With rising interest rates, loan assumability makes a comeback
I like to look into the future and stay ahead of the news cycle when I can. Three and a half years ago, I first wrote about loan assumability as a feature would garner new attention once interest rates began to rise. With the recent spike in interest rates, and with the widespread perception we are past the bottom of the interest rate cycle, the first article on this subject finally surfaced in the MSM. Expect many more to follow over the next several years.
Homeowners with a mortgage insured by the Federal Housing Administration or the Department of Veterans Affairs should consider using their loan terms as a marketing tool when it comes time to sell.
Mortgage loans from both government agencies include a little-known feature known as assumability. In other words, the buyer of a home financed with an existing F.H.A. or V.A. loan may be able to take over, or assume, the seller’s loan, under the same terms, rather than take out a new mortgage.
During periods when interest rates are rising, homes offered for sale with an assumable, lower-rate mortgage may have extra appeal for certain buyers.
“You could now have a seller saying, ‘I have a great house to sell you and a great mortgage to go with it, which is better than my neighbor, who only has a great house,’ ” said Marc Israel, an executive vice president of Kensington Vanguard National Land Services and a real estate lawyer. “It’s a very clever idea.”
It may be clever, but the idea is also very old. The interest rate cycle is very long, and we witnessed steadily declining mortgage rates from 1981 to 2013. So for the last 33 years, nobody thought about assumability because there was no reason to do it. Back in the 1960s and 1970s, loan assumption was common practice. Now that we are entering the long ride up for interest rates, assumability will come back into vogue.
The savings for buyers assuming a loan extend beyond a lower interest rate. Assuming a loan is cheaper than applying for a new one because there are fewer settlement fees. An appraisal is not required (though a buyer may want to obtain one anyway). And in New York, borrowers assuming a loan do not have to pay the hefty mortgage recording tax a second time, Mr. Israel said.
F.H.A. loans do demand that the borrower pay for mortgage insurance over the life of the loan. But when assuming a loan, borrowers do not have to pay the upfront mortgage insurance premium required on a new loan, according to John Walsh, the president of Total Mortgage Services in Milford, Conn.
And, he noted, because the original mortgage holder would have been paying the loan for a number of years, the buyer assuming the loan will start at a point deeper into the amortization schedule than on a new loan. That means more of the monthly payment will go toward principal.
“In a rising rate environment, assumability is a very attractive option,” said Katie Miller, the vice president of mortgage products for Navy Federal Credit Union. “It ends up making homes that much more affordable.” …
Borrowers considering loan assumption should weigh the costs against other loan options, paying attention to the principal and interest payment, the amount of cash required upfront, and the private mortgage insurance premium. “At the end of the day,” Mr. Walsh said, “if the prospective buyer can come up with the down payment and qualify for the loan assumption, then it could be a huge benefit.”
After I first wrote my post on loan assumability, I became less enamored with the idea because the FHA raised it’s costs so much, but despite the problems, many people will use FHA financing, and loan assumptions will become much more common in the future.
Assumption of Mortgage
Even if price appreciation does not materialize, there is still a method for obtaining financing equity from property from a little-known and oft-forgotten loan term known as assumption.
To be more precise, the borrower is assuming both the rights and obligations of the promissory note and the Deed of Trust. Assumable loans have been around as long as lending. Borrowers seeking release from their payment obligations usually sell for cash and terminate the loan; nonetheless, a qualified new buyer may assume the previous borrower’s liability and simply take over making payments on the loan.
Lenders despise mortgage assumptions (and they should)
Both buyers and sellers benefit from assumption, but lenders suffer — which is why assumption is generally limited to government programs and adjustable-rate mortgages; lenders do not want their fixed-rate loans assumed.
Lenders borrow short to lend long; in other words, when they underwrite you a 30-year loan, they obtain the money they loan you with short-term borrowing, mostly from savings accounts, maybe even your own. In the industry this problem is known as an asset-liability mismatch. If lenders have a portfolio of low-interest loans outstanding in a high interest rate borrowing environment, they experience a negative spread, and eventually go bankrupt. In fact, much blame for the Savings and Loan fiasco traces back to a negative spread condition and asset-liability mismatch during the early 80s.
