of around 5% of the total property cost. Yeah, a 5% return. My mortgage (I'll detail it later) costs $1500/month (PITI). Market rent is about $1k-$1200/mo. I looked at other mortgages, but it seems to me that most brokers are a waste of oxygen. You say what you need, and then they offer you a loan that makes them the most commission. I had a few people try to talk me into a Neg AM/option ARM loan. I did some math... Total waste of money. What I need is something to lower my payment while I hedge my position.

Rents are increasing, and I believe that the market will be less of a buyers market in a few years. I am working with a mentor and put together a Lease to Own deal, which may solve my issues, but I would like a Plan B.

My house is worth no less than $268k (zillow estimate, I think it's low. $275k would be better) I owe ~$253k

I have an 80/20. The 80 is 5.125% interest only for 5 years, then goes ARM on me. The 20 is a HELOC currently at 10.125%. My FICO is between 750-775. The property is located at DELETED. It is a normal detached house. This would only be a refinance for a few years, until I can sell the property in a better market, but if a locked option presents itself, I would continue to rent that place forever! I don't need any cash out money, but I will take any available, because I am getting around 10% return on my Funds.

Now this particular person makes some errors in his thinking and in the email, but they're forgivable in non-professionals. The meat of the matter is that he, like so many, cannot afford the current payments under the new circumstances.

This guy has a 5.125% interest only loan. Last I checked (a few days ago) I could just barely do that with one lender for something north of four points, and could not do 5.00 at all. Even if adding roughly $15,000 to his loan amount was worth keeping the same interest rate a little longer, just the fact of adding $15,000 to his loan is going to raise his payments.

In this case, like so many, there literally is no loan I can do for this person that's worth the cost of doing it. I could cut his payment for a while with a negative amortization loan, but only at the cost of raising his real interest rate about 3%, which means it's really costing him about $6000 per year extra, while sticking him with a prepayment penalty in the area of $8,000. A classic case of pay me now, keep paying me, and pay me later, too. Well, I couldn't do that to anyone, much less someone wearing the uniform in times of war, as this man is. Even if this guy had been in California, I would have told him the same thing I did: There's no loan out there right now that will help him in the classical sense of the word help. What he needs is cash flow and time. A negative amortization loan would provide that, but at a much higher cost later - too steep for me to believe it's worth paying. A lower interest rate or longer amortization or even interest only might help some people, but none of those options make sense for someone who has already got 5.125% interest only. I can tie 5.125 by adding over four points plus closing costs to his loan, but I don't need to consult my rate sheets or get out the calculator to know that adding $15,000 to break even on the interest rate is not going to really help him.

Now, this is not to say that refinancing into a higher rate is never justified. If it was going to do something he needed it to do and it makes sense in other ways, yes, I can see it. For instance, if he was going bankrupt due to some bills, but consolidation will prevent that from happening, it might be the lesser of two evils. But that doesn't appear to be the case.

Now when his loan hits it's first adjustment, chances are pretty much 100% that I'll be able to do something worth the cost of doing it. But that adjustment would be to roughly 7.25% if it happened right now. Whatever it is, the way that rate adjustments work is underlying index plus a set margin, determined by your contract. Lenders think of hybrid ARMs as teaser rates; they're always offering rates less than the index plus the margin to start with. Which is one reason to be careful with hybrid ARMs. I love them, I do them for myself; but they will go up when they adjust.

This man is only one of millions out there in similar situations. I can't speak to his specifics, but there were lots of people who bought with loans such that they could only afford the payment interest only or worse. The fact of the matter is that they were poorly advised, or not advised at all if they kept everything quiet and never told the person who might have warned them. They probably should not have bought the property they did, but somebody talked them into it. In most cases, it was someone with a fiduciary responsibility to them who should have known better.

I don't have a problem with interest only loans as purchase money. I do have a problem with negative amortization loans as purchase money for a primary residence. Interest only, though, can be okay if they can afford the fully amortized payment but choose not to. For instance, this gentleman could have afforded more, but was getting a better return on his money elsewhere. Sophisticated user and all that. He knew the risks going in, and chose to take them.

