Searchlight Crusade

I am not exactly certain how to start this essay. I’m kind of in a position analogous to writing Hitler’s biography in late 1940. We know at this point he’s a miserable excuse for a human being, but we don’t have the evidence discovered in the last four and a half years of the war as to how sick he truly was.

The negative amortization loan is something very similar. With Chairman Greenspan and even the heads of many building companies talking about locally frothy real estate prices, we are pretty certain that there’s going to be a drastic re-evaluation of the home market soon. We are missing the data of exactly how bad it’s going to be.

The negative amortization loan, with all its friendly sounding synonyms (Option ARM, Pick Your Payment, 1% loan, and variations and combinations thereof), is an idea that comes around periodically, and right now happens to be one of those times. Last time was the mid 1980s, and we had people driving their cars through the lobbies of savings and loan buildings in protest after they got hit with this loan’s GOTCHA! If you see ads on the Internet or elsewhere advertising “$200,000 loan for $650 per month!” (or something similar) one of these abominations is what they’re trying to hook you with.

These loans look, at first glance, to be wonderful – too good to be true. That is because they aren’t true. Furthermore, given the fact that loan officers and real estate agents want to get paid, and the damage isn’t apparent to the average consumer until well down the line, the unscrupulous ones sell a lot of these. I can point to loan and real estate offices where they do no other kinds of loans. Why? Because given the fact that most people shop for a loan or a home based upon the monthly payment, these are the easiest loans in the world to sell, and how many homes do you usually buy from a given real estate agent anyway? Cash flow is important, but watching only cash flow ends up in Ponzi schemes, Enron, and negative amortization loans.

I want to make very clear that yield spread is not a reason not to do a given loan. If a loan officer shops around and does the work to qualify you for a better loan on the same terms while increasing their compensation, they deserve to be paid that money. But you need to make certain that it IS a better loan by making an apples to apples comparison based upon what you, the client, are actually getting. For example, if one provider is getting you a loan at 5.5%, that looks to be better than 6.5% at first glance, correct? But if the first loan is only fixed for two years, and has two points on it as well as $4000 of closing costs and a five year prepayment penalty, while the second loan is fixed for thirty years and the lender is paying all of your closing costs with no prepayment penalty, I submit that the second loan is the better loan in most circumstances. The negative amortization loan, piece of garbage that it is, compares favorably with no other loan available today. The yield spread varies between three and four points on these things, with most of the lenders tending towards the higher end of that spectrum in order to compete. To give you a comparison, in order to get four points of yield spread on any other type of loan, I have to give people an interest rate at least two full percent higher than the going rate!

Basically, what this loan does is give you three or four options for your payment every month. The lowest of these is the bank allowing you to make a payment as if your interest rate was somewhere between one and two percent, with most of them now congregating towards the lower end of the spectrum in order to compete with one another. This low rate of 1% or so IS NOT YOUR REAL RATE. IT IS NOT WHAT YOU ARE ACTUALLY BEING CHARGED! I don’t know how many people I’ve talked to that were being taken for a ride and asked me, “Isn’t there any way this is the real rate?” THE ANSWER IS NO. Let’s pretend you are a bank officer. Remember, you’re one sharp person, and you have another whole group of very sharp people watching what you do. If for an equivalent amount of risk, you can get about 7 percent somewhere else with a different investment, are you going to give some poor sap I mean someone you don’t know a 1% loan that messes the heck out of your quarterly usage of capital bonus? Not on planet Earth.

The second payment option will be to make a payment based upon an interest only loan at the real rate you are being charged. I’ve seen the piranha that sell these loans trying to prey on each other extolling the virtues of COFI or MTA loans, depending upon which they have. The fact is that they’ve each got their limitations, and their upsides and downsides as opposed to the other. The problem with each and every one of these is that they are month to month variable from the beginning. There is no fixed period. You will never know next month’s rate until it happens. Thus far in my career, I’ve always had loans that are fixed for three to five years, at rates lower than this rate that the loan is really charging you. In other words, this second payment option is based upon a rate that changes every month, based upon the movement of an underlying index plus a margin.

The third payment option is to make a fully amortized payment based upon that same month-to-month rate. This is roughly analogous to a standard thirty-year loan, except that it is not fixed, and unless you make a payment of at least this much, next month’s payment options are going to be worse. The fourth and final payment option given by most lenders who do these is for the client to make a fifteen-year payment. Before we move on, the point needs to be made that almost nobody actually makes the payment for either of these options, much less makes these payments habitually as opposed to the other options. These payments are higher, and are not good selling points for this loan. If the client could afford to make these payments, there are better loans to be had. This is a metaphorical fig leaf to cover their naked taking advantage of you. “Well, he could make (or could have made) this payment but didn’t. It’s not my fault.” The reason they didn’t make the payment, Mr. Unscrupulous Realtor, is because YOU told them they didn’t have to. You SOLD them the house based upon the nominal payment, not the real cost.

Now, what happens if you make each of these payments? Obviously, if you make the payment for either the third or fourth option, you are paying your loan down. If you make the payment for the second option, that is basically a break-even, except that next months payments will be computed based upon one fewer month with which to pay the loan off.

What happens for 95 percent of the people who do these loans 95 percent of the time is they make payment option one. What happens in this case, where the client is making a payment that is less than the amount of interest on the loan for that month? The bank isn’t going to just eat the difference. That interest has to go somewhere.

Where it goes is into the balance of the loan. This means the balance for your loan – the amount you owe the bank – goes up every month that you make this payment option. Furthermore, next month it earns interest also. Next month the difference between what you pay and what you are charged gets higher, and even more money is applied to your loan. You’re being bit by compound interest. This is the first reason why the lenders will pay loan officers who do these loans so much. The lender knows that in the vast majority of all cases, the clients will end up owing them more money than they originally borrowed.

