Publication Date: Friday, April 27, 2007
The good, the bad and the ugly
by J. Robert Taylor, J.D.
The current news on sub-prime loans reminds me of those great spaghetti Westerns from the 1950s; except that instead of having the English dub-in, everyone is speaking Italian. A Western in Italian seems rather silly.
Yet, your loan documents and terms might as well be in Italian these days. Appropriately, the most famous titles for these spaghetti Westerns are "Fistful of Dollars," "For a Few Dollars More" and "The Good, the Bad and the Ugly."
First, some simple definitions.
Mortgage broker. A licensed individual or company who represents the lender not the borrower. This means that they have the obligation to get the best deal possible for themselves and the lender, not the borrower. The only factor that separates one lender from another is the competitive marketplace.
Loan fees. This is what a lender charges for his or her services. Loan fees can be called points or fees, but it all adds up to money you will pay to get the loan. So-called "no points" loans are just loans where the lenders are rebating to the mortgage broker fees because your loan is at a higher rate than a loan where some fee might be charged. Fees are often disguised as "warehouse fees," "processing fees," "underwriting fees," etc. Costs that originate with the lender or broker are all loan fees. The law does not limit loan fees.
Fixed rate. Loan percentage rates may be fixed for 1, 3, 5, 7, 10 or 30 years. Loans where the fixed rate is less than 30 years generally convert into an adjustable or variable rate loan when the fixed term expires.
Adjustable or variable rate. A loan where the lender can adjust the rate during the term of the loan is an adjustable rate loan. Adjustable rate loans are generally adjusted based on an index like the one-year Treasury Bill, six-month LIBOR, or the Prime Rate. Generally the adjusted rate is based on a margin that is added to the index. Margins can be 1 to 4 percent, and when paired with the index are the key to understanding whether or not your loan is good, bad or ugly.
Fixed payment. The classic "fixed-payment loan" is a 30-year fixed-rate loan where the payment is level as well as the interest rate for 30 years and the loan principal is fully amortized over the 30-year term. The modern version is the more sinister fixed-payment adjustable rate loan where the payment is fixed for one to three years and adjusts only by a fixed percentage annually. Even though the payment is fixed, the interest due to the lender is still paid each month by an agreed increase in the principal amount on the loan. These are negatively amortizing loans, meaning the principal amount of the loan may increase if your payment does not include all of the interest due under the terms of the note.
"A" borrower. This is a borrower who has a good credit score, an income, a steady job history, a down payment in the bank, and other cash and assets to lean on in case of financial hardship. Generally, the borrower's payment is no more than 35 percent of his or her gross income. This borrower has little, if any, revolving or long-term debt. This borrower provides the lender with full documentation and verification of debt, assets and income.
"B" borrower. This borrower may have a somewhat less than desirable attribute when compared to the attributes of the "A" borrower. He or she may have a lower credit score, be new on the job, or have less money for their down payment. They may have debts, which will increase their debt-to-income ratio. This borrower may also be relying on gifts from parents to make the down payment or may opt for a loan where there is financing of 100 percent of the purchase price. This borrower sometimes provides the lender with full documentation and verification of debt, assets and income, but often provides far less verified information than the "A" borrower. Lenders often encourage borrowers to make loans based on "stated" income. "Stated income" is a code term for unverified information that can be inflated in order to obtain the loan.
"C" borrower. This borrower wants the loan money, but other than a good credit score (or maybe just "ok" credit score) has no way to meet the requirements of the 35 percent debt-to-income ratio, and total assets are slim and often wants to buy without any down payment. This borrower never provides the lender with full documentation and verification of debts, assets and income. Loan applications often have very little information filled in and none of the information is verified except their credit score and report.
Mortgage rates over the past five years have been stable and low by historical standards. Lower rates allow many who formerly could not afford to purchase an opportunity to do so. It is still the American Dream to own your own home.
In select markets in the Bay Area prices have continued to rise thus helping to build equity for those who purchased with little or no down payment.
Many "A" and "B" borrowers are opting for loans that have attractive short-term fixed rates but then roll into very unattractive adjustable-rate mortgages with high margins. This causes another cycle of refinancing that is good for the mortgage broker, but not so good for the borrower who must pay again for the costs of refinancing either out of pocket or by increasing the amount of money they are borrowing.