However fantastic an investment real estate is, however, it is not a risk free investment, and sometimes the bet does go sour. Members of the real estate profession were doing all they could to push rapidly appreciating prices, and members of the loan profession were doing everything in their power to aid and abet. Both groups were pushing past results to illustrate future performance, and I saw or heard the phrase, "nobody loses money on real estate," so often and in so many places I stopped getting angry at it for a while. Both groups were pushing people into bigger and bigger loans for bigger and bigger properties, and more and stronger bidding wars, and rationalizing it on any basis that happened to be convenient and hadn't been debunked in the client's presence within the last fifteen minutes.

Once again, I'm embarrassed by members of my professions, and not just for their avaricious advice to the unwary, but also for their limited understanding of economics and markets. Trusted professionals are supposed to know better. People with fiduciary relationships are supposed to know better. People earning thousands of dollars more for their "expertise" per transaction should definitely know better.

So what do you do if your payment goes up, and the best rates available to you don't help the situation enough?

Sell for what you can get.

Right now, this is a really rotten thing. Many markets are in the tank completely. If you don't have to sell, you shouldn't be in the market when there's thirty sellers per buyer. That being said, if you can't make the payment, selling is the least bad alternative available to you. Even a short sale is not as bad as being foreclosed upon, and if you don't make the payments somehow, foreclosure is going to happen. It's only a question of when. You want to have sold before that happens.

There are a very few exceptions. But pretending that you are one of them when you're not is a good way to take a very bad situation and make it worse. The first rule of getting out of holes is to stop digging, and denial digs deeper.

Please, if you're in a hole, don't keep digging.

Caveat Emptor

Looking for advise on Neg. Am. loans.

I live in DELETED and I recently went into an office with a buddy asking about a refi and cash out loan on my existing homes in order to help with cash flow. I briefly talked to the broker who was trying to close two loans for my buddy. He said yeah I could probably get you a similar loan 1% or so and cut your payments in half. You'll need to refi in 3 years or so.

I Left my old job ( Sales ) and I am in my first development project subdividing 2 lots in to 4 with custom homes on each. Time line has dragged on dramatically ( approaching 2 years ) and budgeted money is running thin. Should start building within next few months and complete with in 15-18 months. Should make good profit.

In addition I own two SFR's and I have 549K loan on primary and 297K on non owner. Each appraises over 800K.

To help with purchase of the other properties and need of cash flow I also exercised LOC's of 150K and 90K on these properties so total mortgage debt is :

* $ 1,087,550 payments of $6152
* new loans proposed are 650K primary and 595K non owner for total of :
* $ 1,245,000 payments of $3442 saving $2710 per month.
* terms 40 yr : 1.25% on 650K
* terms 40 yr : 1.75% on 595K

* Question are :

1. What should the fees be on these type of loans ?
2. It looks like little over 27K, is that high, seems like it ? Isn't the broker getting kicked a high commission on the back ?
3. Should there be prepayment penalties ? I'm/ /being told can only sell after the first year and cannot refi for 3 years.
4. What index should this be based on ? Think he said one that is constantly moving ?
5. Approximately how much is being added to the principle each year ?
6. Should I be allowed to make extra principle payments each month or at my discretion without incurring penalty ?
7. *** Should I do these loans ? What are the main things I should ask for and stand firm on ?
8. Am I being duped ?

Thanks for any advise. The broker has avoided specifics for the month and now sent an email saying docs should be ready tomorrow and location of Escrow office. When I asked what the specifics were, penalties, stipulations and what would be added to each principle per year ? and if he could get me something in writing he said " When you came into my office, we sat down and went over each program. If you'd like, you can call me and I'll be glad to explain exactly what your loans are going to be. There aren't different scenario's. You told me what you wanted and I got it for you at the price/payment you wanted. "

Coincidently, my buddy was called day before his docs were ready, they were sent to his house the next day with a Notary to sign on spot. While looking over he noticed things they discussed had changed and called him on it, he said take it or leave it, and he opted to leave it.