Furthermore, every single one of these loans that I know of has a three-year prepayment penalty. This means that even after you figure out that you’ve been taken for a ride, you’re either still stuck with them for the rest of three years or you’re going to pay a penalty amounting to thousands of dollars. Not a bad position for a lender to be in for leading you down the primrose path, is it?

I haven’t even gone over recast provisions (the 1% rate, even though it’s nominal, not real, doesn’t last forever), and various other lurking GOTCHA!s. I hear a lot of arguments from the various lazy lowlifes who make a habit of doing these loans rationalizing what they’re doing. “Those old loans had no cap. Now there’s a nine percent cap” If the client could afford six percent, there are other better loans to be doing. “They’ll more than make up for it in increased equity as prices rise.” A) Maybe, IF the market continues to rise, which is doubtful at the current time and never something you should bet other people’s financial health upon. It’s a crapshoot, at best, and the prevalence of these loans is one reason why the market is so overheated. In any event, the client is going to end up owing more money. Unless they’re going to sell and not be a homeowner any more, they’re going to have to pay the loan sometime, and in the meantime the longer they keep it, the worse it gets. What happens in three years if home prices are lower and the loan gets recast and now they cannot refinance out of it? “It’s the only way to get them into a home!” They still end up owing more money, and it’ll keep getting worse the longer they keep the loan. They’re still going to need to pay it back, unless they sell, and sell at a sizable profit. Furthermore, if they couldn’t afford a reasonable loan in the first place when they needed to borrow $X, what makes you thing they’re going to be able to afford a reasonable loan three years down the line when they owe $Y more. This is not a stable, sustainable situation! Maybe in a case like this, they should continue renting. Of course, that doesn’t get you a commission, does it, Mr. Unscrupulous Realtor? It certainly doesn’t encourage the client to stretch beyond their means and get you a bigger commission, either, does it?

For any loan officer who does these reading this, face it: These things are a way to mess up your client who is putting money into your pocket. These put the clients into worse situations than when they started. You are betting upon factors beyond your control to save you. One of these days, probably very soon, these are going to come back and bite you hard. Violation of fiduciary duty. All it takes is one of your clients getting into a bad situation who gets a good lawyer, and your career is toast along with your pocketbook.

For those of the general public reading this, I hope I’ve opened your eyes to some of the pitfalls of this loan. I’m perfectly happy to answer questions if you have them. But this loan is one that is designed for a narrow set of circumstances tailored around cash flow for a limited amount of time (and the one time I actually had a client who was the target market and who could actually benefit from this, none of the companies I submitted it to would approve it). It is abused by being misapplied because it’s such an easy loan to sell to those who do not understand the way they work, and all because people shop for a loan based upon payment. So don’t shop for a loan based upon payment. And if anyone offers you one of these loans, drag them into the sunlight, drive a wooden stake through their heart, and RUN AWAY! Somebody who offers you one of these is not your friend.

Caveat Emptor

Of all the issues having to do with a mortgage, the appraisal generates more overblown problems than any other part of the process. It’s also one of the most critical areas to handle correctly. There are reasons for this: It (along with perhaps the relatively cheap credit report) is the only thing a consumer has to pay for, as in money out of their pocket, before the mortgage is complete. Everything else is (or should be) done “on spec” by the mortgage provider. It is also a weapon used against the consumer by many mortgage providers.

In order to understand appraisals, you need to understand where everybody is coming from. An appraisal is a necessity for lenders. It tells the market valuation of the property in neutral terms. It is one of the essential anti-fraud steps of the process, as well as telling the lender how much the property might sell for in ideal conditions (which a foreclosure most certainly is not). It is the “market” part of the “lower of cost or market” valuation, which is driven into accountants and bankers starting with their first classes on the subject. Think about it. Just because you might be willing to pay $700,000 for the house next door to your parents (or for your parents old house itself) does not mean someone else will if you fail to make the payments. I have encountered at least two instances where a prospective borrower was definitely attempting to defraud a lender – and an appraisal caught it. There have been others where a reasonable person would have been less certain, but some of those instances were likely attempted fraud. Because of these, anytime somebody wants me to press for a drive-by or computer appraisal, a little blip goes off in my little bank of warning signal detectors. The lenders aren’t stupid. They know that lesser appraisals are cheaper, and employing the more expensive alternative requiring the consumer to write a check for several hundred dollars is going to cause some people to go elsewhere. It is the judgment of these highly experienced people who have been trusted to loan hundreds of thousands of dollars at a blow that an appraisal costs them less than an increased probability of the things it is designed to prevent. And when a loan officer like me presses them for a lesser appraisal, a little blip goes off on their radar screen, also. I can’t read minds, but I’ve had more success in getting lesser appraisals by keeping my mouth shut and letting the lender decide it’s safe enough on their own, then I have by asking for one.

You should not expect a mortgage provider to pay for an appraisal, like many will for a credit report. Unlike a credit report, an appraisal is several hundred dollars, and they don’t it get back if the loan doesn’t fund. My attitude, born of experience, is “If this customer is not sold enough on the benefits of the loan to front the money for the appraisal when I’m putting in a much larger investment of my time and administrative and support costs, then this isn’t a good investment.” Other people you may never meet such as the title company, escrow company, underwriters, processors, etcetera are also working in the background – and nobody gets paid if you change your mind, aren’t qualified, find a better deal, whatever. If they are hourly or salaried employees that do get paid, somebody else is investing the money to pay them. I may not have a fiduciary responsibility to all of them, but that doesn’t mean I don’t have any moral responsibility to see that their work is rewarded.

