Searchlight Crusade

One of the most useless and overworked items in the real estate industry today is the pre-qualification for a loan. Sellers want buyers to be “pre-qualified”, and buyers are seeking “pre-qualification” to convince buyers they are serious.

The level of work done for a pre-qualification varies. In some rare instances, the loan officer doing the work not only runs the credit, but verifies the income as consisting of the proper income documentation paperwork (w-2s and/or taxes, plus pay stubs and/or testimonial letter) for the loan, and determines how much of a payment you can qualify for based upon known income and known indebtedness, and actually includes the assumed property tax due to purchase price in the payment calculations, and gives you an answer in how much you can qualify for based upon current rates at the time. This is a fair amount of work, consuming hours of time. A loan officer at a direct lender who goes through this whole procedure might be done in two or three hours. A loan officer working for a broker can actually take a full day, or even two, making calls to various lenders and shopping the loan around after the primary calculations are done. On real transactions, I’ve gone over two days on multiple occasions, trying to find a better loan.

The pitfalls and caveats are many. If the loan officer doesn’t run your credit, which costs money, they really have no idea what your credit is like. If they don’t verify your income, they are making a giant assumption that what you told them is accurate for purposes of a real estate loan (you get to use gross pay, but there are a multitude of potential adjustments). The payment you qualify for when you actually go to buy a house and get a real loan is a so-called PITI payment, which stands for principal, interest, taxes and insurance. Insurance is always an educated guess, unless and until you have a quote from a prospective insurer on a particular property for an adequate amount of coverage. Taxes here in California will be initially based upon sales price, and unless you live within one of the high property tax areas, is pretty much a set rate for the whole state, but there are many special assessment districts, scattered all over the state. I’ve seen properties with as many as four of these, although many if not most properties have none. It’s much harder in some other states to even come up with a meaningful rule of thumb figure. All of these factors throw the taxes figure off.

Principal and interest – the actual loan payment – is what’s left over from your allowed payment. From this, you can compute a principal loan amount based upon known interest rates.

Here’s where the games really start. The first question is “What type of loan are they basing it on?” The thirty year fixed rate loan always has the highest rate-cost tradeoff, which means that if they assume a thirty year fixed rate loan, they are going to be able to “pre-qualify” you for less than somebody else can. What’s the lowest rate, and hence the highest prequalification amount? A month-to-month variable or even a negative amortization loan. Somebody assuming they are going to qualify you for a negative amortization loan is going to “pre-qualify” you for the largest loan – more than you can really afford, as millions of people have discovered the hard way since I started writing this site. Which is more attractive to a client who doesn’t know any better? That’s right, the negative amortization loan. Which loan causes someone who is educated in mortgages want to drag the loan officer into the sunlight and stake them through the heart? That’s right, the negative amortization loan. Amazing coincidence? Not really. From personal experience, many people do not want to become educated, even to the level of a competent layperson, and they will get taken for a ride as a consequence. What they want is to look at houses, pick out one they like, sign a couple sheets of paper, and move in. What these people are likely to get is a disaster. For several years, many people in my industry made a very high class living ripping off people like this while setting them up with a gotcha that was going to bite, and bite hard, but not until after they had their commissions and depart the scene. “How many houses are they going to buy from me, anyway?” is the typical thinking.

One more concern is the fact that while sub-prime loan rates are higher, and in most cases they will have a pre-payment penalty, where A paper loan rates are lower and in most cases do not have a pre-payment penalty. However, the highest payment A paper loans will allow is less than the highest payment sub-prime loans will allow, due to lower allowable debt to income ratio. So the loan officer can typically qualify you for a bigger loan based upon a sub-prime loan. See my article “Mortgage Markets and Providers.”

Additionally, the rates on loans change every day. If the rates changes, so does the amount you qualify for with the same payment. It takes only a calculator to show that even an honest and complete “pre-qualification” done on a rate that’s valid today may or may not be accurate by the time you actually find a home that you wish to purchase.

