Imagine that a household has two wage-earners who take in $100,000 per year. Lenders allow them to finance with monthly payments equal to 31 percent of their income or $2,583 per month. If $100 per month goes to property insurance and $400 a month goes for property taxes, that leaves $2,083 per month for mortgage interest and principal payments. At 5 percent interest that’s enough to borrow $388,025.

Okay, now go back to that household income. If the household income is paid out with a check on the 15th and the 30th of each month then each check is worth $4,166 — before taxes, social security and Medicare. Subtract those costs and you’re looking at roughly $3,500 twice a month.

That sounds like a lot of money, at least until you mention auto insurance, car payments, credit card debt, student loans, state income taxes in most jurisdictions, health insurance and other costs. Suddenly the monthly mortgage bill looms large.

But what if interest and principal payments could be reduced to $1,041.50 every two weeks? Not only that, the loan will be paid off several years earlier, saving more than $63,000 in lifetime interest costs. Would you be ahead?

The Bi-Weekly Diversion

With monthly payments for principal and interest we’re paying $2,083 per month for the standard 30-year mortgage. That sum, times 12 monthly payments, equals $24,996 per year.

With the bi-weekly we shell out $1041.50 per payment. A payment every two weeks means there are 26 payments per year or a total of $27,079 annually.

The reason a bi-weekly mortgage results in a shorter loan term is not because of magic, it’s because you’re paying more to reduce the loan balance each year. The result is a shorter loan term, around 25 years rather than 30. Most of the interest savings come from not having to make mortgage payments for the last five years of the mortgage.

Bi-Weekly Marketing

We all routinely receive third-party bi-weekly mortgage offers, third-party meaning not from our lenders. Such third-party companies want to set up a bi-weekly loans for us, usually for a start-up fee and a charge with each payment. And they’re willing to do this without the need for a credit report or loan application.

So what’s the problem?

1. A mortgage is a contract between a borrower and a lender.
2. The third party bi-weekly company is not your lender.
3. Because the third-party bi-weekly company is not a lender it does not need your credit report or a loan application. It has nothing at risk, no money has been advanced to you.
4. While the third-party bi-weekly company collects your money, your lender is not obligated to accept payments every two weeks.
5. In other words, the bi-weekly company collects your money and simply makes 12 larger payments.
6. The money given to a third-party bi-weekly mortgage company is money that could have gone to reduce your mortgage or other debts.
7. If you’re paid on the 15th and 30th of the month you receive 24 paychecks a year — not 26. This means your paycheck schedule differs from a bi-weekly payment plan.

But wait, isn’t the third-party company audited? Maybe, but so what. Even if a third-party company is audited the point remains that you have to make required payments to your lender every month.

How about insurance for the third-party company? Insurance to cover what? How much coverage is available? Who is the beneficiary? How long will it take to collect? And, again, so what? Your agreement to repay the loan is with your lender and no one else.

Of course, no one mentions what happens if your third-party bi-weekly helper makes your payment late — or worse, doesn’t make the payment at all. It’s your credit that will be impacted, you who will have to quickly come up with any unpaid balance and you who will face foreclosure if you don’t have the money.

Lastly, are you ahead prepaying your mortgage or is the money better spent reducing credit card balances and other debt?

The Right Way To Get Bi-Weekly Benefits

If bi-weekly mortgage payments make sense from a math and personal finance perspective why not take advantage of the concept in a way that costs nothing extra?

First, see if your loan allows prepayments in whole or in part without penalty. Most payment forms allow you to add extra principal with each payment and that’s what you need.

Second, take your current mortgage payment — the amount you pay for principal and interest — and add 8.5 percent. Make the larger payment each month. Example: If you owe $1,000 for principal and interest add $85 for additional principal. Remember that you must also pay taxes, insurance and other required costs.

Third, check your mortgage balance each month to assure the additional payment is being properly recorded.

Notice that if you do it yourself you do not have pay any additional fees or charges. No one else is touching your money but you. No more than 12 payments are being made each year so your lender is happy.