Furthermore, some lenders actually do prohibit brokers from paying the appraiser directly as an anti-fraud measure – and that’s one pointless piece of information I can ignore by having the necessary attitude to succeed in business. This does not mean that your mortgage provider isn’t doing their best to balance the competing interests – that of an appraiser’s right to get paid for what they do, versus a consumer’s desire not to pay for something that doesn’t help them. And twice in my career I have refunded appraisal fees out of my own pocket to customers who told me the truth as they knew it, but didn’t know to tell me something else (both fairly obscure points) that prevented the loan from going through. Because I didn’t ask, I felt morally obligated to compensate their loss. (This is not a legal requirement, and is not common – I’ve asked literally dozens of loan officers from all kinds of loan providers whether they’ve ever rebated an appraisal fee for any reason when a loan didn’t go through. So far, two others have said yes. Most look at me and answer “no” as if I’m some kind of alien from another planet. So go into the appraisal with a clear idea that if the loan fails, you’re not getting the money back. Period. That way you may be pleasantly surprised, but you won’t be expecting something unrealistic)

You should not expect an appraiser to work for free. It may not be rocket science, but it is an exacting field where in order to become licensed you must spend at least two years of your life as an apprentice, with an income of basically nothing. As a result, there is usually a shortage of appraisers. I’m often amazed that appraisals aren’t more expensive. On the other hand, many of them want to get paid for work that sabotages the loan it’s supposed to support. There is a Big Thing in appraiser’s association circles about how they hate loans with a minimum appraisal required, and explicit minimum appraisals actually are illegal. The appraisers, being normal humans, ideally want to be able to run their appraisal off the easiest comparable property values and let the chips fall where they may. On the other hand, there have been literally dozens of cases in my experience where choosing different but still comparable properties for comparison and doing a little more work netted the value necessary to make the loan work – the appraiser just didn’t want to be bothered, something that is against the grain of good business practice – and they are supposedly businesspeople. I have also seen this abused by a broker who wanted to make more on loans – if the appraisal came in for $40,000 more, this broker got a bigger rebate from the bank, and thus, made another $1200 on the loan. Lenders for their part do not want appraisals ordered where the appraisal is going to come in at a certain minimum no matter what the property is worth. But it isn’t a sign of good business practice to expect to be paid where your work is going to sabotage a substantial investment that others have already made in a project, as a below value appraisal does. It is naïve to expect that loan provider to continue to supply you with business, when you’ve just cost their former prospect several hundred dollars and kept that prospect from getting their loan, as a result of which the loan provider’s investment is lost, and furthermore you have left the loan provider to face all of the negative ramifications of an unhappy consumer. So some sort of compromise needs to be worked out among the competing interests of a consumer that doesn’t want to pay for something he doesn’t have to or that does no good, an appraiser that wants to get paid for the work, a lender that wants an honest appraisal, and a loan provider that wants an investment to pay off.

The one that I have found that works best is not a minimum appraisal. Besides being illegal, asking for a minimum appraisal is a violation of my fiduciary duty to the lender. Instead, what I’ll do is write something along the lines of “If comparables do not support a value of $X, please re-confirm the order prior to performing the appraisal.” It isn’t bulletproof, by any means. But it gives everybody the best shot at a fair shake without giving anybody carte blanche, and it prevents the vast majority of the problems. The appraiser does most of his or her work before going out to the house in question, checking sales of comparable properties in the Multiple Listing Service that they subscribe to. If the “comps” don’t support $X, and the loan collapses, he’s lost some work time. For a businessperson, this should be no big deal, and what they’ve lost is a small fraction of what other people working on this loan have lost. Furthermore, I’m going to keep sending business to that appraiser. If the comps support $Y, which is less than $X, and I can re-work the loan or find another loan and get the consumer to sign off on it based upon $Y (something that is far easier to do before the consumer gets angry at writing a $400 check and not being able to get the loan on the terms promised), the loan proceeds and the appraiser gets paid, and everybody is happy. If the comps support $X and the appraiser gets paid, everybody is happy – unless the actual appraisal comes in lower, and this does happen where a property is not as well cared for as most, doesn’t have standard features, etcetera. There’s nothing that can be done. You thought your home was worth $X, and it isn’t. End of story. The loan provider took every precaution they legally could. The appraiser took every precaution to protect you that they legally could, and now they’re entitled to be paid. It’s no fun for anybody – consumer, loan provider, or appraiser. I will put up with this a few times for an appraiser who makes a habit of calling me when the comps are low. I’ll keep sending them business. Chances are it’s not their fault. On the other hand, every so often I’ll get a call from some appraiser who gave me three “hop, pop and drops” (as in “hop on over, pop the consumer for the bill, and drop a uselessly low appraisal on them”) in quick succession, and wonders why his phone isn’t ringing. And of course, the various appraisers organizations are trying to pass legislation or regulations that basically give them the right to come back with any old appraisal they want to, and make it even more difficult to ask them to perform in accordance with good business practice.

An appraisal is not what your house will sell for. There are any number of subjective factors an appraiser cannot take into consideration, or cannot account for fully. The types of things they look at are objective. Size of the lot. Square feet of the house. Number of bedrooms. Number of bathrooms, and so on. These have all got measurable, objective answers. Cleanliness of rooms and condition of paint are hard to measure objectively. Nonetheless, potential buyers take them into consideration to a much greater degree than an appraiser.

One fact you should know about the appraisal: They’re good for a maximum of three to six months, measured from the date of the appraisal to the date the loan funds, which is likely to be thirty days or more after you apply. Usually three months is the limit if no loan was actually funded based upon that appraisal. If it’s older than the lender’s underwriting guidelines allow, every lender in the known universe is going to require a new one, unless your loan is one of the fortunate few that doesn’t require an appraisal.