Another game loan officers play is with the rate versus cost and points tradeoff. It is counter-intuitive but true that it is actually easier to qualify someone for a lower rate. If you qualify for a given loan program at 5.5 percent, you will qualify for the same program at 5.25 percent, but you might not qualify at 5.75 percent. The reason is that the payment is (or should be) lower if the rate is lower, and payment is what qualification is based upon. The cost to you is that most people refinance or sell before they have recovered the additional costs of these lower rate loans. (See Mortgage Rate and Points for details and sample computations.) So they’re going choose a loan that sticks you with multiple points – costs you’re not likely to recover – all in the name of qualifying you for a larger dollar amount. The money to do that can make a difference on your loan to value ratio, as it eats up your planned down payment. So you want to be very careful that the loan officer’s assumptions aren’t planning to use the same money twice, because you can’t spend the same dollar both on your down payment and buying your rate down.

THERE IS NO WIDELY-ACCEPTED STANDARD FOR “PRE-QUALIFICATION.” Let me say that again. There is no widely accepted standard for prequalification. One more time: There is no widely accepted standard for prequalification. Consequently, everywhere in the nation, but particularly in California and other high cost areas, the pressures on providers to “pre-qualify” you for inflated numbers is intense. If you don’t qualify for enough to buy any home, they obviously don’t have a transaction. If they pre-qualify you for less than someone else, most people are more likely to go to that somewhere else, and the loan officer doesn’t have a transaction. The competition is qualifying them based upon month-to-month variable loans or even negative amortization, and so if they don’t as well, they don’t have a transaction. Few loan officers qualify clients based upon how things really are, and the easy transactions where everything fits and the people qualify based upon traditional measures are mostly long gone. If the agent and loan officer doesn’t have a transaction, they don’t make any money. If they don’t make any money, they don’t stay in business, they can’t make the payments on the Porsche, their house gets repossessed, their wife has to sell her jewelry to keep them off the streets, etcetera. It’s not a pretty picture for them, and it often leads to them putting clients into situations they cannot really afford (I originally wrote that in June 2005, long before the mortgage meltdown became plain to everyone else). Finally, of course, the size of commissions is based upon the size of the transaction, so if they “pre-qualify” you for more, they have the prospect of making more when you buy the bigger house that you cannot really afford.

This doesn’t even go into the issues of a stated income loan. Stated income loans are gone now, but when we had them were intended for self employed folks who get to deduct a large number of expenses everyone else doesn’t. They were where a borrower couldn’t prove income according to industry standards via taxes, w-2s, pay stubs, or perhaps bank statements for sub-prime loans, so they stated their income and in return for a higher interest rate, the bank agreed not to verify the actual income level. Please note that it’s still got to make sense for someone in your profession. For example, if you are a school teacher they are not going to believe you $250,000 per year. But people do make up numbers much larger than the real amount they make. It is not for nothing that stated income was often called a “liar’s loan”. That is fine and good, as long as you actually can make the payment. When you can’t it becomes a real issue. Not necessarily for the loan officer, who’s going to get their money and depart the scene, and as long as you make the first payment or two they’re off the hook. No. The one who’s going to have to deal with the mess is you, the client. Keep in mind that as soon as the loan is funded, that loan officer is out of the picture whether you went through a direct lender or not, and they know it. That real estate agent is also out of the picture as soon as you have your house, and they know it. You’ve got to live with the situation they created, and they kind of know it, but often it just isn’t important to them, and certainly not as important as seeing that they get paid, and paid as much as practical. So watch out, and shop around. The person who “pre-qualifies” you for the lowest amount may be the one you should do business with, because they are using assumptions you can actually live with. Go over their numbers with a calculator in hand.

The stated income loan leads into our next issue, which is that few people will expend the necessary effort to do a “pre-qualification” correctly. It takes several hours to do an accurate “pre-qualification” correctly, but a Wildly Assumptive Guess takes just a few minutes. You may imagine which is done more often, especially since the numbers will change with available rates anyway. This especially applies if the agent does not run credit or does not get income documentation. Due to the availability of the stated income loan when I first wrote this, there was no absolute need to obsess about accuracy and being sure of the numbers, and many loan officers still don’t understand that this has changed. Due to pressures to come up with high numbers, loan officers still make assumptions that range from pretty optimistic to wildly optimistic. This is wonderful if you just want to be able to say you were a homeowner for a few months while the bank forecloses on you. It’s not so great if you’re trying to get into a survivable financial situation.

You may get the idea that when it comes right down to it, most “pre-qualifications” are convenient fiction, worth an approximately equal size of toilet paper, if not quite so soft on certain portions of your anatomy. You’d be correct. So “Why are they so ubiquitous?” becomes the obvious question.

