Foreclosures: what you need to know (a re-post from 2007)

This is a piece I had published in December 2007.  As the pundits and reporters spin us out of the Great Recession, I thought it might be interesting to look back at my thoughts from a couple of years ago - as the pundits were spinning us into the Second Great Depression.  Enjoy. :)

-Bryan

Foreclosures: what you need to know

Bryan Seaford©2007


Introduction

The news coverage of the past few months has included a healthy dose of information on home foreclosures, predatory lending practices, and numerous soft stories of people losing their homes. In the media over the past few weeks, there have been questions about whether or not we will enter a recession. A casual viewing of the news might make one believe we have been in a recession almost a decade.

Churn: why it happens

With new neighborhoods, some churn is expected during the first five years. Churn is when a house is purchased, then quickly comes to market in a shorter period of time than was the homeowner’s original intent. The churn is a natural result of four groups striving to better reach their goals. The groups are: builders, lenders, agents, and buyers.Builders earn revenue when the home is sold. Builders rarely use cash on hand, instead opting for a construction and development (C&D) loan from a lender. During the build process, the builder is paying interest to the lender. To pay off the loan and avoid additional interest costs, the builder sells the home as quickly as possible for as much money as possible. If a builder has chosen to hold a home in inventory, the builder believes the higher future market price is greater than the additional interest that must be paid. In short, the builder wants to sell the home quickly and for profit.

Lending institutions buy (borrow) and sell (lend) money, and keep the difference in the price. When a lending institution makes a loan to a buyer (or builder), it is selling money to that person. The cost of the money is interest. Lending institutions borrow from individuals (interest on a savings account), institutions (commercial paper, short-term notes), and from the federal government. The lender wants to sell the largest amount of money for the highest possible rate, and borrow at the lowest possible rate. Think about the amount of interest you earn on your checking account, if any. Now look at your mortgage rate. See the difference? That difference is the revenue to the lending institutions.

The real estate agent is working for someone as well, and it’s usually the seller. The agent is compensated as a percentage of the home price, usually 3%. For agents employed by the builder directly, the compensation is usually a smaller number, with greater opportunity to sell through a sales center. Standard commissions charged to the buyer are 6% of the sale; typically 3% to the buyer agent and 3% to the selling agent. The split between the two is customary, and is often negotiable between the agents. The interest of the agent is best served when a house is sold for the highest possible price, as the higher cost of the home translates into a higher commission for the agent.

The final group in the equation is the home buyer. Let’s assume we’re talking about an individual purchaser, buying a home to live in and not an investment property. The motivation and risk for a buyer is a little different.

The purpose of a builder, a lender, and an agent is to generate revenue and make a profit. All three measure success as income generated from business activities. The buyer, however, typically earns income through a source not related to the transaction (employment, investing, or running a business).

The buyer also has undiversified risk. Typically, builders build many homes, lenders buy and sell money to many people, and agents are working with several buyers at once. If a home takes too long to sell, the builder can write off the house as a loss and sell it below market value, often with a tax benefit that can carry forward for several years. The lender and the agent are also diversified.

The buyer, however, is purchasing only one home. The buyer is purchasing peace of mind, quality of life, self-esteem, and provision. These attributes often outweigh the financial burden perceived at the time of purchase, and the desire to fulfill these needs can cause a buyer to “stretch” to get into a home, mentally calculating sacrifices to make the mortgage payments.So what causes churn in new neighborhoods? The builder wants to build and sell, and is motivated to get the higher price. The lender wants to lend as much money as possible to the buyer because the more money lent equates to more money earned. The agent wants to sell the home for as much as possible because the earned commission is directly linked to the price of the home. Then there is the buyer, focused on peace of mind, quality of life, self-esteem, and provision. Three of the four groups want the higher price and higher payments, and the fourth is focused on things greater than money.

Loans

When people talk about loans, it can become confusing. Much like buying a car, it’s easy to wonder if all the fees, payments, and commissions add up; and can be hard to determine exactly what the final price will be. Lenders have created some very exotic loans over the past few years with all sorts of prepayment, payment, and floating options. Here, we will simplify and address the basics.

For our purposes, the words “mortgage” and “loan” are interchangeable. In reviewing legal or binding documents, be sure to speak with someone that can explain the different ways these words may be used in the documents.Broadly speaking, there are two types of loans: fixed rate mortgages (“fixed”) and adjustable rate mortgages (“adjustable,” or “ARM”). The type refers to how to pay the lender for the use of the money you borrowed to purchase the house.

A fixed mortgage has a set payment and interest rate at the beginning of the loan that will last the life of the loan. The interest rate doesn’t change, and amortization schedule doesn’t change over time. Ignoring escrow and assuming no prepayments, the loan payment is the same in the first month as in the thirtieth month. It’s a predictable loan.

An adjustable rate mortgage, or ARM, does change over time. ARM interest rates are usually tied to the Prime Rate (as published in the Wall Street Journal) or LIBOR (London Interbank Offered Rate) through a formula such as Prime + 3%, LIBOR + 2%, for example. The interest rate is usually “reset” each year, meaning that the rate is the same for 12-month periods, and that on or around a certain date the new rate is determined by the change in Prime, LIBOR, or whatever base is written in the loan. The spread, or the “+x%,” usually stays the same. If the base rate goes up, the buyer’s payment goes up. If the base rate goes down, the buyer’s payment goes down.