The most important fact every homeowner or homebuyer needs to know about an appraisal: The entity that orders the appraisal, controls the appraisal. If you pay for it, you’re entitled to a copy. That doesn’t mean you’re going to be able to take it to another loan provider and use it. The appraiser will require both a release from the previous loan provider (who after all, is responsible for giving them business), and a retype fee of about $100, possibly more. Whether the loan provider will release it is problematical. They are not required to. Some won’t, no matter how good the reason. Some want to be paid, first. Even the most liberal and ethical aren’t going to release it if you’ve simply found a better deal. Remember, they’ve invested some serious resources in making this loan happen based upon your representation that you wanted it.

In another essay, I advise you to apply for a back up loan every time you buy a property or intend to refinance. Now I’m going to tell you the second smartest thing that you can do: Make certain you’re the one who orders the appraisal and owns it. Now some loan providers use only their own “in house” appraisers and require the appraisal to be paid for up front, when you fill out the loan application. They do this to make certain they keep control of the appraisal, so no other loan provider can use it, obliging you to pay a second appraisal fee if you want to go somewhere else. Unless you can get them to agree in writing to release the appraisal (they won’t), this is a giant red flag not to do business with that provider. The appraiser should be someone you have the option of choosing, and should be paid at point of service when the appraiser comes out to the home. (Don’t choose an appraiser who’s a family member, however. Lenders frown on this. Expect some pointed questions or having to get another appraisal if your name and the appraisers names are similar.)

Even other loan providers will try to slip in and assume ownership of an appraisal. If you want to control the appraisal, you must order it direct from the appraiser yourself, and if your loan provider provided the recommendation, the appraiser still might consider themselves bound if they get a significant amount of business there. On the other hand, as I also state in another essay, time is always a critical factor in every loan. The appraisal holds the whole process up if it’s not done promptly, and a reasonable appraiser is going to put his priorities on getting the appraisals done from the people he gets business from on a consistent basis. So if you’re going to order it yourself, order it immediately, or even on your own before you start the loan process if you know the parameters. This is difficult in the case of purchases, but very possible in the case of refinances. On the other hand, purchases are less time critical. Warning!: There are different kinds of appraisals, and different qualification levels of appraisers. There isn’t space here to cover them all. If you order the wrong kind of appraisal or order it from the wrong kind of appraiser, it’s useless. Just because 90% plus of all appraisals are the same kind from the same grade of appraiser or better doesn’t mean yours is one of them. The best way to handle this situation is to give the loan provider no more than two business days to give you the parameters for the appraisal, and be preparing the ground ahead of time by telephoning appraisers. Somebody that will charge $450 and do it within two days is almost certainly a better value than someone who will charge $350 and take two weeks. Immediately upon receipt of parameters from your loan provider, order your appraisal. That exact second. Don’t even put the phone down. As I said, time is critical. Some loan providers will not allow you to do this, insisting upon being the one to order the appraisal. This is a red flag. You probably want to take your business elsewhere. Handling the appraisal correctly is not trivial for a consumer, who after all is not usually a real estate professional, but if you handle it correctly, you put yourself in a position of much greater leverage.

Caveat Emptor

Most people tend to shop for a mortgage based upon the payment. They figure the lowest payment will be the cheapest loan.

This is the way most people make banks rich. Because they are looking for the loan with the lowest rate and the lowest payment, they choose the loan with two or three points that’s going to take twelve years to pay for its costs, and then after they’ve sunk all those costs into the front end of the loan, refinance within two years and sink a whole new set of costs into the loan. The bank gets all this lovely money, and then the consumer lets them off the hook by refinancing, and the bank doesn’t have to carry through on the full amount of their end of the bargain.

In point of fact, when shopping for a mortgage loan, there are at least four factors the consumer should consider. The best loan for a given consumer in a given situation at a given time is based upon all of these factors. Each varies in importance from loan to loan.

These factors are:

The monthly payment

The monthly interest charges

The costs that are sunk into the loan in order to get it

How long you’re likely to keep the loan.

This is not to say that only these factors are of importance. For example, the possibility of “back end” costs when you refinance is likely to be a critical factor when considering a loan that has a prepayment penalty. If you know there’s a good chance you’re going to get hit with an $8000 charge for paying it off too early, that needs to be added into the likely costs of the loan.

The monthly payment is important for obvious reasons. If this is not something you’re comfortable paying every month for month after month and year after year, then getting this loan is probably not something you should do. The costs of getting behind in your mortgage are significant, and the costs of going into default are enormous, and both may likely continue even after you have dealt with them. I talk with people all of the time who say, “We’ve got to buy something now, before it gets even worse!” Many agents and loan officers will happily put someone who says this into a home, with a loan payment that looks affordable on the surface, but isn’t. If you don’t examine the situation carefully, you’re likely to be getting into something you cannot afford, and is likely to have huge costs and ramifications for years down the line. Neither of these people is your friend. They are each making thousands, often tens of thousands of dollars, by putting you into a situation that is not stable, and that you’re going to have to deal with down the line, while they’re long gone and putting some other trusting person who doesn’t know any better into the same situation as you. If the situation is not both stable and affordable, pass it by.

With that said, the monthly payment is usually the LEAST important of these four factors. As long as it’s something you can afford, do not charge straight ahead, distracted by the Big Red Cape of “Low Payment” while you are being bled to death by other things. Many of these Matadors (which means killers in Spanish) will bleed you to death while acting like your friend by distracting you with the “affordable low payment”. Due to lack of a real financial education in the licensing process, a disturbingly large number do not realize they are bleeding people, but that doesn’t help their victims. A loan payment that is higher but still affordable may be a better loan for you – and in fact this is more likely true than not.