The answer is sellers and seller’s agents. Sellers are going to go through a significant amount of trouble and expense going through the motions of selling their homes. Furthermore, they can only have one proposed sale in process at a time and they may have a deadline. They understandably want some kind of reassurance that this buyer can actually qualify for the loan. For their part, seller’s agents can be some of the laziest people I’ve ever met when you come right down to it. They’ve paid the money for the advertising that draws people or joining the big well-known National Brokerage With Television Advertising! Once they get the signature on a listing agreement, many think they’re entitled to sit around with thumb you-know-where and wait for the commission to roll in. They don’t want to go over the buyer’s pre-qualification with the seller, and most of them have no idea as to how to do it. But they certainly don’t want to carry out their part for more than one proposed transaction, hence their desire for this Magical thing called the “pre-qualification.”

The correct way to respond to this concern, for a seller, is simple and yet many people think it’s hard-nosed. Require a deposit. Require it be remitted to you on the last day of escrow as part of the initial contract, whether or not the loan funds. Now the standard form in California, as a default, makes the sale conditional upon the loan for seventeen days, but this can be changed by specific negotiation. True, you might scare away some buyers who aren’t certain that they’re qualified, and in buyer’s markets this may scare them away entirely. But you won’t enter into escrow with anyone who’s unsure. You shouldn’t rely on a “pre-qualification”, which is basically just a piece of paper that’s now been filled up with meaningless markings and so can’t be used again for something more important, like a game of tic-tac-toe.

Furthermore, many buyer’s agents, knowing how useless a “pre-qualification” is, don’t want to take the time to do them themselves and so tell their clients to go get one somewhere else, but that when the time comes they have someone who will do the actual loan. It didn’t take very long for the word on this practice to get out, and so loan officers and agents with a very short time in the business learn not to do them unless they are going to get something out of it. Which basically means control of the transaction or an upfront payment. I certainly can’t name anybody with more than a few months in the business who will do a “pre-qualification” unless a client either signs a Buyer’s Agent Agreement or pays them a fee or does something that assures them they will get a transaction. And if your agent says go get a “pre-qualification” on your own, go and get another agent. If they or the loan agent they recommend can’t be bothered, then obviously they are too busy to give you the necessary attention to get your transaction done properly and on time. It’s very hard to fight the system that requires a “pre-qualification,” no matter how useless it is, but it’s part of the work they signed on for. They should do it themselves. If they try to get someone else do do their work, consider it a Red Flag not to do business with them, because they’re already trying to skate by without doing work that they should be doing. Being a good agent or loan officer is work, and that’s what we get paid for. Somebody who’s trying to do less work now is likely to try and skate by without doing important work later.

Caveat Emptor

From an email:

I was wondering if you could tell me whether the following ways to save on interest are actually possible. If they are what are the penalties typically associated with these suggestions. I know you have mentioned a pre-payment penalty but what amount is reasonable? 1) Pay a certain amount over your monthly mortgage payment to pay your mortgage off sooner, pay more in principle, and to save on interest. Example: Your minimum monthly payment is $2000 so you pay $2200 a month instead. 2) Pay your mortgage twice a month so that more principle is paid off before interest catches up. Another nice thing about this is that most people are paid twice a month.

Prepayment penalties are something that is associated with the loan your loan officer chooses for you when you sign up. They become set in stone when the documents are signed, the loan is funded and the documents are recorded.

Sad to say, only a very small minority of clients ask about pre-payment penalties at sign up, and judging from my experience with people at a later time, most people either cannot spot it in the documents (there should be a section entitled something like “Pre-Payment” or “Borrower’s Right to Pre-Pay”. On the other hand, you need to read the whole Note that you’re signing enough to understand what every piece says).

As I’ve said in Mortgage Markets and Providers and Yield Spread Explained, pre-payment penalties are a function of the market you’re shopping in. Not necessarily the best market you can shop in, but most loan officers are going to be looking to make money, not necessarily to get you the loan that’s really the best possible loan. Pre-payment penalties add to what they get paid, and it’s invisible to the client while you’re getting the loan unless you go looking for it. In all markets, there is a trade-off between what you pay in up-front costs to get a given rate on a given type of loan, and what rate you get. Adding a pre-payment penalty (or not removing one) adds to the loan provider’s commission, sometimes multiple points, and out of this they give you back a half point or so to make their loan look more competitive. A Good Question to ask and catch many loan officers off-guard is “and what is it without any pre-payment penalty?”