Rather than letting thrifts die, we deregulated and allowed them to build taxpayer insured Ponzi Schemes prompting a massive government bailout. The Savings and Loan industry collapse was the early warning of problems with banking deregulation — not all deregulation is good; for instance repeal of the Glass–Steagall Act was a disaster as it enabled the conditions that contributed to our global Ponzi Scheme that collapsed in late 2008.
In rising interest-rate environments lender spreads are squeezed but not eliminated as older, low-interest loans are replaced with newer, high-interest loans. If all loans were assumable, lenders would be handicapped in their ability to rematch their assets and liabilities. To avoid asset-liability mismatch, lenders put due-on-sale clauses in their promissory notes specifically to prevent low-interest loans from surviving to term with a series of debt-assuming owners.
Fortunately for buyers, the federal government cares not about making a profit or cost of financing, and they hold loans to term; as a result, assumable loans are underwritten to standards compliant with FHA or other government programs and insured by same.
Understanding by example
A buyer looking at properties like today’s will spend nearly $4,000 a month paying down a 30-year mortgage on a $900,000 house (current FHA loan cap is $729,750 in Irvine). Fast forward ten years, and the future buyer of this property will likely be able to afford a $6,000 monthly payment, but since interest rates will also be higher, the mortgage is not larger, and thereby, prices are not higher. As I mentioned in, A Theory of House Prices and Housing Markets, expanding mortgage balances are necessary for prices to appreciate, and rising interest rates cause mortgage balances to contract rather than expand. In fact, if interest rates move higher faster than wages, prices decline.
If a future buyer is spending $6,000 per month to borrow the same amount that $4,000 supports today, then the future buyer would be $2,000 a month better off by assuming the old loan at 5% rather than underwriting a new one at 9% or higher. It is the desirability of the low payment on the old loan that makes assumption work.
Any rational buyer would want to assume a loan with lower payments and fewer than 30 years remaining to pay. The only downside for a buyer is that they will never refinance into a lower interest loan simply because they already have one. I have written many times about the virtue of buying when interest rates are high and refinancing into a lower interest rate to accelerating amortization. Buyers obtain this same benefit through assumption, and sellers can extract value from the transaction.
Seeing this potential outcome in advance will help you position yourself to take full advantage. Most fixed-rate private loans — including those issued by GSEs — are not assumable, and borrowers who utilize financing today with due-on-sale clauses will have no opportunity to extract value from their financing.
Sell faster or sell for more
If interest rates rise, assumable fixed-rate financing has value even if the financing has not been in place long. For instance, if a buyer must become a seller two or three years into their mortgage – and if they have equity and can sell – they will have a significant advantage over sellers with similar properties who do not have assumable loans. A few years from now, the lower mortgage payment will be an attractive feature prompting buyers to select one property over a neighboring one. If you faced two competing properties but one offered an assumable loan that reduces your payments 5%-10%, all things being equal, wouldn’t you chose the one with the lower payment? I would.
As interest rates go up and time passes (which reduces remaining amortization), an assuming owner enjoys monthly savings and a shorter amortization schedule. At first, this is merely a sales point, but at eventually, the benefits accruing an assuming owner morphs into a source of real monetary value a seller can obtain.
How to use owner financing to obtain equity from assumable loans
There are three primary ways owners obtain direct and measurable financial value from their assumable loan:
- Buyer increases down payment and pays more total dollars
- Seller offers and buyer accepts a seller-financed second mortgage and the seller either keeps the cashflow or discounts the loan in the secondary market and obtains a one-time cash infusion.
- Seller offers and both buyer and lender accept a wrap-around mortgage.