The three other factors are each far more important than payment. Payment is important. People who are unable to make their payments are called insolvent. Many of them file bankruptcy, have liens placed upon them, wage garnishments, suffer for years because of bad credit ratings, etcetera. But just because the cash flow is better right now does not mean the situation is better – that way lies the Ponzi scheme, Enron, and many other famous wrecks in the financial graveyard.

There is no universal ranking of which of the remaining three is the most important. They must be compared as a group in the light of a given situation: YOUR situation.

The monthly interest charges are simple. Principle balance times interest rate. This starts at the amount of the new loan contract (with all the costs added in, of course) times the interest rate.

The costs sunk into the loan shouldn’t be any more difficult to compute, but they are. As I have gone over elsewhere, it is an unfortunate fact that rarely does a mortgage provider tell the entire truth about the costs of the loan until it’s too late to do anything about it. If you have an ethical loan provider, the amount on the Good Faith Estimate (or Mortgage Loan Disclosure Statement here in California) should match what shows on your HUD 1 at the end of the process. Please remember to note any prepayment penalty or other back end charges as a separate dollar amount.

The thing that is most difficult to determine is how long you intend to keep the loan. Most people have no reliable crystal ball to gaze into the future.

The obvious answer to this dilemma is to compute a break even point. This completely falls short with regards to higher costs incurred after disposing of the loan as a result of having a higher balance, but it’s a start. If one loan has lower costs and a lower interest rate, there’s no need to go through the computations. But if as is common, one loan has a higher sunk cost and the other has a higher monthly interest charge, divide the difference in sunk costs by the difference in interest charges per month. This gives a figure in months that is a break even point. Don’t forget to add in any possibility of a prepayment penalty.

With this breakeven figure in months, you can calculate which is likely to be the better loan for you, using your own situation as a guide. If the breakeven is 54 months and you’re being transferred in 36, the answer is obvious. If you’ve refinanced at intervals of twenty-four months your whole life, a 54 month breakeven is not likely to be beneficial. If you’re going to need to sell in two and a half years when mom retires, that’s a clue, too. And if you’re a first time homebuyer starting out, remember that 50% of all homes are sold or refinanced within two years, so unless you have some reason to suspect that you are likely to be different, take that into account.

Caveat Emptor

This is going to be one of those occasional posts that gets expanded and reposted from time to time. This list is not exhaustive, although over time it is intended to become closer. If you have one, send it to me (dm at)

Any of these is sufficient reason, all by itself, not to do business with that company or person, to cancel your loan if in progress, or to go get another backup loan.

Any actual lie

Up front application fees, or sign up fees.

Up front lock fees.

Up front appraisal fees, as opposed to at the point of appraisal.

Any up front fee beyond credit report.

Requiring the originals of your documents.

Trying to sell you a Negative amortization loan, under any of its names, without explaining in detail all of the gotchas and limitations and why you need it (and you’ve got to be in pretty sorry shape to need it!)

Not locking your rate, or letting it float

On stated income or NINA loans, not giving a real idea of what the payment is going to be, and making sure you can afford it.

On full documentation or EZ documentation loans, needing to document more money than you make.

Requiring you to pay an “in house” appraiser (Who is receiving a salary)

Not allowing you to choose an appraiser if you want to (you should want to).

Not allowing you to order the appraisal if you want to (you should want to).

Consistently using the same phrase in response to a question. “Nothing out of your pocket” ($30,000 added to your mortgage) and “Thirty Year Loan” (note the absence of the words “fixed rate”) are two that are sufficiently pervasive as to merit independent mention.

An answer to a question that is somehow similar, instead of to the question you asked. Especially if said obviously intended to distract and mollify you, or is a pat phrase you’ve heard them use before.

You check their calculations on a couple of calculators and the numbers are both consistent and different from what you were quoted as a payment. (Some web calculators lie, but they usually lie in slightly different ways, although note that an auto payment calculator uses different first payment assumptions).

California replaced the one page federal Good Faith Estimate with a two page Mortgage Loan Disclosure Statement. I haven’t seen a lot of abuses of this yet, mostly no doubt because it is so new. I don’t even know if there are solid regulations and implementation policies and standards on it yet. I haven’t seen anything from the Department of Real Estate in the mail, and all web searches (including with the Department of Real Estate) come up with is a link to various lender’s online form, not the regulations for filling it out. So I’m presuming that said regulations are similar to the federal Good Faith Estimate, especially as the only thing a recent seminar we paid for on changes in the business had to say was, “If you give the client a Good Faith Estimate, you will be held to have complied with federal regulations but not state of California regulations.” Which implies that California didn’t alter the existing federal standards so much as add a few more requirements, the effects of which are to leave all of the games loan providers play with the federal Good Faith Estimate intact, as well as adding a couple more. (See my two part essay on the Good Faith Estimate for a list of the most common of those games)

The first page of this new form is similar to the Federal Good Faith Estimate. The first major difference is that there is no explicit loan or rate quoted at the top, and the broker or lender must disclose whether each given cost of the loan is paid to the broker or to someone else. There is no explicit line item (as there is on the Good Faith Estimate) for “Estimated Closing Costs” to explicitly sum all of the things that are actual fees or costs of the loan, as opposed to reserve requirements or things that are your fees paid in advance, such as property taxes. Your property taxes are the same whether you have lender A, lender B, or no loan at all. Ditto your homeowner’s insurance, school taxes (if any) and flood insurance (if any). Setting a form where they are part of a total to be compared, rather than apart from that total, is just offering the loan provider one more opportunity to play games or distract you from the really important information.