Pre-payment penalties are a thing to avoid if you reasonably can. On the other hand, circumstances can force you to accept one. No loan officer works for free, and if about all you’ve got is the money for the down payment, accepting a two year pre-payment penalty (meaning it is in effect for two years) can get the loan officer paid while you still get a affordable rate at a cost that is within your means.

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

On some loans, the pre-payment penalty is triggered by paying any extra money. One extra dollar and GOTCHA! But probably eighty percent or so give you the option of paying it down a certain amount extra each year, usually 20 percent of the principal at year’s beginning, without triggering the pre-payment penalty. This amount INCLUDES the normal pay down of principal via the monthly payments, so if you have a $200,000 balance at the start of the year, a lump payment of $40,000 is going to trigger the penalty because the regular payments will then push the pay down over 20%.

Now as to the alternate payment schemes you mention, the first method, paying extra, is very possible and recommended with most mortgages. Anything extra you pay should be applied directly to principal. Especially in the early years of the mortgage, this has a multiplier effect, as now that you don’t owe that money any more, your interest charges in the future will be less so less of your payment goes to interest and more to principal. On a $300,000 30 year mortgage at 6%, your monthly payment is $1798.65. Of this, $1500 is interest – which you’re paying just to break even – and 298.56 is principal, which actually goes to pay off your loan. Let’s say you pay $200 per month extra. If you’re one of those extremely rare people who actually pay off your mortgage, you’ll be done in 278 months – 82 months early. Almost 7 years. The interest you pay drops from $347,514 to $256,000 – you saved $91,514 in interest charges by paying $200 per month early.

If, as is far more likely, you refinance after 2 years, instead of owing $292,404, you’ll only owe $287,284, a savings of $5120, which means you owe $5120 less on your refinance, and might get better terms because of it. Or you have $5120 more in your pocket if you sell. So it’s only a 7.5% rate of return – it is guaranteed. If this mortgage outlasts 95% of all loans and makes it to five years – sixty months – you’ll only own $265,114 instead of $279,163, a difference of $14,049. This is money in your pocket or money you don’t owe on the refinance, which you’re not paying fees on, and which might get you a better deal. Or it’s $14,049 more from the sale of your property to buy another one. It’s a 17 percent overall return on every penny in you added in five years, including the last payment you made. That’s better than you’ll do with CDs with the first month’s money.

Suppose you only make one extra payment, once. Let’s say you make an extra payment at the end of the month when you buy or refinance instead keeping the money in your checking account until the end of the next month. Making that one payment saves you more than five months at the end of your mortgage if you keep it the full thirty years. Let’s say you just pay $200 extra once, that first month that you actually make a payment. You owe $225 less after 24 months, $270 less after 5 years, and $1207 less in the last month of your loan (assuming you keep the loan the full thirty years).

Furthermore, the higher your interest rate, the more difference these payments make.

Your second question, about paying your mortgage twice a month, is trickier, and here’s why: What most people who do this are doing is actually making payments every two weeks, not every half month, which means you’re making an extra payment per year in pure principal. To separate the two phenomena, let’s drag the calculator out. Cut the interest rate in half, cut the payment in half, and double the number of payments. Punch in n=720, i=3%, and let’s see what happens. The payment comes out to $898.92. Double this to $1797.85. This is about 81 cents per month difference. If you pay half of the $1798.65 twice per month, you shave less than half a month off of your payment schedule.

On the other hand, make 13 payments in 12 months, and (to make things simple for a simple calculator) that’s roughly equal to making payments of $1948.54 per month, which has you done in the 295th month – almost five and a half years early.

So you see, the twice a month schedule really does comparatively little for you – it’s the fact that you are making an extra payment per year that really helps in this case.

So with some banks charging hundreds of dollars to sign you up for things like this (I know of lenders who charge $400 and up just to sign up), I’d suggest instead to instead spend the sign-up money on a direct pay-down of your mortgage (providing you don’t have one of those “one extra dollar” prepayment penalties), and keep making those monthly payment with a little extra on the side instead.