Foreclosure

You can still default and be foreclosed if you prepay your mortgage. You must make your required payment, on time and in full, each month and without exception until the debt is completely repaid. That you have made voluntary prepayments does not change your contractual obligation with the lender.

Calculators

Good bi-weekly mortgage calculators which do not require your name or other information are provided by MortgageCalc.com and BankRate.com.

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“Independent mortgage banks and subsidiaries made an average profit of $1,423 on each loan they originated in the third quarter of 2010, up from $917 per loan in the second quarter of 2010,” according to the Association.

In addition, the MBA also reported that “88 percent of the firms in the study posted pre-tax net financial profits in the third quarter of 2010, compared to 85 percent in the second quarter of 2010 and 82 percent in the third quarter of 2009.”

These are strong results. Initial worries that federal mortgage reforms would hinder industry profits have proven wrong.

Good Faith Estimates

After 14 years of wrangling the government introduced a new Good Faith Estimate form this year which HUD says can consumers as much as $700 per transaction.

The new GFE is a three-page form designed to show total loan costs — NOT total closing expenses. By obtaining a GFE and not a “worksheet” or something else consumers know that lenders are obligated to deliver loans with certain terms and conditions by closing, assuming that the value of the property and consumer information satisfy required loan criteria.

HUD-1

The new GFE ties into a new HUD-1, the summary form which settlement agents must use as closing. The new HUD-1 is designed to clearly explain all transaction costs, including taxes, title insurance and closing expenses — and to show the costs being paid by buyers and sellers.

An important part of the new HUD-1 is that a portion of the information it shows comes from the lender’s GFE. In other words, borrowers can look at the HUD-1 to assure that rates and terms promised with the GFE have been delivered.

Dodd-Frank

The Dodd–Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203), passed this summer despite strong industry opposition, established new protections for borrowers.

In basic terms, the new protections include restrictions against financial steering and a new duty of care requirement. Lenders can obtain a “safe harbor” to protect against lawsuits and reduce reserve requirements when they originate qualified residential mortgages. QRMs are defined essentially as conventional, VA and FHA mortgages with three or fewer points and origination fees and fully documented (full docs) loan applications.

An interesting twist with Dodd-Frank is that it allows prepayment penalties for QRMs but NOT for unqualified mortgages. The maximum prepayment penalty is restricted to three percent of the loan amount in year one, two percent in year two and three percent in year three.

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Under Wall Street reform several federal agencies are supposed to work out a final definition of the term “qualified residential mortgage” or QRM. However, we largely know how such loans will be defined because of the requirements of legislation.

Qualified Mortgage Standards

In basic terms, a qualified residential mortgage will look like this:

1. The loan application must be fully documented. Income and employment claims must be verified. (Kiss goodbye to “no doc” and “lo doc” loan applications.
2. For fixed rate mortgages, the borrower must be qualified on the basis of monthly costs for mortgage interest, mortgage principal, property taxes, property insurance and related assessments (think of condo fees, mortgage insurance, etc.)
3. For adjustable-rate mortgages, the borrower must be qualified at the highest rate possible during the first five years of the loan term.
4. If the lenders knows or thinks that the property will be financed with a second loan, the lender must qualify the borrower on the basis of the combined loan costs. In other words, simultaneous second and piggy-back loans are fine as long as the borrower qualified for the total debt.
5. Requires a six-month notice before the start rate for an ARM can be changed.
6. The loan term cannot be more than 30 years.
7. Points and fees are limited to 3 percent of the initial loan amount.
8. Allows prepayment penalties for qualified loans — but not for loans which are not qualified. The maximum prepayment penalty will be 3 percent the first year, 2 percent the second year and 1 percent the third year.
9. Bans lenders from requiring single-premium credit life and similar products.
10. Bans lender requirements for mandatory arbitration

.

11. Requires regular monthly payments with no balloon payment at the end of the loan term.

So, generally, a qualified residential mortgage is a conventional, FHA or VA loan that requires three or fewer points at closing and is underwritten with a full-docs loan application.

I say “generally” because there are some exceptions to the rules and likely there will be more when the final definitions are unveiled.

What’s clear, however, is that lenders who offer mortgages outside the guidelines will face significant liability, so much so that you can already see changes in the financing marketplace. If you don’t believe it just try and find an option ARM….