The first concept – buyers increasing their down payment and paying more total dollars — should be familiar to anyone who has prepaid interest points when originating a loan. People frequently pay interest up-front in order to lower their interest rate and monthly payments over the life of the loan. When a buyer assumes a seller’s low interest-rate loan, they are doing the same thing, but instead of that money going to a lender (or mortgage broker) that money accrues to the seller. Do you see why lenders hate assumption?
The second and third concepts — issuing seller financing as either a second mortgage or wrap-around mortgage — are far less common and much more complicated, but the financial rewards are great, and any seller with an aging and assumable first mortgage should explore the options assumable financing creates.
Seller financed second mortgages
Let’s go back to the opening example of a loan issued today with a $4,000 monthly payment. Fast-forward to 2020, and the same loan balance financed at 9% yields a $6,000 a month payment. Obviously, a buyer would prefer the $4,000 payment to a $6,000 one, and the seller would like to extract the equity accumulated through paying down the loan balance plus a premium for the value of their financing.
If the seller allowed themselves to be taken out by a buyer using a conventional loan, they would obtain the $138,619 in financing equity obtained by paying down their mortgage debt, and at the closing, the sales price would show no change, and the seller would obtain a check for their financing equity minus fees. However, If the seller offers and the buyer agrees to a second mortgage with a $2,000 payment for a 15-year term at 9%, the seller would obtained an annuity worth $197,186 when the loan balance has only been paid down $138,619 for a value-added of $58,567 or about 8%.
(The annuity value of a $2,000 monthly payment over 15 years discounted at 9% is $197,186)
Why would a buyer agree to this? Well, if you were buying this property in 2020, you are still paying $6,000 a month, so you are no worse off on a monthly payment basis, and your total debt is the same, so you are no worse off on a total debt basis; however, and this is a big however, you will have one loan on a 15-year amortization schedule and another with 20 years remaining out of 30 — you have just accelerated your amortization and reduced your Time to Payoff. I would take such a deal, wouldn’t you?
Both buyer and seller benefit greatly from assumption; only lenders dislike it.
A wrap-around mortgage, more-commonly known as a “wrap”, is a form of secondary financing for the purchase of real property. The seller extends to the buyer a junior mortgage which wraps around and exists in addition to any superior mortgages already secured by the property. Under a wrap, a seller accepts a secured promissory note from the buyer for the amount due on the underlying mortgage plus an amount up to the remaining purchase money balance.
The new purchaser makes monthly payments to the seller, who is then responsible for making the payments to the underlying mortgagee(s). Should the new purchaser default on those payments, the seller then has the right of foreclosure to recapture the subject property.
Because wraps are a form of seller-financing, they have the effect of lowering the barriers to ownership of real property; they also can expedite the process of purchasing a home. An example:
- The seller, who has the original mortgage sells his home with the existing first mortgage in place and a second mortgage which he “carries back” from the buyer. The mortgage he takes from the buyer is for the amount of the first mortgage plus a negotiated amount less than or up to the sales price, minus any down payment and closing costs. The monthly payments are made by the buyer to the seller, who then continues to pay the first mortgage with the proceeds. When the buyer either sells or refinances the property, all mortgages are paid off in full, with the seller entitled to the difference in the payoff of the wrap and any underlying loan payoffs.
Typically, the seller also charges a spread. For example, a seller may have a mortgage at 6% and sell the property at a rate of 8% on a wraparound mortgage. He then would be making a 2% spread on the payments each month (roughly, anyway. The difference in principal amounts and amortization schedules will affect the actual spread made).
As title is actually transferred from seller to buyer, wraparound mortgage transactions will violate the due-on-sale clause of the underlying mortgage, if such a clause is present.
Note that pesky due-on-sale clause is back. Lenders do not like wraps any more than they like assumption and they dislike it for the same reasons, asset-liability mismatch.
Facts about loan assumptions
- Assumptions do not require a down payment. If the seller has equity it’s paid to the seller. If the loan is break even to value to upside down, it’s simply taken over.