Seems odd to hear nothing and be avoided on questions other than its what we discussed in the office which was very brief and non specific. Now he's ready for me to sign. Really concerned about fees, penalties and addition to principle.

Answers to your questions:

1. Closing costs on NegAm loans are about the same as any other loan. $3500 as a rule of thumb, perhaps a little more because your loans are bigger (so title and escrow cost more, appraisal is a little more). Even if you're adding impound accounts and paying 30 days of interest, I can't see closing costs of $27k.

2. Yes, $27 k is too high. But every dollar they can skim is a dollar in their pocket, and since what you are looking for is a low payment, it doesn't make much difference to the payments, so they figure you'll sign. As I've said before, these loans are a way for them to appear to compete on price without really competing on price.

3. I do not know of any negative amortization loan where the pre-payment penalty can be bought off completely. It's built in to every single one I've ever found. I occasionally use that as a come-back while I'm throwing the idiots who wholesale these out of my office; "You say you've got something worth my time, and then you tell me about these POS loans that everybody else is pushing for all they are worth. Were you lying, or do you have one without a pre-payment penalty?" To date, nobody has said yes. The prepayment penalty he quotes, is one of the less bad ones, but I'll bet, sight unseen, that he boosted your margin above index rate to buy it down. The best one I've got, the penalty is "soft", waived if you actually sell the property.

4. Negative Amortization loans are pretty much all based upon COFI, COSI, or MTA. All of them are moving rates that change slightly every month. I do know of one where the underlying rate is fixed for three years, but the minimum payments are higher, and it wasn't exactly a great rate when I was told about it some time ago (6.9% plus adds that depend upon the situation)

5. That depends upon the underlying rate, which is your index plus a set margin. Most of them are sitting in the range of 7.75 to 8.25%. (I initially assumed 8%, but it was 8.4) 8.4% times your total balance is about $104,500 of interest per year. Less your payments of about $41,300 adds roughly $63,200 per year to your balances, not including compounding or shifts in the index. Incidentally, you are not saving money on the real cost. You're simply deferring part of the cost until later and allowing it to compound. Comparable "A paper" rates on 30 year fixed might be about 6.25 and 6.5% respectively, or about $80,000 per year of interest, which would save you about $2000 per month in the real cost of the money, interest.

6. The reason they're called Option ARMS or Pick a Pay by some people is that you get a choice of four payment options every month. Nominal, interest only, 30 year amortization, and 15 year amortization. Depending upon the lender and the product, the prepayment penalty can be either "first dollar" (i.e. pay anything other than one of the four payment options and gotcha!) or 20% (you're allowed to pay down 20% of the principal each year without triggering the penalty).

7. I advise very strongly against these on your primary residence, and on investment property there are usually better alternatives. However, you're kind of in mid-leap, and from what you say, it seems like you have a cash flow problem. You're committed, and there may not be a better alternative to doing a negative amortization loan. If your project doesn't work out, you've got serious issues, and you can't not start at this point.

8. It does appear likely from where I sit that there are much better bargains out there. I avoid these loans like the plague on humanity that they are, but if you've got a valid reason why they are the least bad alternative for you (and it seems like you might, with your impacted cash flow situation), chances are excellent that I can do something better. I don't know enough about your situation to make any type of guarantees, but if you're not in an emergency situation where you need the money within the next three weeks, I suggest you shop your loans around. This place is making about 3.75% on your loans, or $46,500 for the two loans, plus junk fees. These loans aren't that tough. Whereas the important thing to you is not how much they are making but the bottom line to you, I suspect that you can find other folks willing to do both loans for considerably less, by giving you a rate that doesn't add nearly so much to the underlying index (Wall Street, and therefore the lenders pay based upon the margin, which is quite simply the addition to the underlying index that you agree to pay in your contract). Furthermore, good loan officers live on specific numbers. I'm delighted to discuss exactly the loan I'm going to deliver to my clients once I have shopped it around and know what that loans terms are. Every loan I lock has a Guarantee attached to it: These are your terms, or I pay the difference. The upshot is, I strongly suspect you can find someone who will deliver a better loan cheaper, whether you stay with a Negative Amortization loan like I suspect you will, or go with something with a better rate fixed for a longer period.

