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November 17, 2003, Revised December
20, 2005
�I have been offered a deal where I take
over the home seller�s mortgage. What are the pros and cons of doing this?�
Benefit of Mortgage Assumptions to Buyers
When
a homebuyer assumes responsibility for a home seller�s existing mortgage, it
is called an �assumption�. The buyer assumes all the obligations under the
mortgage, just as if the loan had been made to her.
The
major driving force behind assumptions is the lower interest rate on the assumed
mortgage relative to current market rates. If the home seller has a 5.5 %
mortgage, for example, and the best the buyer can get in the current market is
7%, both parties can be better off if the buyer assumes the 5.5% loan. An
assumption also avoids the settlement costs on a new mortgage.
For
years, we heard little about assumptions because market rates were so low. Now
that rates are above their lows, and may rise further, we can expect that
assumptions will receive increasing attention.
The
value of an assumption depends on the difference in rate, the balance and period
remaining on the old loan, the term of the new loan, on how long the buyer
expects to have the mortgage, and on the �investment rate� � the rate the
buyer could earn on her savings. Assuming that the 5.5% loan has a $100,000
balance with 200 months remaining while the 7% loan would be for 30 years, that
the buyer expects to be in the house for 5 years and can earn 4% on investments,
the value is about $7,000. A spreadsheet that makes this calculation is
available on my web site.
The
$7,000 of savings does not include the settlement costs on a new loan. On the
other hand, the savings would be reduced if the buyer has to supplement the
existing loan balance with a new second mortgage at a higher rate. This could
well be the case if the existing loan balance has been paid down appreciably,
and/or the house has appreciated since that mortgage was taken out. The buyers
who do best on assumptions are those who have the cash to pay the difference
between the sale price and the balance of the old loan.
However,
buyers should not expect to receive the full value of an assumption. The seller
must benefit as well; typically, the parties share the savings. The seller�s
share will be in the form of a higher price for the house. Indeed, some
economists believe that the full value of the assumption should be reflected in
the price of the house, but this is as implausible as the opposite view, that
only the buyer benefits.
Lender Attitudes Toward Mortgage Assumptions
The
benefit to buyer and seller from assuming an old loan comes at the expense of
the lender. Instead of having the 5.5% loan repaid, which would allow the lender
to convert it into a new 7% loan, the 5.5% loan stays on the books. Back in the
70s and 80s, lenders couldn�t do anything about this. Mortgage notes at that
time did not prohibit assumptions, and the courts ruled that lenders could not
prevent them.
Following
that experience, however, lenders have inserted due-on-sale clauses in their
notes. (An exception is FHA and VA mortgages, which do not contain these
clauses, see below). These stipulate that if the property is sold,
the loan must be repaid. Even with
a due-on-sale clause, the lender may allow an assumption -- keeping the loan on
the books avoids the cost of making a new loan � but the interest rate will be
raised to the current market rate.
Assumptions Using
a "Wrap-Around" Mortgage
Raising
the interest rate to market removes most of the benefit of the assumption to the
buyer and seller. In some cases, they attempt to retain the benefit by agreeing
to a sale using a wrap-around mortgage, without the knowledge of the lender. The
seller takes a mortgage from the buyer, which may be for a larger amount than
the balance of the old loan, and continues to pay the old mortgage out of the
proceeds of the new one. The new mortgage �wraps� the old one.
This
is a dangerous business, particularly to the seller, who has given up ownership
of the house but retained liability for the mortgage. The seller is in deep
trouble if the buyer fails to pay, or if the lender discovers the sale and
demands immediate repayment of the original loan. I wouldn�t do it, even if I
were selling the house to my mother.
Allowing Assumptions at a Price
Instead
of prohibiting assumptions, thereby encouraging wrap-arounds, why don't lenders
explicitly allow them for a price?
Good
question. When interest rates are above their lows and new borrowers are
concerned that they could go much higher, some would be willing to pay a premium
rate for the right to transfer that rate to a home buyer in the future.
For
example, a borrower taking a 6.5% 30-year FRM might be willing to pay 6.875% for
the right to allow a home buyer to take it over when he sells his house. The
higher rate is akin to an insurance premium. If market rates are above 16% when
he sells, as they were in 1981, he will save a bundle.
An
assumable mortgage has some resemblance to a portable mortgage. If you sell your
home and your mortgage is assumable, it can be transferred to the buyer; if it
is portable, it can be transferred to a new property you buy. Portability is of
no value if you decide to rent, go to a nursing home, or die, whereas an
assumable mortgage retains its value in these situations. On the other hand,
some portion of the value of an assumable mortgage must be shared with the
purchaser. A mortgage that is both assumable and portable would have enhanced
value.
Lenders
who offer an assumability option will require that any new borrower meet the
lender�s qualification requirements. Borrowers purchasing the option will need
to be confident that the lender won�t tighten its requirements when market
rates increase. The best assurance would be a commitment to accept approval
under one of the automated underwriting systems developed by Fannie Mae or
Freddie Mac.
Assuming FHA and VA Mortgages
Loans
insured by FHA or guaranteed by VA have always been assumable. During periods
when borrowers are concerned about future rate increases, this gives them an
edge.
FHA
loans closed before December 14, 1989, and VA loans closed before March 1, 1988
are assumable by anyone. Buyers who assume these mortgages don�t have to meet
any requirements at all, but the seller remains responsible for the mortgage if
the buyer doesn�t pay.
Any
seller who allows assumption by a buyer without a release of liability from the
lender is
looking for trouble. Even if the buyer pays, and that is a crapshoot, the
seller�s ability to obtain another mortgage will be prejudiced by his
continued liability on the old one.
WARNING:
The release of liability from the lender must be in writing, and you must preserve the document.
This will protect you in the event that the new borrower defaults and the
collection agency comes after you � it knows nothing about your release of
liability. This happens!
If
an old FHA or VA is attractive to a buyer, the seller can request that the
agency underwrite the buyer. If the buyer is approved, the seller will be
released from liability. At this
point, there can�t be many of these loans left with balances large enough to
be attractive to buyers.
Assumption
of FHA and VA loans closed after the dates shown above requires approval of the
buyer by the agencies. The process is much the same as it would be for a new
borrower. Upon approval of the buyer and sale of the property, the seller is
relieved of liability. FHA allows lenders to charge a $500 assumption fee and a
fee for the credit report. VA allows a $255 processing fee and a $45 closing
fee, and the VA itself receives a funding fee of � of 1% of the loan balance.
FHA and VA
loans that were closed during the low-rate years 2000-2003 will become
attractive targets for assumption if interest rates continue to rise. Potential
sellers who have one of these loans can use the spreadsheet on my web site to
estimate how much the assumption would be worth to a potential buyer.
Copyright Jack
Guttentag 2003
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