- Assumptions do not (for the most part) require appraisals. It depends on the investor. An FHA insured loan would not require an appraisal, a private investor ARM loan would.
- Credit qualifying is based on underwriting standards available at that time. Income, assets, credit, and debt to income ratios apply.
- Condo project HOA’s are not re-evaluated. If an FHA loan was made in an association that was acceptable at origination but has since deteriorated, it is of no issue to the assumption department. Since the borrower must credit qualify for the assumption, the current HOA dues might impact the buyers ability to qualify, but that’s the absolute depth of scrutiny these loan applicants will get.
- “All in” lender costs to assume is about $1,500 per transaction. It is not a scalable fee. There will be escrow, title, and other non lender costs, but minimal at best.
- The loan must be originated and in place for 12 months before an assumption can be completed.
- The seller or borrower must pay any escrow shortage/past due interest.
- These are our current guidelines, subject to change of course, and not applicable to every lender, but likely similar to what everyone else has as policy.
- We get “many” requests to assume, but are closing 1-2 per month. I’d say this is likely due to below market financing available today. Most vintage 2005- 2008 FHA loans were priced in the high 5′s. 2009 FHA loans do not have 12 month seasoning yet. Project forward into 2011-2012 – if we aren’t all wiped out from the planetary alignment/Mayan calendar event…. I’d guess there will be plenty of cheap rates available for buyers willing to purchase FHA financed homes through assumption of the original note.
The GSEs will underwrite ARMs with assumability, but since they are ARMs, the assuming buyer is not locked in to a low rate, so it becomes worthless and pointless. Assuming an ARM does not work like assuming a fixed loan. Don’t mistake one for the other. You want to take out an assumable fixed-rate loan.
Squatting: why the high-end hasn’t collapsed
Conventional wisdom says that owners in high-end neighborhoods are sitting on mountains of equity, and since they are generally high wage earners, they are also paying their mortgages. Unfortunately, that isn’t the case. Delinquent jumbo loans in Coastal California pollute bank balance sheets. Today’s featured property is one of many multi-million dollar mansions where the owners squatted for over four years.
Recording Date: 03/29/2012
Document Type: Notice of Rescission
Recording Date: 11/30/2011
Document Type: Notice of Default
Recording Date: 06/11/2010
Document Type: Notice of Default
Recording Date: 11/13/2009
Document Type: Notice of Sale
Recording Date: 08/06/2009
Document Type: Notice of Default
[idx-listing mlsnumber=”OC13192178″ showpricehistory=”true”]
16 GENEVE Newport Beach, CA 92660
$3,625,000 …….. Asking Price
$4,100,000 ………. Purchase Price
7/28/2005 ………. Purchase Date
($475,000) ………. Gross Gain (Loss)
($290,000) ………… Commissions and Costs at 8%
($765,000) ………. Net Gain (Loss)
-11.6% ………. Gross Percent Change
-18.7% ………. Net Percent Change
-1.5% ………… Annual Appreciation
Cost of Home Ownership
$3,625,000 …….. Asking Price
$725,000 ………… 20% Down Conventional
4.87% …………. Mortgage Interest Rate
30 ……………… Number of Years
$2,900,000 …….. Mortgage
$753,488 ………. Income Requirement
$15,338 ………… Monthly Mortgage Payment
$3,142 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$755 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$230 ………… Homeowners Association Fees
$19,465 ………. Monthly Cash Outlays
($2,774) ………. Tax Savings
($3,569) ………. Principal Amortization
$1,357 ………….. Opportunity Cost of Down Payment
$473 ………….. Maintenance and Replacement Reserves
$14,952 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$37,750 ………… Furnishing and Move-In Costs at 1% + $1,500
$37,750 ………… Closing Costs at 1% + $1,500
$29,000 ………… Interest Points at 1%
$725,000 ………… Down Payment
$829,500 ………. Total Cash Costs
$229,200 ………. Emergency Cash Reserves
$1,058,700 ………. Total Savings Needed