Caveat Emptor

Title Searches Missing a Lien

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I refinanced my house and an existing lien was not discovered

Now the important question: Is it a valid lien, or has it really been paid, and just not released of record? If it has been paid, you don't owe money simply because the lien on your property was not properly paid off. If you can prove it was paid off, either by yourself or a previous owner, you're out of the woods.

Since you are asking the question, however, I'm going to assume that it is a valid lien. Most are. You owe the money. It doesn't magically go away simply because the title company (or lawyer doing the title search) missed it.

Now, assuming you live in a title insurance state, it should make no difference to the state of your mortgage. You bought a lender's policy of title insurance as part of your transaction, and the title policy insures the lender from loss due to the extra lien.

You still owe the money, of course. Like any other bill, just because you neglected to pay it off or neglected to pay it on time does not mean you somehow don't owe the money. If it was in effect from before you bought the property, though, your owners policy of title insurance should kick in and pay it off. That's the way title insurance works - they tell you about known issues with your title, and then they insure (almost) everything else. They'll then go after the previous owner, of course. That's what subrogation is all about. They stepped in and paid to keep you from getting damaged, but they now assume the right to receive the money from the person who damaged you. If you live in an attorney title search state, my understanding is that you are going to have to sue the attorney involved, but suing attorneys is a tough proposition, and you can't recover the base lien, only increased damages resulting from that attorney's negligence. If the previous owner was really responsible for it, the title insurer is going to have to run them down and file a lawsuit, and quite often the previous owner has no assets that they can get at.

If the lien was your doing, as most are, you're going to have to start making an effort to pay that lien. How much of an effort depends upon whether you have a lender's policy of title insurance. If you do, it's really no huge deal, because the lender has access to the checkbook of a national megacorporation. If you don't, the lender can potentially force you to pay it in cash right now. They can also force you to refinance by calling your loan, or to take out a second mortgage to pay the lien off in many cases. It's possible they might just pay it and tack it on to your balance, usually boosting your payment in the process. Talk to a real estate lawyer in your state for details, but the lender is not generally going to leave an uncovered lien in place, when the pricing they gave you for that loan was predicated upon there not being such a lien. Since the lien predates their loan, it's almost certainly senior to it, by which I mean that if something happens and you have to sell the property to pay off the liens, it gets paid before your mortgage. The lender is not usually going to tolerate that.

Now suppose that you got a thirty year fixed rate loan at 5% back in 2003, and suppose rates have gone up to seven and a half percent by the time you rediscover the lien. The lender can do better with that money from your loan, and so they are going to want to seize upon any excuse to make you pay it off. This, all by itself, is a really good reason to be careful with your liens.

If you intentionally hid the lien, the lender may even sue for fraud in many jurisdictions. If you intentionally hid it, for instance, it's quite likely that your policy of title insurance won't cover you, and the lender is going to be very unhappy about that.

Most people, however, don't intentionally hide a lien, they just forgot it was there, and when the title search comes up empty any worries in the back of their mind went away. If they even think about it, they mentally write it off. "Oh, I must have forgotten that I paid it." You still owe the money, and now that it's discovered, you're going to have to start paying on it, but if they've got lender's title insurance the lender shouldn't freak.

Now, missing liens is actually fairly rare, but once title insurers miss them, they usually will not be caught on subsequent title searches, because the title company will use the previous title search as a starting point (around here, they actually call them "starters", but I don't know how widespread the practice is) for their new title search. Sometimes they do catch them, and ask the previous title company for an indemnity (which basically says that the previous title company is still liable for having missed it).

Caveat Emptor.
Copyright 2005, 2006, 2007 Dan Melson. All Rights Reserved


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