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When you refinance a mortgage you replace an existing loan with a new one. There’s no need to negotiate with the old lender because his mortgage claim will be extinguished. However, borrowers with toxic loans need to see if a refinance will set off claims for a huge prepayment penalty at closing, perhaps an amount equal to mortgage interest for six months.

Mortgage Modifications

Mortgage modifications come in several forms. First, we have loans which automatically self-modify — that’s the nature of an adjustable-rate mortgage (ARM).

Next we have mortgages where the lender voluntarily agrees to modify loan terms. Given that a mortgage is a contract such voluntary modifications are rare. Voluntary modifications might include changes in rates and terms, and also assumptions where one borrower takes over the debt of another with permission of the lender.

Tough Times

Because of the foreclosure meltdown we now have government-organized modifications under the Making Home Affordable program. In basic terms such modifications are open to those facing foreclosure or who have lost so much equity that financing to a new and lower rate is now possible outside the program.

Owners Versus Investors

When principal balances are reduced it’s possible for investors to face federal taxes on the unpaid balance, money that’s regarded imputed income. For example, if a $100,000 mortgage is settled for $75,000 then the unpaid $25,000 has traditionally be considered taxable income under federal rules. However, if the loan being modified is for a personal residence, then under Mortgage Forgiveness Debt Relief Act of 2007 the amount forgiven is generally not be taxed by the federal government. For specifics, please speak with a tax professional and be sure to ask about both federal and state policies.

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There are times though when either the borrower or the lender will seek a mortgage modification, a change in the original terms of the loan agreement.

On the borrower’s side, there are several forms of mortgage modification.

• A lower rate.
• A longer loan term.
• Both a lower rate and a longer loan term.
• The waiving of various fees and penalties such as a prepayment penalty.
• A short sale where the lender agrees to allow the sale of the property for an amount that’s less than the debt in full or partial settlement of the loan.

It’s also possible for a lender to want a loan modification. For instance, rather than foreclose a lender might accept a deal where the interest rate or monthly payments actually rise. A lender might extend a loan to avoid foreclosure or a lender might tack missing payment onto the end of a mortgage to, again, avoid foreclosure.

As well, if a lender needs cash, it might agree to the early payment of the loan in exchange for something less than the entire debt. This is called a curtailment.

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Until this point HUD has generally allowed lenders to offer their own Good Faith Estimate of Closing Costs, however the new standard form for all lenders — a form that took 14 years to develop — will finally assure that borrowers actually understand what’s being charged for their loans, why and by whom.

“The mortgage crisis,” says former HUD Secretary Steve Preston, the last HUD secretary appointed by President Bush, “was fueled in part by people agreeing to mortgages that they ultimately could not afford. In some cases, people didn’t understand or know that their mortgages could result in large payment increases after just two or three years. Others did not recognize the total costs that come with homeownership. And others paid higher loan origination and closing costs simply because they did not know about other affordable options.”

So what makes this form better?

First, it’s a three-page document that every lender will have to use — meaning that offers from lenders will be the same and can readily be compared.

Second, the document is not just a list of fees and charges, it also explains in basic terms the purpose of each expense.

Third, mortgage brokers will have to show their yield-spread premiums (YSPs), costs which Preston says were “rarely understood by, or fully disclosed to, borrowers. These premiums are directly tied to the higher interest rates that borrowers pay. Consumers deserve to understand this and they need to get credit for essentially paying these premiums.”

Page One

The first page is actually a summary of loan costs — the specifics are found on page two.

Item 1 tells you how long the quoted rate and terms last. Items 3 and 4 concern loan lock-ins — how long the rates and terms will last if you lock them in at the time the GFE is issued.

The loan summary tells you the amount of the loan, the initial loan rate and monthly payment. IMPORTANT: If you have an ARM the next few items will tell you:

• How high the interest rate can go.
• When the interest rate can first rise.
• The maximum monthly payment you can expect.
• If a prepayment penalty is allowed and, if yes, how much it will cost.
• Whether there is a balloon payment at the end of the loan terms.