This “service” banks provide for their customers is nothing more than a cash-cow fee to pad their own bottom line, all for something the vast majority of borrowers have the right to do for themselves for basically nothing.

And for the rest of you out there, I say the same thing I said to this person “Please ask if you have further questions you’d like answered.”

Caveat Emptor

“Should People in their sixties take out a mortgage?”

The short answer is “Not if you don’t have to.” Now if I suddenly vanish, the explanation will be that the loan industry put a contract out on me.

Success in loans, and sales in general, is often attributable to selling people stuff they don’t need. If you don’t sell something, you don’t eat. Getting people to call or stop by the office is expensive. The traditional idea of sales is that you have to make a sale at every opportunity, whether it really makes sense for the client or not.

The various tricks of selling a mortgage to retired folks is a case in point. “It’s a cushion,” “It’s there in case you need it,” and all sorts of other stuff to that effect. Combine this with the “If you wait until you need it, you won’t qualify!” and most folks who don’t know any better will cave in and apply.

This is exacerbated by the fact that most people seem to want to stay in the same home they raised their family in. This is understandable, emotionally, and often the worst thing you can do financially.

Let’s consider the typical three or four bedroom house with a yard, and the retired couple. It becomes more and more difficult, physically, for them to do the required routine cleaning, and even more difficult to do the maintenance and repairs that any home needs from time to time. Sometimes the kids are close enough and willing to help, sometimes they aren’t. If their finances are tight in the first place, they get tighter and tighter over time.

Into this environment comes the guy with a Reverse Annuity Mortgage (RAM) to sell. This is a special kind of mortgage, with a special protection for the homeowner (here in California, and in many other states as well) that they cannot foreclose in your lifetime. You cannot be forced out. Well, what if you’re sixty-five and live to 100, as a far larger proportion of today’s 65 year olds will? That’s thirty-five years they are locking this money up for, and there is always the possibility that by the time they consider the cost of selling, etcetera, there will be no equity. The interest rates are significantly higher than a regular “A paper” mortgages, higher than most sub-prime loans, even, and the pay to the loan officers who do them is much higher than a typical loan.

Lending is a risk based business, and that kind of lending carries its own risks. Who pays for the risk to the lender? You do. Especially as opposed to the typical loan where half have refinanced in two years and ninety-five percent in five, this is a long term loan they are being exposed to. Yes, the recipient could get cancer and die in a few years, but they could well survive that. The lender has no way of knowing what the interest rate environment for the money will be in a few years. So either the rate the clients get is variable, or the clients pay a higher rate to have a fixed interest rate.

Once you start taking money out of the RAM, it starts earning interest. Since in the most common forms the homeowners are typically not making payments, it’s usually compound interest. If you are making payments, it makes your cash flow even tighter, and you need to take more money. In either case, your balance is increasing, faster and faster with time, until you hit the limit, at which point you can no longer get additional money. This often happens surprisingly quickly, as you have the power of compound interest working against you. This all but guarantees that the family will have to sell the home, often for less than they could have gotten had they the luxury of a longer sale time. Furthermore, if keeping the home in the family is something you would like, a Reverse Annuity Mortgage is almost certain to torpedo the hope.

Contrast this with the swap down option. Suppose instead that adult children buy a small place suited to the parents needs such as a condominium, and the parents live there, while the adult children live in the parents home. This minimizes cleaning, upkeep, and maintenance that the parents need done.

If this won’t work, another option is selling the home and buying something smaller. Remember, a RAM will almost certainly cause the family to lose the home anyway. You get more mileage out of cashing in the equity by selling, and investing the equity, than you will from borrowing against the equity. Instead of working against you, compound interest is on your side. Most states have laws preserving property tax basis if that’s something that is advantageous.

Let’s say that with a $500,000 home, moving down to a $200,000 condo. Net of costs, you net at least $250,000 to invest, and let’s say you do so at 7 percent, significantly less than a well invested portfolio. This gets you $17500 per year, or about $1460 per month, indefinitely, and you keep both the condo and the $250,000. Contrast this with taking the $1460 per month out of your equity. Even if you can find a RAM at the same 7 percent, the entire equity is gone out of your home in a little over fifteen years, and that’s without including initial loan charges.