ARMs are usually offered at a lower rate than fixed rate mortgages, and are often considered more attractive to lenders. Lenders borrow short-term (savings accounts, CDs, federal loans, etc.) and lend long term. When a lender writes a fixed rate mortgage, it is obligated to honor the interest rate for the term of the loan. If short-term rates move above the fixed interest rate, the lender loses money, paying more to borrow than it makes lending. ARMs will move with the general interest rate environment, making it less likely that the mortgage interest rate will be less than short-term borrowing costs. Because of the profit protection, lenders offer a lower rate for ARMs.

The Problem

The problem with ARMs has to do with outlook. The assumption for many ARMs is that the buyer will be earning more money in the future, and will therefore be able to afford a larger payment if interest rates go up. Another assumption is that the buyer will continue to earn income throughout the life of the loan. Also, there is the assumption that the buyer is able to make the financial sacrifices to “stretch” into a home, and that there will be no anomalous events that would affect the buyer’s ability to pay. Finally, there is an assumption that interest rates will be “reasonable,” however that is separately defined by the buyer and lender, over the life of the loan.

If any one of these assumptions is incorrect, the ARM could be in trouble. Health difficulties, financial woes, an unexpected rising interest rate environment, predatory lending, and misinformed buyers are all risks to the culmination of the loan.We are currently in a rising interest rate environment. ARMs are resetting to the higher interest rate, and monthly payments are increasing for people with ARMs. Many buyers with ARMs are not prepared financially to make the stretch to the higher interest rate, and find themselves unable to make the new payments. The lenders rely on the higher interest payments to maintain profitability. Because of the large number of ARMs written over the past five years, the problem has become acute. Instead of a single person losing a home, we are seeing several ARM buyers unable to pay the new monthly rate, which affects lenders significantly. Instead of a single loan going bad for a lender, an entire class of loans has an expectedly increased default rate, triggering several lender bankruptcies.It’s difficult to place blame on a single class. The federal government has underwritten loans that lenders would not otherwise make as part of a homeownership initiative. Lenders, basking in the glow of the past few years of economic prosperity, relaxed lending standards and offered loans to buyers that would not have been considered creditworthy before. Buyers, through the wealth effect caused by the ability to purchase a larger, nicer home to meet their needs, have stretched to get into homes. The competitive real estate environment has pushed agents to push for loans to support the purchase (and commission). Builders, many of whom are now publicly traded companies, saw the opportunity for expanded profits through expanded operations, and made preferred lender arrangements to obtain special financing for buyers in new communities.

And so we get our headlines. Buyers are defaulting on loans and losing their homes. Lenders are going bankrupt because of an inability to obtain short-term financing due to loan defaults. The Treasury Department, the Federal Reserve, and the president are claiming expanded powers to deal with the crisis. Congress is considering changing the tax code to help those that must sell a home for less than the remaining mortgage. The FHA is considering more “flexibility” to subsidize our way through the crisis. Economists are calling this a correction. Financial institutions have lost significant market capitalization. Media talking heads everywhere are speculating that we are headed into recession, with some drumming up images of 1929 and the Great Depression.

What to do when the payments are too much

When the payments become too much for a buyer to bear, there are options. Recognizing that this is a cash flow issue is the first step. A creditor is requiring more cash each month than the buyer is willing or able to pay. Rate resets can often add up to hundreds of additional dollars each month. The buyer needs more cash to meet the outflow demands.The U.S. Department of Housing and Urban Development (HUD) has a wonderful booklet called, “How to Avoid Foreclosure.” HUD is an exceptional resource, and can be found online at www.hud.gov.

Things to remember

1. If you are having difficulty with payments, don’t ignore letters and phone calls from your lender. Often your current lender is your best resource for resolving the issue.


2. Recognize that lenders don’t want to own your property. Lenders are not typically in the property management business, and it’s expensive for them to liquidate a home. It takes time, resources, and usually equates to a loss for the lender.


3. If you abandon the property, you lose some assistance options that may be available to you through HUD.


4. Regardless of where the blame lies for the situation, focus on the solution. Identifying the catalyst is helpful for your next home purchase – not this one.


5. Credit card cash advance rates are typically higher than mortgage rates. If you take a cash advance on your credit card to pay your mortgage, recognize that you will have to pay the credit card cash advance rate (normally 20%-25% annual rate) next month on that money. Generally, borrowing from one creditor to pay another is an extraordinarily bad idea.

Things to do

1. Earn more, if possible. This is a cash flow issue for you, and more cash in means there is more to go out. If you are passing on earning opportunities, consider taking a second look at that second job.


2. Learn about all your alternatives that may let you keep your home.


3. Desperation is a magnet for fraud and scam artists. Be very wary of those that approach you unsolicited, and be sure to vet every source of help.


4. Straight from the HUD pamphlet: “Do not sign anything you don’t understand. And remember that signing over the deed to someone else does not necessarily relieve you of your loan obligation.”


5. Talk with your lender. Your lender is already invested in your success in the loan and the profitability of the lender’s investment relies on your ability to repay the loan with interest. Institutions outside of the existing loan relationship must be compensated in some way for the intervention, and additional costs could be incurred.


6. Talk with your loved ones. You may have someone in your circle of family, friends, and associates that is willing to help you out. In these conversations, make sure that any terms of repayment, interest, etc. are extraordinarily clear and understood by both parties. Take the documents to a professional, even if it is a gift. Your loved ones are important, too important to endure strife over money matters.


7. Seek professional advice. If you’re having trouble making your payments, seek professional advice – not articles in the paper or magazines, or even a neighborhood newsletter. A professional can guide you through the options you may have, including loan modification, payment deferrals, partial claims through the FHA Insurance fund, and more. A professional will also be able to advise on credit counseling.

Disclaimer: Bryan is not in the mortgage industry, and does not claim to be an expert on these matters. You are encouraged to see professional advice and guidance in these situations.