There is a sum of all the things the client is paying to the broker versus paid to others. I wonder if this might not backfire on the lending and packaging houses that got this part added. They’re going to show a line of fees paid almost entirely to them, whereas the only things paid to or from an actual broker are origination fees (if any), processing fee (my processor works for me or for the brokerage, not the lender), and broker’s rebate to client (if any, and which if it exists is something paid by me the broker to you the client – a good thing in most client’s opinion). Psychologically a telling advantage, even if it doesn’t really mean anything.

At the bottom of page one, there are subtotals for fees paid to others and fees paid to brokers, and then an overall total. Then there’s a section which says “Compensation to Broker,” explicitly adding “(Not Paid Out of Loan Proceeds)”. In other words, this isn’t coming out of your pocket, although they could certainly give you better terms by reducing their compensation in the vast majority of cases. But the fact that one broker is making more than another (or is required to state explicitly what they make where a direct lender or “packaging house” originating their own loans is not) does not mean you’re not getting a better loan from them. Some brokers get discounts others do not. Some brokers disclose honestly and completely, others do not. Examine the loan you are getting – all of the terms, rates and conditions, and decide based upon those which loan is better. That’s what makes a difference to you. The rest is a matador’s red cape – a distraction from what is important.

Once again, this isn’t important to you, the client, but it has in passing performed a service to many workers in the loan industry. Many lenders give bigger brokers a volume rebate, over and above the basic per loan rebate, and the brokers were keeping this a secret from even their own workers lest they have to increase compensation. Now these brokers have to disclose it to the clients. This means the brokers have to tell the loan officers about it so they can disclose it. Now that all loan officers know about it instead of only a few, those who are high producers and have leverage can say, “I’m helping you make all this money. I want part of it.”

Page two of this two-page form starts with section I, which is a short accounting of the money. My inclination is not to trust this any more than anything on the Good Faith Estimate. In other words, whether this is accurate is likely to be a function of your particular loan officer’s good will more than anything else. Once again, the only form where there are real penalties for being inaccurate is the HUD-1, which comes at the end of the loan, not the beginning. But it’s a good intention, nonetheless, and perhaps one of these years it’ll actually mean something even if your loan officer is Simon LeGreedy or has a nose fourteen miles long. Proposed loan amount less costs, less other stuff of yours that’s getting paid off, less the purchase price of the home or payoff of existing loan. The idea is to give you an explicit “you’re going to get this much cash” or “you must pay this much cash to make this balance”

Section II is something I want to draw your attention to: Proposed interest rate is a good thing to have, although there is no more guarantee that this is the rate you’re going to get than a federal Good Faith Estimate. But it has a choice of two things to check off “Fixed Rate” or “Initial Variable Rate”. Just because Fixed Rate is checked does not mean the loan they are discussing is fixed rate for the full duration of the loan. Let me repeat that: Just because Fixed Rate is checked does not mean the loan they are discussing is fixed rate for the full duration of the loan. It might be fixed for thirty years – or it might be fixed for three months. This is a good place for unscrupulous loan officers to offer misleading information verbally, while checking the correct box doesn’t usually mean a whole lot.

Section III is proposed term of the loan. If something less than 360 months is written here (or whatever the amortization of the loan is in years), it’s telling you there’s a balloon at the end. Once again, there is no way to verify that if 360 months is what is written, it’s real.

Section IV is proposed loan payment. Ideally it’s computed based upon the amounts given in the previous three sections. Verify that it at least makes mathematical sense by running these numbers through an amortization calculator, or doing the calculation yourself. Many loan officers will play games with the payment because people shop loans based upon payment.

Section V: does the loan have a prepayment penalty, and on what basis? I’m glad to see this section here. I’ll be even gladder if and when I see evidence the answers mean anything in the sense of legal penalties for lying. Lying about prepayment penalties has been rampant for a long time. Lying about prepayment penalties is a good way to make an absolutely awful loan look pretty good. Lying about prepayment penalties gets someone to sign up with the loan provider who lies because of this. And when you find out at the end of the loan process, when they present the loan documents, that they were lying (if you even notice, which many are expert at making sure you don’t!), you may not have any good alternatives to signing those documents anyway.

Section VI basically tells you the lender cannot require credit life insurance or disability insurance. Many lenders would if they could. Not that disability insurance is a bad idea – quite the opposite in fact (I’m of two minds on credit life insurance, and this is not the place for that essay).

Section VII requires you the client to tell them, the lender about all the other liens on the property and hints at penalties for dishonesty. Not that the lender or broker is going to take your word for it, of course. But the gall of requiring a consumer to be accurate on this or face penalties, pay for the loan, etcetera when many brokers and lenders could submit the form to the Pulitzer committee for consideration in the category for best short fiction amazes me.

Section VIII is about Article 7, which covers loan amounts so small as to be irrelevant for all practical purposes in California. There’s also a bit about whether or not a broker is lending their own money. This is potentially both confusing and interesting, but beyond the scope of this essay. It’s good that they are requiring license numbers now. In California, you can easily look them up for past violations online at http://www2.dre.ca.gov/PublicASP/pplinfo.asp (many other states have similar registries). Not that someone without past violations is pure, and not that someone with them necessarily intends to do anything dirty to you. But it’s good information to know. Another good place to check them out is with the Better Business Bureau, which compiles information on every business, members or not, at http://www.bbb.org/ You’ll need a business name and address, phone number, or web site. Now, if they’ve got one strike against them, they could easily have been caught in circumstances beyond their control. But a pattern of abuses is a clear warning. A few days ago, I decided to risk $50 for a business card order with a company that has a truly awful rating BBB rating. The cards arrived two days later and I couldn’t be happier with any aspect of the transaction. But my next order from them won’t be any bigger until they have established a track record with me (and also I with them so they can see a long history of orders they want to keep coming, and which will stop if their service isn’t satisfactory).

