Unconventional Wisdom

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Ah, for the good old days, when financing a house purchase was a relatively simple matter.

All a home buyer needed was enough cash for a down payment and a respectable credit rating. The lender usually was a local bank or savings and loan, where the buyer likely kept the family savings and checking accounts.

Lenders offered pretty much the same terms to just about every borrower: a down payment of 20 percent (or more) of the purchase price and a mortgage financing the remainder at a fixed rate to be paid off over 30 years.

The lawyer’s role in the mortgage process was to review a few loan documents, explain them at closing and show the client where to sign.

Those “good old days” of residential mortgage loans aren’t all that ancient–most real estate lawyers still remember them fondly.

And the mortgage process never really was that simple, of course–it just seems that way when viewed through the prism of today’s free-wheeling mortgage marketplace.

The array of mortgage loan alternatives now available is a key factor helping to fuel a residential real estate market in the United States that, despite occasional dips, shows no signs of slowing down. Buyers pressured by relentless increases in home prices often seek nontraditional loan arrangements that allow them to drive their financial resources right to the edge in order to make their purchases. That type of brinksmanship carries risks as well as rewards.

“The main thing driving the introduction of these new mortgage products is that the housing market is so hot,” says Orlando Lucero, a real estate lawyer and vice president of Stewart Title in Albuquerque, N.M. “Builders and others are trying to get more people into homes.”

The U.S. Census Bureau reports that 69.2 percent of households owned their homes during the last quarter of 2004. That’s the highest level of home ownership since at least 1980, according to the bureau’s figures, although ownership rates have topped 60 percent throughout the past quarter-century.

Sales figures also reflect a housing market that continues to boom even in the midst of an unpredictable economy.

A Steady Climb

The Census Bureau reports that sales of new single-family houses in March 2005 increased by 12.7 percent over a year earlier, to a seasonably adjusted annual rate of 1.43 million. (“Seasonally adjusted” refers to the number of houses that would sell if a particular monthly rate were applied to the entire year.) Meanwhile, the National Association of Realtors reports that total existing home sales–condominiums, townhouses and co-ops as well as single-family houses–reached a seasonally adjusted rate of 6.89 million, the third highest pace on record and a 4.9 percent increase over March 2004.

The market has been bolstered by some of the lowest interest rates since the late 1970s, but sales prices also are climbing steadily. The national median existing-unit price for all housing types in March was $195,000, an increase of 11.4 percent over March 2004, reports the National Association of Realtors. Prices for new houses also continue to rise.

Income, however, hasn’t matched the increases in housing prices. The Census Bureau says median income for U.S. households in 2003 did no better than remain unchanged from 2002. In the previous two years, median household income dropped.

In the face of these trends in the U.S. housing market, nontraditional loans with various types of no down payment, interest-only monthly payment, adjustable rate and minimum payment features are appealing, particularly to first-time homeowners.

In 2004, the National Association of Realtors says, 42 percent of first-time home buyers put no money down on their purchases. Another 27 percent put less than 10 percent down. In all, 81 percent of first time buyers last year made less than the once-customary 20 percent down payment on their homes.

“There’s no such thing as traditional financing anymore,” says Christopher Ross, who practices real estate law in Bellport, New York, which is on Long Island.

That isn’t necessarily a bad thing, says Aurora N. Abella-Austriaco, a Chicago lawyer who is president of the Illinois Real Estate Lawyers Association. She applauds the fact that alternative mortgage products have allowed more buyers–especially first-timers–who wouldn’t qualify for conventional mortgages to enter the market. But she also cautions that it can be difficult for buyers to fully appreciate the complexities inherent in many forms of unconventional mortgage financing.

“People are so eager to buy, they sometimes take the short view and only look at the total payment at the beginning of the loan,” says Abella-Austriaco, who chairs the Single Family Residential Committee in the ABA Section of Real Property, Probate and Trust Law. “Sometimes it’s the lawyer who needs to lead them through the full investigation of what this loan will end up costing them, and then let them decide if they can afford it.”

Sorting through the complexities of unconventional mortgage products can be a daunting task for the lawyer as well as the client, particularly because they so often contain variables that make it difficult to project with any certainty such key elements as interest rates and monthly payments during the life of the loan.

Ross says he frequently sees loans advertised as fixed when the interest rate actually is only locked in for a short time–usually anywhere from one to five years. Many clients, he says, are unaware that a variable rate means their payments could increase significantly if interest rates jump.

And too many buyers, Ross says, choose mortgages that are beneficial only if the equity in their homes maintains a steady climb. In many cases, he says, that kind of risk should be avoided with a primary residence because there is no guarantee about how–and how fast–values will change.

As a lawyer, Ross says, “you have to be really good at explaining to people just what they’re getting into. They have no idea how high interest rates will be in three years, much less 10 or 20. If they’re already stretching to afford the house, they could lose it.”

But it’s not just the mortgage loans themselves that have gotten more challenging, say real estate practitioners. The entire loan approval process is more complicated.