Nobody can make you do this, and there are many reasons why you might not want to. But looking at it from a strictly financial viewpoint, it’s hard to find the justification for a Reverse Annuity Mortgage. In fact, I have never seen a situation where I would recommend it from a viewpoint of financial prudence. There might be family situations that make it the “least bad” solution, but that doesn’t mean it isn’t bad.

Caveat Emptor

I’ve said upon more than one occasion that the factors at closing are all in the loan provider’s favor. Unless they signed up for multiple loans, the typical consumer has no leverage to get the loan provider to play it straight at closing, and actually deliver what they said they would back when you signed the application. Many people never notice that their lender has taken advantage of them until they get the first payment notice, which is far too late to do anything about it. Furthermore, others never notice at all, and of the ones who do notice something is wrong in a timely fashion, eight to nine out of ten are so fed up with the loan process that they sign the documents anyway. I keep hearing sworn oaths from people who signed up with my competitors that they won’t sign the documents at closing if they’re not what they were promised, yet when I follow up the vast majority of them did. I can only conclude that these people actually enjoy being led on like the rats by the Pied Piper of Hamlin.

Assuming that you are not one of those people who enjoys being treated like a disposable rat by someone who’s making a goodly sum of money from your business, what can you do? The first thing used to be apply for a back up loan, but the new lending environment stopped that. The loan isn’t real until it’s locked, and lenders have made it far too expensive to lock loans before there is an underwriting approval. If it isn’t locked, the rate/cost tradeoff will change with the market’s daily movements, but closing costs don’t change like that. There is no excuse for not correctly disclosing all closing costs – and that includes escrow title and appraisal – at loan sign up. Rate and discount are the only things that should be able to change.

How can you tell if you’ve been treated right by the loan officer? There are dozens of pieces of paper that get pushed in front of you at signing. Disclosures for this and disclosures for that. Truth in lending statements. Yet more disclosures. Certificates good for a discount here and a discount there. This is partially legal requirement, partially intentional on the part of loan providers. There really is a legal requirement for most of these disclosure documents, but the loan provider likes that they are there because they all distract your attention from where it needs to be focused.

There are three documents at the heart of every loan closing. They are the Trust Deed, Note, and Department of Housing and Urban Development form 1 (HUD 1). I advise reading everything, especially any title transferring documents (Grant Deed, Quitclaim Deed, Deed of Special Warranty, etc), so the lender cannot easily throw a curve in amongst the auxiliary documents. But most don’t bother trying. The three main documents are where you should be focusing your attention.

Sometimes, the Note is included in the Trust Deed, but most of the time they are separate, stand-alone documents. The Trust Deed gets recorded with the county, while the Note usually does not. Some states that I haven’t worked in may use other systems (A Mortgage Note, for instance, which needs an actual court action in order to foreclose, and which California along with most other states have gotten away from because it is more costly).

The Deed of Trust is simple enough. Look over the Deed of Trust enough to see that it properly references and does not contradict the Note.

The Note requires more attention, and cross referencing between it and the HUD-1. Is the amount borrowed consistent with what you were lead to believe? Is the rate correct? Is it fixed for the correct amount of time? Is there a prepayment penalty, and if so, for how long? Check out the repayment terms, and make certain there are the payments are what you were lead to believe. The Note is a legal contract detailing what you are agreeing to by signing all of this paperwork. Make certain it reads the way it is supposed to. Take your time, read it over, do not allow yourself to be rushed. Do not think to yourself, “I’ve got three days to call it off” because once you are done signing the odds are long that you will not think about your loan further until your first payment becomes due, and that is too late. Read it now. If there is anything that you do not understand, ask for a clarification. Good clarifications start from a point of the wording that’s on the paper, and make easy sense in English. Do not accept a clarification that you do not understand. Do not sign hoping to get a better clarification later. Do not sign period if you aren’t certain you understand.

