Tough new rules limit refinancing optionsPeter G. Millersub-prime, adjustable-rate mortgage, foreclosure, Freddie Mac
Imagine driving along the highway. You run over some glass, and
a tire goes flat. It's no problem, because there's a spare in the
For the past several years, real estate buyers have had a
financial spare tire--a backup system that was always there if
times got tough. But now that spare tire is about to disappear in a
vanishing act that will surprise some borrowers and bankrupt
others. What happened?
The "smart" play in real estate between 2001 and 2006 was to buy
as much property as possible, finance with little or nothing down
and then make the smallest allowable monthly payments.
Such a strategy made sense in a world where home values "always"
rose and lenders provided ideal forms of financing, loans where
initial monthly payments equaled no more than the cost of interest
and sometimes less.
But now the game has changed. Freddie Mac, a major buyer and
packager of mortgages, has announced that starting in September, it
will substantially change the way it purchases sub-prime
adjustable-rate mortgages (ARMs). From this point forward, loans
with little money down and tiny payments up front are going to be
much tougher to get.
Freddie Mac will not buy sub-prime loans unless the borrower is
qualified to pay for the loan at its fully indexed and fully
amortizing rate and not merely an upfront and low-ball "teaser"
Freddie Mac will require stronger proof of financial capacity.
For most borrowers, this will mean showing tax returns and W-2
Freddie Mac wants sub-prime lenders to collect money each month
to ensure that property taxes and insurance are being paid.
"Right now," said Jim Saccacio, chairman and CEO of RealtyTrac.com, "the new
Freddie Mac standards apply only to sub-prime loans--mortgages used
to finance borrowers with high-risk credit records. However, the
potential for excess risk also exists for loans for more qualified
borrowers. The result is that borrowers in every credit category
would be smart to assume that mortgage standards are about to
tighten throughout the marketplace."
Freddie Mac's rules are important, because they create big
profits for lenders. Freddie Mac buys loans from lenders--lots of
loans. According to The New York
Times, the company has purchased sub-prime loans totaling $184
billion (see "Freddie Mac Tightens Standards," Feb. 28, 2007).
The catch is that Freddie Mac only wants loans that meet its
standards. If you're a lender, you want to meet the requirements of
Freddie Mac and other mortgage buyers, because then your loans can
be quickly sold. Once sold, the cash you receive can be used to
create new loans, new fees and new profits.
While the new Freddie Mac standards will plainly impact new
borrowers, the real marketplace worry concerns those who now have
loans, but will need to refinance in the next few years.
Between 2001 and 2006, millions of properties were financed with
interest-only and option ARM financing, loans that allowed
borrowers to make low monthly payments during initial start
periods--the first few years of the loan. Borrowers with such
financing know (or should know) that once initial start periods
end, the loans can only be continued with far higher monthly
payments--in some cases, payments that will double.
Despite the potentially bankrupting impact of such larger
monthly payments, most borrowers did not worry, and with some
reason. As start periods ended, properties could be refinanced so
borrowers could get another few years of low monthly payments.
Now, however, the ground rules have changed.
First, if the original loan was obtained with a stated-income
mortgage application that contained, shall we say, generous and
unchecked income estimates, new applications would demand
verifications and proof. Without evidence of real income, borrowers
would be unable to refinance.
Second, if the original loan application were obtained with a
full-documentation application that had every number checked and
verified, the borrower would still have to meet new and tougher
qualification standards to refinance.
In practical terms, suppose buyer Dixon qualified to borrow
$200,000 in 2005. Though he now has the same income and credit, and
can document everything, his loan application will be judged on his
ability to pay the real monthly cost of the loan and not just a
payment based on an upfront teaser rate. What's the result? It may
be that he can only borrow $175,000 in 2007.
This means Dixon cannot refinance unless he can also pay down a
substantial chunk of his existing debt in cash ($25,000, in this
example). Without the additional cash, Dixon is effectively locked
into his existing loan, the very loan that he doesn't want to pay
or perhaps can't afford to pay once the start period ends.
For some borrowers, the new rules mean existing
loans--especially recent loans--cannot be refinanced.
Unfortunately, the alternatives to refinancing may also be
unworkable because larger payments may be unaffordable. In slowing
markets, homes may not sell at a profit and rents may be
insufficient to cover monthly mortgage costs. For too many
borrowers, it will no longer be possible to delay mortgage problems
by refinancing, an option that could have prevented foreclosure and
Are the new standards too harsh? Did Freddie Mac do the right
"Freddie Mac," said Saccacio, "deserves credit for being the
first to make a terribly tough choice. It's the right decision--one
that will be painful now, but a strategy which will ultimately
result in far fewer foreclosures, a reduced number of lender
failures and smaller investor losses."
Peter G. Miller is the author of "The Common-Sense Mortgage"
and is syndicated in more than 90 newspapers. He may be reached at
(301) 593-0970 or e-mail [email protected]