Section IX explicitly tells you, the client, that this is not a loan commitment. This is good, so far as it goes. I’ve spoken to many otherwise intelligent people who somehow had acquired the idea that because a loan provider filled out a Good Faith Estimate, it meant the loan was a Done Deal. It most certainly does not mean anything of the sort. No real estate loan officer EVER writes a loan commitment, and it’s been that way for at least a couple of decades. Loan commitments are the exclusive province of the underwriter, who is intentionally and for anti-fraud reasons isolated from the client (i.e. the underwriter is not allowed to communicate with you directly). The most an ethical loan officer will say is “my experience does not show me anything that should cause you to have a problem”

Now, here’s the rub, and an indication of what this section really should say. Does it not stand to reason that if the loan is not a Done Deal at all, it most particularly is not a done deal on the exact stated terms?

Caveat Emptor.



UPDATE: The Jawa Report solicits trackback pings for postings of our choice, so here is one. Thank you!

For all of the rants I post about bad business practices, there are a lot of things the mortgage industry gets right. One of these looks like a red flag not to do business with them, and may seem like a cruel trick, but it is neither.

With every single loan that is done, you, the client, will get a package in the mail from the actual lender. It looks very official, and in fact it is.

Depending upon lender policy, it usually contains intentional mistakes on things such as the loan type, rate of the loan, or the points involved.

Every so often, I get a panicked phone call because I forgot to warn the client the package was coming.

The point of this particular package is not what it appears to be.

You see, every so often, somebody comes into the office and applies for a loan on a property they don’t own. Sometimes loan brokers actually go out and meet the client in their home, but other sorts of loan providers sit in their office and business comes to them. So the bank has really no way of knowing if this is the actually the person who owns or even lives in the property. So they mail a loan package to the property.

The idea is that if you haven’t applied for a loan, you’re going to speak up. You’re going to call the bank, the broker, and everyone else asking, “What the heck is going on? Is somebody else trying to get a loan on my property?”

This is the point of the particular package. It’s an anti-fraud measure. And it has just worked.

No matter which provider, no matter what type of loan you get, nobody is going to loan you money without the appropriate documentation. The more documentation you have that you are a good risk, the better the rate you are going to get, and the lower your costs are going to be.

Everybody hates filling out forms and providing documentation. There’s a billboard two blocks from my house advertising, “Stress free loans.” Actually, these signs are all over. And I’ll bet they bring in a lot of business. Low documentation loans are easy money – I could do them all day and all night, and make more money, and make the lender more money, while doing less work, than I can by hunkering down and actually serving my clients best interests. Those billboards say “stress free loans” which three words look like an English sentence meaning this will be easy, but the real translation to English reads, “Hello, I am a lowlife scum who wants to take advantage of lazy people who are too ignorant to know better by making a lot of money providing loans at higher interest rates and less favorable terms than they could obtain elsewhere.”

The fact is, that for something dealing with this much money, if there is documentation you can produce to prove that you are a better risk and gets you a better rate, you should be eager to present it. If I can spend half an hour instead of fifteen minutes filling out forms and as a reward I save $40 or more every month until the next time I decide to refinance, I want to fill out the extra papers. If I refinance every two years, I have essentially been paid $960 for a quarter hour of work. That works out to $3840 per hour. I don’t know about you, the reader, but even when I’m completely inundated with clients, I don’t make that kind of money per hour. I don’t know any job that pays that much, unless you want to include wealthy investor. And let me tell you, the wealthy investors I’ve dealt with are eager to spend the extra time filling out said forms. It really is a “Rich Dad, Poor Dad” situation. They know it will Save Them Money, and don’t have to be sweet talked into filling out one more form or providing a little more documentation. They’ve got it already copied for me, and if I want their business, I’d better buckle down and get to work on finding the loan with the best terms possible. If you, the reader, wish to be wealthy, you could do worse than emulate their example.

There are, when you get right down do it, three different levels of documentation. The lowest level of documentation is NINA, which is short for “No Income, No Assets.” There are other names for it (“No Ratio” being the most common). This is a loan where the rate you get is purely driven by your credit score (as well as other factors, such as the equity in your home or down payment you’re making, but those are constants endemic to the situation, not variables about which I am talking). You’re not even documenting that you have a source of income. You’re basically saying, “Here I am! Gotta love me!” to the bank, and they really do love you because you’re filling their coffers by paying the highest rates for your loan. Guess what? You’re still filling out all the forms (or somebody is doing so on your behalf, which they can do to the same extent on other loan types!), and you’re still providing all the documentation on the property – how much it’s worth, proving you own it, proving the taxes are current, etcetera. Owing to identity theft laws, you can expect to have to provide two things that basically show that you are you. You can expect to deal with problems if the county doesn’t show the taxes as current, your landlord or current mortgage holder shows you as being behind or that you have a history of being behind or the county doesn’t show you officially in title of record, or any of a host of other potential problems, but hey, at least you didn’t have to show that you’ve got a source of income!