Next the form will tell you whether the lender will create an escrow or “trust” account to collect money each month for property taxes and insurance. Generally, if you buy with less than 20 percent down an escrow account is required by the lender.

Finally, the form adds your origination charges (the “A” items on page two) with other settlement costs (the “B” items on page two). Be aware that you can have additional costs at closing, depending on how the sale agreement is written.

Page Two

The second page is divided into two parts, A and B. Part A looks at “origination” fees, the cost to buy your mortgage.

First, the form shows your origination fee in a dollar amount, including any yield spread premium (YSP). Under the old rules, the yield spread premium could be shown as either a dollar amount or as a percentage of the loan. Now, the entire cost of the loan, including any YSP, is shown as a single dollar amount.

Next, the form shows if your interest rate is being impacted by the origination fee. In other words, let’s say you can borrow $100,000 at 6 percent interest over 30 years with no points. This is called the par pricing for this loan. But, let’s say that you could also borrow $100,000 at 5.75 percent — if you were willing to pay 1 point at closing. A point is equal to 1 percent of the loan amount or $1,000 in this case. The form shows if you are paying for any reduction of the interest rate OR any increase in the rate by paying a smaller origination fee.

Next we go to part B. This part of the form shows the cash costs you can expect to pay at settlement (or escrow) when the loan closes. As the bottom of part B is a total which shows “Your Charges for All Other Settlement Services.”

The totals for parts A and B are then shown at the bottom of the page and on the bottom of page one as well.

HUD encountered considerable opposition from the lending industry, especially with regard to the question of how yield spread premiums should be disclosed. In an important decision which reviewed 14 years of effort to update the good faith form, a court found in 2009 that HUD had acted fairly and in the public interest with the form it produced.

Page Three

The last page should really be the first page because it contains instructions for understanding the form.

The first section lists charges that the lender cannot increase, charges that can rise by as much as 10 percent, and charges that change prior to settlement. This is important information, it means that you should check the numbers on your good faith estimate with the final figures presented to you at closing.

Next, HUD gets into the issue of higher or lower settlement fees. In the same way that mortgage loans have par pricing, so does the settlement process. In other words, if you are willing to pay a somewhat higher interest rate you may be able to lower your cash costs at closing. Indeed, you may not have to bring any cash to closing.

In the third section HUD offers borrowers the opportunity to compare loan offers from different lenders. This is important because borrowers should look at different loan offers to find the rates and terms which best meet your needs.

Lastly, HUD notes that your loan may be sold in the future. If so, after settlement “any fees lenders receive in the future cannot change the loan you receive or the charges you paid at settlement.” Translation: A contract is a contract.

HUD estimates that the new form will save typical borrowers $700 each time they finance or refinance a home. That’s a lot of money, but more could be done to cut borrower costs — and it shouldn’t take 14 years to make additional changes.

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Copyright 2009 Peter G. Miller. All Rights Reserved. Use of this material without permission is illegal, however direct links to this page are welcome.

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On August 15th and within five minutes of each other, email arrived from the Mortgage Bankers Association and the National Association of Realtors arguing both sides of the issue.

Saying that “abusive lending erodes confidence in the nation’s housing system,” NAR told the Federal Reserve that “prepayment penalties often trap borrowers in loans they cannot afford by making them too expensive to refinance. While some lenders may, in fact, offer lower rates in exchange for a borrower agreeing to a prepayment penalty, in the experience of many Realtors, that option is not typical. A 2005 study by the Center for Responsible Lending concluded that borrowers with subprime loans and prepayment penalties do not receive lower interest rates, and may actually pay higher rates.”

NAR then went on and said “the use of prepayment penalties with terms that extend beyond the initial fixed interest rate period that is a feature of many adjustable rate mortgages is particularly egregious. Some originators encourage consumers to accept these loans by reassuring them that they can always avoid a jump in payments by refinancing before the reset period. But then, when they do refinance, assuming they can in the current credit environment, the lender charges a prepayment penalty. This is one of the most unfair practices engaged in by irresponsible lenders.”