Check out the HUD-1 carefully. It is the only form that’s required to give an accurate accounting of the money. Make certain the costs are what you were led to believe, and that it all adds up correctly. The numbers should start with the Old Loan (if Refinance) or purchase price, plus costs, plus reserves if you’re doing an impound account, plus prepaid interest, minus any money you’re bringing in (down payment, etcetera) or the seller or your broker is crediting you, and that should be the balance of the new loan. Take your time with the HUD-1 and the Note, and do not allow yourself to be rushed. Do not sign until you are certain that you understand and agree. If this takes a little longer than the signing agent planned for, tough. Many loan providers are adept at distracting you with this disclosure or that disclosure. Some companies actually provide them with training in how to distract you, and how to gloss over thousands of dollars that you didn’t agree to. Stick to your guns. The Note is what you are agreeing to, the Trust Deed is there to enforce it, and the HUD-1 is the only form accounting for your money that is actually required to be accurate. The Note, Deed of Trust and HUD 1 are what the lender is going to force you to comply with in a court of law. Make certain that they are what you agreed to before you sign them. If they’re not, it’s probably time to start the process over with someone else instead.

Caveat Emptor

Supply and Demand.

Now that I’ve given the short answer, it’s time to explain the macro factors behind interest rate variations. But I’m going to keep referring to those first three words. It is a tradeoff between the supply of money and demand for it.

The most obvious thing influencing loan rates is inflation. This is a general environmental factor. If the inflation rate is higher, then other factors being equal, there will be fewer people willing to lend at a given rate, and more people willing to borrow. Who wouldn’t want to borrow money if the money you have to pay back is actually worth less than they money you borrowed? All loans are priced such that a given inflation is part of the background assumptions of making it. If inflation is 4 percent, someone lending money at seven is making an effective 3 percent. If inflation is ten percent, they are losing that selfsame three percent. Which scenario would you prefer to loan money in? Which scenario would you prefer to borrow money in?

On the other hand, when inflation is high, loan rates usually rise to compensate. When the prime rate is twenty-one percent, that means that a business borrower has to make a minimum of twenty-one percent on the money just to break even. That’s if they’re a prime customer. Making twenty one percent is tough. The reason you borrowed (“rented”) the money was because you have a use for it to make money. There’s a lot fewer opportunities that make enough over twenty-one percent to make them worthwhile, than there are opportunities making enough over seven. This is one reason why inflation is a Bad Thing.

What alternatives exist is a major factor on the supply side, as well. If you absolutely must invest your money in US Government securities, that’s where you’re going to invest, and since you’re increasing the supply of money to the treasury, the price is less. Supply and Demand. This is one of the many reasons why Congress’ handling of the social security trust fund is a national disgrace. If they were private trustees, they would be held liable for not investing it where the best returns are (as opposed to stealing ‘borrowing’ from in at zero interest via a virtual IOU). If, however, you think that stocks are looking more attractive now, that means that the supply of money for loans will shrink by whatever dollars you move out, and the rates will rise. The effect for any one person is small, but there are a lot of people in the market. In aggregate, it’s many trillions of dollars. Supply and demand.

Savings rates means a lot, also. When there is a lot of new money coming available in the borrowers market that money is going to be cheaper to borrow, in the form of lower interest rates. This is partially why rates went down throughout 2002, and stayed down into 2003, and 2004. People who had been burned in stocks wanted nice “safe” mortgage bonds. When there is comparatively little new money coming into the market, the only source becomes old loans being paid off. Negative savings or negative investments in the bond market means that what money is coming off older loans is at least partially being used to fund the withdrawals. Competition for money gets fierce, and price – by which I mean interest rate – rises. Supply and Demand.

Competition for money is also a part of the demand side. When the government needs to borrow a lot, for instance, that increases the competition. Even on the scale of our capital markets, whether the government is breaking even or needs to borrow the odd $100 billion has a real and noticeable effect When they need to borrow $400 billion, you can bet it’ll raise the cost of money. The government doesn’t care, and the bureaucrats running the treasury have been told to get this money. They will do their jobs and get the money, whether it costs 4 percent, 14, or 24. Every time competition from the government drives up rates, a certain number of borrowers whose profit margin on the loan was likely to be marginal will drop out of the auction. But government spending rarely grows the tax base. It’s those corporations and small businesses investing in future opportunities that grow the tax base, and they are the ones dropping out of the auctions as money gets more expensive. This is why government deficits are a Bad Thing. Supply and Demand.