The next level of documentation is a “Stated Income” loan. This is where you document that you’ve got a source of income, but not that said income is sufficient to justify the loan, so you tell the bank you make that much, and they agree not to verify the actual numbers. This is going to require two additional items: verification of employment, or a testimonial letter if you are self-employed, and reserves. Reserves are quickest to explain. Industry standard is money sufficient to pay the loan, your taxes, and your homeowner’s insurance for six months, in a form that is sufficiently liquid such that the money can be accessed, for a long enough period that the bank will believe it isn’t borrowed – and the bank will require documentation of its availability if it’s in an account type such as 401k where access may be restricted. Verification of your employment is somebody in the HR department filling out a form on your behalf and verifying it over the phone. The testimonial letter for self-employed borrowers comes from your lawyer, accountant, or tax preparer on their letterhead saying that you really do have a legitimate business. It basically reads: “To whom it may concern. John Smith is self-employed as the owner of business X. He has been doing this for Y years. Based upon information provided to me, he will earn the same amount of money this year as last year.” The person providing the testimonial must sign the letter. It really is only three sentences, but that person is putting their business on the line for you if it’s not true. So they tend to require evidence if you’re coming to them for the first time to get this letter written and signed.

The bank is basically looking for two years in the same line of work or at the same company to approve this one. Sub prime lenders may take a year or even six months, although their terms will not be as favorable. What the bank is looking for is evidence that you can really afford the loan. “He’s got a source of income, He’s got a good credit score, he’s making all his payments, he’s got money in the bank, okay, we think he’s living with his means and can afford to pay us back. We’ll lend him the money.” There are variants on stated income of which “stated income, stated assets” is the most common, but these carry higher rates, higher charges, or both, in many cases actually end up looking more like a heavily propagandized NINA loan than anything else.

I’ve heard Stated Income (and NINA) commonly referred to as “liars loans”, and they are often used for such, but that is not their intended use. As a matter of fact, people get in a lot of trouble with these loans, and many times it comes back on an unscrupulous loan officer or real estate agent trying to push something through for which their clients really aren’t qualified. If you can’t afford the payment, am I doing you a favor to qualify you for the loan? I submit that I most emphatically am not. On the other hand, I’ll admit to having used the loans for that purpose in the past, but an ethical loan officer using it for this purpose should sit down, tell the people what the real payment is going to be, and make certain they can afford it – sometimes they’re renting and their effective cost of housing is going to go down! And in that case, I submit that I probably am helping them if I push the loan through. On the other hand, if you’re doing Stated Income or NINA (especially on a purchase) and the loan officer doesn’t sit you down and cover what the payment is going to be within a couple dollars per month, and make certain you’re okay paying it, this is a red flag in no uncertain terms!

What Stated Income is meant for is self employed people and people working on commission who really do make the money, but have write-offs such that their taxes aren’t going to show enough income. Or people who had a bad year, or large losses or high write offs one year, but are still basically solid.

The highest form of documentation is Full Documentation (almost everyone says “full doc” because the unabbreviated phrase is a mouthful). This does not necessarily mean I’ve got to prove to the bank that you make every penny you actually make, but only that you make enough to justify the loan. The proof the bank will accept is very straightforward. Self-employed borrowers are still going to need that testimonial letter from stated income. They will additionally be asked for their federal income tax packet. This is all of the forms, front and back, that you sent to the IRS last April 15th, and perhaps the April 15th before that, too. It’s got to be a signed copy, and it must include copies of any w-2s or 1099s that you get. People in the construction profession, as well as those who may be w-2 employees but work on commission will also need to furnish their taxes, and the bank’s underwriter can always require it of anyone. It is to be noted that banks do not have to accept your loan on a stated income basis – they can require that you furnish full documentation.

Those people who are hourly or salaried employees of a company can usually get by the full documentation of income requirement with just w-2 forms. If you are a company employee, the last 30 days worth of pay stubs will also be required.

The basic rationale for this is simple. Very few people tell the IRS that they make more money than they do, because the consequence is higher taxes. So the bank is willing to use tax forms to prove your income. In the case of a w-2 employee, the company is telling the IRS that those are the wages it paid you, and therefore wants a deduction for, and you went and paid taxes on it, so the bank will usually accept that. Similarly, your pay stubs should have year to date pay on them. Here the bank will accept the word, metaphorically speaking, of a third party without a stake in the outcome of the loan.

A subset of the full documentation loan is the streamline refinance. As the name indicates, it is available on refinances only, not purchases. There are a lot of limits on these loans, but when I get to do one it is the easiest of all loans. Basically, it’s a case where the same lender is now offering better rates, and no equity is being taken out of the home, and they’ll allow you to do it because otherwise you’ll take this client elsewhere. 90 percent of a loaf is much better to them than none.

Within the sub-prime mortgage world, they will often take the deposits from 12 consecutive months of bank statements (sometimes 6 or 24), usually discounted by a certain amount, and accept that as proof of income. This is called EZ doc, although there’s nothing easy about it and as a matter of experience there are more fights with the underwriter and jumping through hoops here than with any other type of loan documentation. The rates are somewhat higher than for full documentation, but not nearly the rates for stated income. Mind you, sub-prime rates are higher in the first place as well. Furthermore, many of these sub-prime lenders will advertise the fact that “EZ doc rates same as full doc!” I shouldn’t have to explain to adults that this translates to English as they don’t give the lower rates to true full documentation loans, now should I?

So, on the subject of documentation, I think you should be able to tell that the higher the quality of your income documentation, the lower the rate that you are going to get from a given lender. If you can qualify, a full documentation loan is probably going to save you more than enough money to pay you to do the extra paperwork, which is marginal anyway. The only reason not to do one is if you can’t supply proof that you make enough.

And as one final warning: If a loan officer requires originals not only of the forms they ask you to sign (original signatures required – really!), but of your own documentation, it is a BIG RED FLAG. I can’t think of any document that lenders will not accept copies of. The only reason to require your originals is that they don’t want you able to apply for a loan with someone else, so they’re putting an end to your shopping, and once they’ve got them, good luck trying to get them back (at least until the loan is done so they get paid). A good loan officer needs good readable copies – not your originals.

Caveat Emptor!