It had been a difficult five years. The rent they received was $500 shy of the mortgage payment. Then the letter came from the lender saying their initial low adjustable rate was expiring and their payments would be recalculated. They decided they could no longer hold on to a bad investment. If the lender would not modify their loan, they were prepared for a short sale or letting the property go back to the bank. When they discovered they did not qualify for a federal loan modification and their lender would not consider changing the terms of their adjustable rate mortgage, they called me.
The rental Phil and Suzie purchased five years ago seemed like such a good idea at the time. The older rural home needed remodeling but the price was right and Phil was a contractor who could do the repairs and remodeling himself. The plan was to fix it up, rent it for a few years and then flip it for a tidy profit. They were like many small investors at the time, risking capital and labor in anticipation of future rewards.
Contractors are usually pretty precise when bidding work and materials for others but they are not immune from becoming too emotionally involved when building or remodeling for themselves. Often, they have a tendency to spend too much money and time remodeling features they shouldn’t. Although a rental, Phil upgraded everything. By the time he had finished it was a showplace. The original purchase price had been $300,000. Now he had another $200,000 in remodeling. In order to reimburse themselves for the remodeling costs, they did a cash-out refinance. Since the plan was to sell the property within five years they selected a lower interest adjustable rate mortgage.
Single-family homes as investment real estate is different from owner occupied. Financing is more costly because the default rate is higher. Lenders require larger down payments and the interest rates are higher. When Phil and Suzie did their refinance, the 6.75 percent rate looked attractive. Now they were looking at a 2.25 percent rate increase.
While there are a number of loan modification programs for financially distressed homeowners, few exist for investors and their investment real estate. Homeowners in default on their mortgage are allowed certain privileges that often delay the foreclosure process for a year or longer. Not so for investors.
Short sales are a viable alternative for homeowners with a financial hardship but lenders often turn a deaf ear to approving a short sale on an investment property when the investors still has their personal home with equity.
Phil and Suzie had struggled to maintain their good credit but construction jobs were scarce and the projected interest rate increase would make it nearly impossible to continue subsidizing this investment. Frustrated, they were considering walking away from their underwater rental.
“How did you figure the interest rate?” I asked.
“By looking at the note,” she said. “It says the 2.25 percent will be added to the index.”
“OK, but what is the index?”
“That’s my interest rate, isn’t it?”
“Not exactly. Let me look at your loan papers before you do anything further.”
The down side of an adjustable rate loan is the interest rates usually go up. Adjustables have lower initial rates that historically increase over time, sometimes to really high levels. The past few years, however, we have witnessed significant reversals with adjustable rates. The interest rates have declined.
Suzie had confused the margin of 2.25 percent for her expected increase in the interest rate while ignoring the index to which the 2.25 percent was added. The six-month LIBOR (London Interbank Offer Rate) index had actually declined from 5.5 percent when Phil and Suzie did their refinance to .75 percent today. Subsequently, the interest rate on the rental would be dropping from 6.75 percent to 3 percent, lowering their monthly payment $500. Instead of a negative cash flow the rental would now carry itself.
Adjustable rate mortgage used to be the soup du jour of mortgage loans. Adjustables accounted for nearly 60 percent of all mortgage loans in the region between 2004 and 2006. And why not? The initial interest rates and accompany payments were lower than the old 30-year fixed rate. Besides, if the interest rates went up too much you could always refinance into a fixed rate or, at worst, sell. That changed a bit. Now 90 percent of borrowers are sticking with a fixed-rate mortgage.
That’s probably best. Mortgage documents are confusing, redundant and non-negotiable anyway. If a borrower wants the loan, they sign all the documents that an escrow officer shoves in front of them. Any deviation from the old standard fixed-rate mortgage only adds to the complexity of the deal. Most adjustable rate borrowers and probably many of their loan originators never fully understood the variables of indexes and margins. They certainly didn’t anticipate the consequences of a real estate implosion that has resulted in 3.3 million homes lost to foreclosure since September of 2008.
Adjustable mortgages were not responsible for all the loans gone bad. But the greed and ignorance surrounding the adjustable loans and other creative financing was the kindling that sparked the fire.
Ken Calhoon is a real estate broker in El Dorado County. He can be reached through his Website at www.kencalhoon.com.