One factor has been the emergence of mortgage brokers, who “shop” borrowers to lenders around the country. Lawyers say a broker can be a great benefit to a home buyer who isn’t sure where to seek a loan and can help effectively troubleshoot problems. But they also cite cases in which brokers steered borrowers toward mortgages that weren’t appropriate for their finances. Using a mortgage broker also adds another party to the process and reduces direct contact with the institution that will actually provide the loan.

Another area of concern for lawyers is the growing frequency of real estate files that have “RUSH” stamped on them.

Michael Sweeney, who practices real estate law in Madison, Conn., on Long Island Sound east of New Haven, says more and more contracts call for closings to take place in as little as two or three weeks. That means the buyer’s attorney often has only a few days to review the mortgage and other closing documents prepared by the lender, the seller’s attorney and the title company.

The growing popularity of electronic closing packages adds to the already frantic pace of many closings, Sweeney says. Changes in interest rates, fee add-ons and other surprises often show up in final versions of a lender’s paperwork that come over the wires literally minutes before closing, he says.

“The alleged advances in productivity for lenders using e packages don’t mean my job in reviewing them takes any less time,” Sweeney says. “I’d like to eliminate e-packages altogether.”

Lucero says lenders sometimes will fax preliminary loan documents to him a day or two ahead of time so he has more time to review them before closing. When that’s not possible, he says, he doesn’t hesitate to take as much time as necessary at closing to make sure that both he and his client understand the documents.

“For most people, this is the biggest investment they’ll ever make,” Lucero says. “We need to make sure it’s done properly.”

Other lawyers say they keep a careful eye out for unanticipated last-minute charges that can add to the already heavy financial burden buyers are about to take on.

Abella-Austriaco says it is a good idea to check the charges in the final loan documents against the good faith estimate that federal law requires lenders to give borrowers at the start of the loan approval process. Comparing the two documents sometimes reveals “junk fee” add ons that lenders failed to disclose to buyers in the good faith estimate.

“If you see things like ‘yield spread premium’ or ‘administrative fees’ or ‘document prep,’ you know they’re junk fees,” Abella Austriaco says. “You can call the lender right there and ask for those things to be removed. And if they’re not on the GFE, they pretty much have to remove them because they weren’t properly disclosed.”

Lawyers say it also is important to make buyers aware of charges that may not be on the GFE, such as property tax escrows, property insurance and, in the case of condos, monthly assessments payable to the owners’ association for upkeep and repairs to common areas. Otherwise, buyers may not be aware of the impact those charges can have on overall monthly payments until it’s too late to figure out how to absorb them.

Buyers also should be aware of the potential financial impact of big hikes in property taxes that could affect the property they’re buying, practitioners say.

The Arms Race

The first major break from conventional loans in the residential real estate market came in the form of adjustable rate mortgages. ARMs first gained widespread attention in the late 1970s as conventional mortgage rates took a dramatic turn upward, eventually reaching as high as 12 percent or more. Lenders began making loans widely available that pegged interest rates to various economic indexes and often provided an initial low rate for the first few years of the loan.

Today, those early types of adjustable rate mortgages might seem downright stodgy, but the principle of variability that they introduced to the mortgage equation is still the basis for many of the more innovative mortgage products now available to home buyers.

An adjustable rate component still is an effective way to hold down monthly payments during the first few years of a mortgage while below-market interest rates are in effect. But over time, those rates catch up to and even surpass the market rates. For that reason, Lucero says, adjustable rate mortgages work best for buyers who expect to own the house only a few years. But ARMs can be trouble for buyers who try to use the initial low interest rate to help them stretch their finances to obtain a dream house they can’t really afford if adjustments in the monthly payments eventually increase beyond their means, he says.

Because of the uncertainty about how monthly payments may change under an adjustable rate mortgage, a borrower should fully understand how soon, and by how much, those payments could change, Abella-Austriaco says. Buyers also should be aware, she says, that they might have to pay a hefty charge to refinance if the ARM includes a prepayment penalty.

Lenders have started offering products that seek to split the difference between the certainty of fixed-rate mortgages and the initial savings of ARMs.

A variable-rate, fixed-payment mortgage, for instance, keeps the buyer’s payments level for a period of years, even though the loan’s interest rate still may fluctuate. The danger with such a loan is that the buyer could wind up with negative amortization–in other words, the borrower owes more money on the loan than what the mortgaged property is worth.

To Westfield, N.J., real estate lawyer James M. Miner, this type of loan is a classic example of a buyer focusing on the total initial monthly payment and failing to consider what may happen a year or two down the road. While a lawyer can’t prevent a client from taking such a loan, Miner says, the lawyer should make sure the client understands the potential downside.

Interest-only loans also are becoming increasingly popular with home buyers seeking to stretch their purchasing power. These loans typically require the borrower for an initial time to make payments equal only to the monthly accrued interest on the loan. During that time, the borrower doesn’t pay down any of the loan principal, so the only gain in equity would come from an increase in the value of the house.

As with so many unconventional mortgages, an interest-only loan may be beneficial if the buyer stays in the house for a short time–usually less than five years–say Abella-Austriaco and other experts. Ross says an interest-only loan may be effective for a borrower with a reasonable expectation that income will increase significantly by the time principal is added to the payments. The borrower also should recognize that a sale of the property will likely produce less equity.