The Mortgage Bankers Association offered an entirely different view. They argued that “prohibiting or significantly restricting prepayment penalties can be expected to increase rates to borrowers and would eliminate certain financing options for consumers. MBA supports the limitation of prepayment penalties to three years for all mortgage loans and expects that the market will conform to the recent subprime statement requiring prepayment penalties not extend beyond the reset period of hybrid ARMs and allow borrowers a period of up to 60 days prior to the initial ARM reset to avoid a prepayment penalty.”

If the question were one of “either/or” you would certainly have borrowers backing the NAR position in overwhelming numbers. But while the NAR position is plainly more popular, it still requires some tinkering because there is one important instance where prepayment penalties are justified.

Imagine that you get a $200,000 loan. You want to hold down closing costs so the lender offers a trade: We’ll pay most closing costs if you accept a somewhat higher rate.

By “most closing costs” the lender means that it will pay all settlement expenses except prepaid items such as tax and insurance escrows, mortgage insurance, HOA/Condo fees and mortgage insurance premiums. The lender won’t be responsible for owner’s title insurance coverage or any charges to pay off an existing loan.

In this situation — commonly and incorrectly called a “no-cost” loan closing — there are surely expenses. For the borrower the costs of closing are paid over time in the form of a higher rate. For the lender, the costs are paid up front, perhaps $5,000 or more depending on the jurisdiction where the property is located.

“When the lender pays all closing expenses without increasing the loan balance then a prepayment penalty is fair because the lender should have an opportunity to recoup its actual cash costs,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading foreclosure marketplace. “We need to work out a system which preserves the so-called “no cost’ closing option while giving lenders a fair opportunity to recover their up-front expenses.”

How Long?

As to a prepayment penalty period, three years — with a qualification — seems like a fair time for the lender to recover it’s costs. The qualification is this: The prepayment penalty in month #1 should not be the same as month #36.

As an example: Imagine that you have a subprime loan with a $200,000 balance and a six-month prepayment penalty if the loan is paid off at anytime during the first three years. The loan has a 9 percent interest rate and because of improving credit you have a chance to refinance down to 7.5 percent after two years. The prepayment penalty is $9,000, money due at closing when the loan is refinanced. ($200,000 x 9% = $18,000. $18,000/2 = $9,000).

For most borrowers, especially those trying to end subprime mortgages and their steep rates, a $9,000 penalty is an impossible barrier, something which cannot be overcome. The result is no refinancing during the penalty period and vastly-higher costs month after month.

Prepayment penalties have a huge impact on effective interest rates. For instance, if the loan is refinanced after two full years, the borrower paid interest worth $17,944.55 in the first year, $17,816.37 in the second and a $9,000 penalty. That’s a total cost of $44,760.92 over two years — an effective rate of roughly 11.2%.

Regardless of what the big print says, our model loan never has a 9-percent rate during its first three years. Why? Because if a borrower wants to refinance to a lower rate, sell the property or pay off the loan during the prepayment period, the actual cost of the loan is substantially greater than the quoted rate. Instead of an up-front teaser rate, what we really have is an inverse-rate loan, financing with a higher start cost and then a lower interest level at the end.

What About Discounts?

It’s sometimes argued that borrowers should accept a prepayment penalty in exchange for a lower rate. Superficially, such a trade seems reasonable, but the borrower is dependent on the mortgage lender for rate information. Since rates are in constant flux and because different rates apply to different loan products and borrowers with different credit profiles, there is no set interest level to discount. Because the borrower does not know the benchmark interest rate for a given combination of loan factors, there’s no evidence — as NAR reports — that there has been a particular discount, or in some cases any discount.

The idea that lenders are offering a discount would have greater credibility if loan officers had a fiduciary duty and borrowers were their clients. As agents of a borrower, lenders would be required to obtain the best possible rates and terms for borrowers. Instead, lenders argue fiercely that it’s not their job to advance borrower interests.

“Some have proposed that a fiduciary duty standard should be implemented and mortgage originators and their loan officers should act in the ‘best interests’ of the consumer,” Harry Dinham, president of the National Association of Mortgage Brokers, told Congress. “NAMB remains opposed to any proposed law, regulation or other measure that attempts to impose a fiduciary duty, in any fashion, upon a mortgage broker or any other originator.