It is particularly bad for those "A" and "B" borrowers who purchased with little or no money down. They obtained 100-percent financing, which included a first mortgage with a short-term fixed rate then rolled into an adjustable rate mortgage with a very high margin. The second mortgage, which generally was for 20 percent of the purchase price, was usually an adjustable rate mortgage tied to the prime rate. The prime rate in June 2005 was 6.25 percent and is now 8.25 percent. For those borrowers their payment has increase more than 30 percent in the last two years.
Mortgage brokers who sell the 100-percent mortgages are quick to let the borrower know that they can just refinance to lower their payment and rate when the initial fixed term expires. However, they often fail to explain that there is no market for refinancing 100-percent mortgages and the borrower must pay off the second mortgage in order to refinance the first mortgage -- easier said than done for most people. It does have the added benefit of helping the mortgage broker to pay off his or her credit-card bills. Often the borrower is just stuck with the loan they initially got when they purchased and must face the ever-increasing payments or must try to sell to get out from under.
Many markets in California and the Bay Area have not appreciated or have even fallen in value so that those who purchased homes with loans that are now ready to turn into adjustable-rate mortgages are going to be in shock when they see how much their payment changes. It may be impossible to refinance these highly leverage loans since there is no market for reselling these riskier loans.
Borrowers on sub-prime loans may be forced to sell their American Dream if they cannot make the new increased payments. If the value of the property has not increased by about 8 percent or more it is likely that you will lose money when you sell.
"Fistful of dollars." Many people who have been hurt by these sub-prime mortgages are those who have refinanced to pull equity out of their home -- to remodel or to help their child buy a home. A typical example is a client who came to me recently whom I will call Darlene. Darlene is a single Latino mother, who has owned her home in the Bay Area for 15 years. Darlene's daughter wanted to buy a home, so she encouraged her mother to refinance her property, get a new loan, and give her $80,000. Darlene refinanced and had an adjustable-rate mortgage at 7 percent interest.
A year later a mortgage broker called her and told her that she had to refinance because her rate was going to increase. Darlene speaks no English and the person who called her spoke in Spanish. Out of fear Darlene agreed to refinance her loan. The refinance cost her approximately $30,000 because of a prepayment penalty that was due when she paid off the original loan.
Six months later the broker called her again and told her that her rates were going to increase again and that she needed to refinance. Again she trusted the broker and signed the loan documents. In less than six months and after the two refinances were done her rate went from 7 percent to 8.875 percent and her loan balance went from $320,000 to over $400,000. Her new loan has a prepayment penalty and negatively amortizes over $2,000 per month. So at the end of the year her $400,000 loan will be more than $424,000.
Her payment is $1,100 per month. She has a fixed income of $1,200 per month. When the payment adjusts in two years she must sell her home that she has owned for more than 15 years or lose it to foreclosure since she has no ability to make the payments.
The mortgage broker in this instance had her sign her loan application and all the loan disclosures just three days before the loan closed. He sent a notary public to her home so she never had a chance to review any documentation at an escrow or title company. By having her fill out the application just three days prior to funding, the broker avoided giving her a disclosure of the actual costs of the loan until just three days before it was going to close. The broker failed to leave any copies of the documents she signed. She speaks and reads only in Spanish and all the loan documents were in English.
Not so many years ago you could only get a home loan if the payment, taxes and insurance amounted to about one-third of your monthly gross pay or less. Now big business has been cashing in on borrowers who have little or no clue as to what they are signing up for, but they do have good credit scores, or should I say had good credit scores.
"For a few dollars more." Before you give your bank or mortgage broker a few dollars more for your loan or refinance you need to take the following steps.
First, compare, compare, compare. Loan brokers hate to be shopped because it exposes the truth about what they are offering. Shop them to death and get a loan rate commitment in writing before you agree to anything.
Second, read all of the loan documents. If you can't read them or hate detail then hire someone else to review them for you.
Third, have the broker disclose exactly what he will be paid in the transaction, including any rebates from the lender, when you first speak to him or her. The fee should not change. Also get an accurate estimate of all fees not just loan points.
Fourth, if you are feeling uneasy or pressured then find a different lender/broker to deal with.
Fifth, watch one of those Clint Eastwood classics and make sure you side with one of the good guys because the other guys all end up dead.
--J. Robert Taylor, J. D., a real estate attorney and broker for more than 20 years, has served as an expert witness and mediator and is on the judicial arbitration panel for Santa Clara County Superior Court. Send questions to Taylor c/o Palo Alto Weekly, P.O. Box 1610, Palo Alto, CA, or via e-mail at email@example.com.