A recent twist on the interest-only approach is the cash-flow adjustable-rate mortgage. This type of loan gives borrowers the option of paying a monthly minimum that may not even cover the total amount of accrued interest. Brokers tout these loans as ideal for self-employed people and others whose income tends to fluctuate during the year. During periods of low cash flow, the borrower can make the minimum payment. At other times, the borrower makes a normal payment that includes principal and interest.

Problems can arise, practitioners say, when buyers make the minimum payment too often. Doing so can actually cause the total balance on the loan to increase, rather than decrease, since unpaid interest is capitalized to the balance of the loan. Eventually, the buyer may owe more on the loan than the current value of the house, and the lender may revoke the minimum payment option.

So-called piggyback loans are another mortgage product becoming increasingly popular for the growing ranks of buyers seeking to avoid making significant down payments on their home purchases.

A key drawback of low down payments is that, while lenders are willing to approve mortgages to buyers who pay as little as 5 percent and sometimes even nothing up front, federal law allows a lender to require such a borrower to purchase private mortgage insurance whenever the amount of a loan exceeds 80 percent of the home value. PMI premiums can be a costly add on to monthly mortgage payments.

Proceed With Caution

Many lenders allow borrowers to avoid PMI payments by taking out two loans: one for the standard 80 percent of the purchase price, and the other, often in the form of a home equity loan, covering the remaining 20 percent. This piggyback approach is commonly referred to as an 80-20 loan.

An 80-20 loan does provide a way out of paying for private mortgage insurance (which protects lenders from loss in the event of a default), Lucero says. But a buyer should consider this type of loan cautiously, he says, because it requires the entire purchase price to be financed. The lender should be asked to disclose the cost of private mortgage insurance, he says. In some cases, that may cost less per month than paying off the second loan, which may be treated as a home equity loan or revolving line of credit that carries a higher interest rate than a standard mortgage.

Lucero also notes that PMI is only temporary. After the loan to value ratio drops below 80 percent, the buyer is entitled to have the insurance canceled.

Another reason for caution about piggyback loans is that Congress is giving some thought to the notion of eliminating income tax deductions for interest paid on home equity loans.

In January, the Joint Committee on Taxation, which includes members from both the Senate and the House, proposed that step, which would produce an estimated $22.6 billion in federal tax revenue during the first four years. The proposal still is in committee, but even if it dies there, Lucero says, borrowers should be aware that, under current federal tax law, interest on second mortgages is not deductible to the same extent as interest on primary mortgages.

1031, Good Buddy

Just as homeowners enjoy the benefit of deducting mortgage interest on their federal income taxes, a tax avoidance–or, more accurately, a tax delay–vehicle also exists for those who venture into real estate investment.

Section 1031 of the Internal Revenue Code permits the owner of investment real estate to defer capital gains taxes on its sale if the proceeds are used to purchase a similar type of investment property. To qualify, the new property must be identified within 45 days of selling the first property, and the closing on the new purchase must take place within 180 days of selling the first property.

While 1031 exchanges–also called like-kind exchanges–are generally limited to investment properties, the owner of an apartment building who lives in one of the units may, for instance, qualify even if the new property purchased is commercial.

While 1031 exchanges appear tempting to potential real estate investors, they have fostered more interest than action because their rules are daunting to people who don’t deal with them on a regular basis, says Adam Shapiro, a real estate lawyer in Philadelphia. Moreover, 1031 exchanges aren’t always suitable to the circumstances for investors who dabble in real estate or for sellers who aren’t necessarily looking to purchase another property, he says.

But there are ways people in these circumstances can take advantage of section 1031, according to Shapiro and other real estate practitioners.

The owner of an apartment building or a small commercial property, for instance, may want to sell the property as retirement approaches without taking on the burden of owning a new piece of investment property. But just selling the property may result in capital gains taxes that significantly eat into the proceeds.

For this person, a standard 1031 exchange probably is not a viable option, according to Shapiro. But it may be possible to roll proceeds from the sale into an exchange company that invests in many properties and pays dividends to its members. Exchange companies usually charge fees and members must pay capital gains on dividends for the year in which they are received, he says. But the biggest drawback to this approach is the high buy-in price–often several hundred thousand dollars.

Another caveat for real estate owners considering 1031 exchanges is that, if property that was part of a 1031 exchange goes to heirs after the owner’s death, tax advantages may be lost, Shapiro says.

Heirs usually can exclude capital gains taxes on the value of the property as of the date of the decedent’s death–known as “stepped up basis.” But if previous capital gains were deferred via a 1031 exchange, the stepped-up basis is lost and the full capital gain is taxable, Shapiro says. “Sometimes, it’s actually better to pay the tax now rather than later.”

Real estate financing has become a more complex matter for lawyers as well as buyers, Connecticut lawyer Sweeney says. The complexity is unlikely to go away. So, he says, “if I could change one thing, it would be the perception of many lawyers that real estate is easy.”

Margaret Graham Tebo, a lawyer, is a senior writer for the ABA Journal.

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