“Simply put, a mortgage broker should not, and cannot, owe a fiduciary duty to a borrower. The consumer is the decision maker, not the mortgage broker,” Dinham said.

But how can a borrower make an informed decision when lenders have all the information and borrowers are dependent on lenders? The parallel situation in real estate works like this: A property owner is promised 100 percent of a given sale price. If the target is met the broker’s commission is equal to everything above the target value. Such an arrangement presumes that the borrower knows the value of his or her property, a presumption so absurd that so-called “net listings” for residential properties are illegal in most if not all states.

What Happened To Good Credit?

There’s substantial evidence that the benefits of good credit are not being passed through to mortgage borrowers.

James Lockhart, the Director of the Office of Federal Housing Enterprise Oversight (OFHEO), the regulator that oversees Fannie Mae and Freddie Mac, says that “subprime originations market share almost tripled from 7.2% in 2002 of total originations to 21.4% in 2006.” Meanwhile, FHA originations fell from 1,246,561 loans in 2002 to 502,000 mortgages in 2006.

The Census Bureau has just reported that median household income amounted to $48,200 in 2006 and that the poverty rate is down from 12.6 percent in 2005 to 12.3 percent in 2006.

How can it be that the number of people with “weak” credit tripled in the midst of good economic times and one of the largest real estate growth spurts in U.S. history? Could something else be at work?

One reason for subprime growth is simple: Borrowers who qualify for lower-cost FHA financing are being steered to higher-cost subprime loans. Why? Lenders get far larger profits. (For an interesting look at lender economics, see: Inside the Countrywide Lending Spree, The New York Times, August 26, 2007)

The same scenario is also true for stated-income loan applications. By using stated-income apps lenders charge higher fees — including higher fees for employed borrowers who can readily document their income but do not know that such an option exists. You can’t, of course, use a stated-income loan application for an FHA mortgage and therefore as a broker you can’t get the higher rate or additional fee available with a subprime loan.

What About Investors?

The argument is made that if prepayment penalties are restricted or prohibited then investors will no longer purchase mortgages.

Some investors will surely take their money elsewhere if the prepayment system is changed — but where? After the stock market lost some $5 trillion in its most recent crash, some investors plainly left the market — but the market continued, most people stayed invested and the Dow today is substantially above the pre-crash high of 11,722.98 reached during January 2000.

The U.S. mortgage marketplace now involves trillions of dollars. If investors leave, where will they put their money? It’s difficult to see trillions of dollars deposited in local passbook savings accounts or uncertain foreign assets. The overwhelming majority of U.S. mortgages — including subprime loans — are being paid off, reason enough to keep funds in such investments.

The Case For Declining Prepayment Penalties

Instead of a flat, one-size-fits-all penalty at any point during the penalty period, a lender should be entitled to a prepayment penalty equal to 100 percent of its actual cash closing costs only in month #1. Each month thereafter the size of the penalty should decline by 2.778% until it reaches zero. (2.778% x 36 = 100.008%)

Why? Because each month the lender has a chance to get interest from the loan — and the trade with a “no cost” mortgage was more interest for reduced costs up front. Having a $5,000 penalty in month #1 may make sense, but not in month #36.

As to $9,000, if that sum exceeds the cash payment made by a lender at closing then it’s simply excess, unearned and unjustified profit for the lender; a cost unrelated to any borrower benefit and an expense made possible only because the lender has more leverage than the consumer.

“There’s also a very practical, market-driven, reason for both borrowers and policy makers to favor ‘no cost’ mortgages,” Saccacio explains. “Lenders do a lot of loans. They have economic power in the marketplace. They can force down expenses for settlement services in a way that individual borrowers cannot. A lender who does 500 loans with a settlement provider is going to pay a lot less per closing then an individual borrower. If settlement costs are reduced that means lenders get back their cash investment faster and borrowers face smaller prepayment penalties.”

As to prepayment fees for loans where the lender is not paying up-front costs, as the old expression goes, “forgetaboutit.”

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Published originally by RealtyTrac.com during August 2007 and posted with permission.

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