The desirability of the alternatives is another factor on the demand side, as well. There’s more than one way to make money for most. If it become prohibitively expensive to borrow (bonds), sell part ownership instead (stock). There is a point at which even the most die-hard sole proprietor needs the money, and just can’t afford it as opposed to selling some stock to new investors. This can dilute earnings, and cause you to lose control of the company (there were multiple reasons why the high inflation period of the seventies and eighties was followed by the era of the corporate raider, but that’s one major part), but better to dilute your share of the pool by ten percent while increasing the size of the pool by fifteen. That is a net win, while borrowing the money at twenty-something percent is likely not.

Now, let us consider the money supply here in this country, and thence the state of likely interest rates. We have increased government borrowing. We have the social security trust putting decreasing amounts of money into the government. We have a national savings rate that’s negative (and it is the overall rate, not just working adults that we’re concerned with, here). More and more people are becoming comfortable with foreign investment. And mortgage bonds are looking jittery right now, with foreclosures the way they are. Finally, no matter what the government propagandizes, we see the real inflation rate is substantial. Supply and Demand, remember?

Therefore, in my judgment, we are likely to see raises in the interest rate, at least in broad. If you’re on a short term loan that is likely to adjust in the next couple of years, the time to refinance is now, unless you’re planning to sell before it adjusts.

(If, on the other hand, you have a long term fixed rate loan, stay put. Once you’ve actually got the loan funded and recorded, they can’t just draw the money back unless you do something like fraud or default. Even if you go upside down on your loan for a while, if you’re already in a fixed rate loan, that’s okay. The market price of the home only matters at loan time and at sales time. If you don’t need a loan and you don’t plan on selling, why should you care? Oh, and one final note to the young: home prices will rise again. Sooner than you probably think, around here.)

Caveat Emptor

My lender told me that there is an application fee?

He said an application fee of $250 and then we’ll need the appraisal fee and of course we’ll need an inspection. Does all this sound legit, is there always an application fee?

If they are asking for upfront money, they are trying to hold your money hostage to commit you to the deal. Most of the companies that do that know that 1) Better rates are available to the public and you’re likely to find something better if you try, 2) they’re going to hit you with a bunch of extra stuff they didn’t tell you about at the end.

Never pay for more than a credit report up front. You should want to choose the appraiser if you’re going to pay them – that way you own the appraisal, not them. You should also choose the building inspector if you’ve got to have one – most refinances don’t, but only a complete idiot wants to spend that much money to buy a property and doesn’t pay a few hundred for the inspection first. If the lender orders them, they own them. They have to give you a copy, but you can’t take it to another lender to use if this one hoses you.

Now, at closing, you can expect to pay some fees. How much depends upon a lot of factors. I tell people with entry level single family residences to expect about $3500 total in actual loan costs, plus whatever points are paid to buy the rate down, plus the expenses related to the purchase, which vary a lot. By the time you’re done with title and escrow and appraisal and lender’s fees, that’s what it really is. I’d rather tell the truth and guarantee the total, but since most people don’t realize how many games prospective lenders can play, quite often the person signs up with the person who talks a good game but won’t guarantee the quote. Usually you can choose a higher rate to get some or all of your costs paid (I love doing zero cost loans myself, and they actually are a good thing for most clients), but there is ALWAYS a trade-off between rate of the loan and cost of the loan.

Nonetheless, the idea of money you pay before the loan is ready is to commit you to the lender. People understand checks that they write in their gut. That $1500 check for the deposit on the loan is more important to many people than the $450,000 loan that comes with it. As evidence, I have offered people loans that were more than $5000 cheaper on exactly the same loan type and rate, but people would not sign up for my loan because they didn’t want to “lose” that $1500 deposit. I’ve shown people better loans at lower rates on exactly the same terms that saved $1500 per year in interest, and they wouldn’t switch. Why? Because they are thinking about that money that came out of their checking account, that they scrimped and saved and set aside laboriously over a period of months, not the money in the loan, which is just as real, but they haven’t had to save it, and they don’t realize that it is real in the same way as that deposit check.

So lenders who want large deposits typically do so because they know that their loan will not stand the light of scrutiny, and competition from other lenders, so they want to tie you to them emotionally, with money you don’t get back if you switch lenders. Money that you’ve physically got in your checking account, money that you understand on the gut level. Be very wary of this sort of lender. Seeing as there are many loan providers who will do your loan without requiring such a deposit, I would suggest you find one of them (or better yet, two of them) to do your loan instead.

Caveat Emptor