Good People- Bad Loans

LEGAL MATTERS COLUMN

BENICIA HERALD

September 28, 2007


GOOD PEOPLE – BAD LOANS

By: Mark Mitchell of Gizzi & Reep, LLP

Lately, there’s been a lot of talk about “sub-prime” loans in the news. The term “sub-prime” refers to the qualification, or credit rating, of the borrower. This type of loan is most commonly used when a borrower’s credit rating is in the lower range. Since a lower credit rating means a higher risk of borrower default, interest rates on sub-prime loans are generally higher. The higher the risk, the higher the rate.

Besides higher interest rates, there are other minefields awaiting the unwitting sub-prime borrower:

Loan Adjustment Interval. Virtually all sub-prime loans have a variable interest rate that will change over the life of the loan at pre-determined intervals. Often there is a low “introductory rate” or “introductory payment” for the first few months of the loan or, in some cases, for only the FIRST payment!

Index and Margin. The Index and Margin determine how much your payment will be. There are many different indexes used. The margin is the amount you’ll pay over the index. For example, if an index is 4.5% and the margin is 4.0%, your actual interest rate is 8.5%. If the index moves to 5.5%, your new interest rate is 9.5%. Some index rates are more stable than others so it’s important to know which one your loan is tied to. Your margin rate is usually negotiable so be sure to pay attention to that number.

Negative Amortization. Standard, fixed-rate thirty year home loans typically are fully “amortized,” meaning the home is fully paid off by the end of the loan term. Many sub-prime loans have artificially low introductory payments that do not fully cover the interest owed. That unpaid interest gets added to the loan balance so that, after making payments for a period of time, the homeowner actually owes an amount greater than what was initially borrowed. This creates a real problem in a declining market where homeowners discover they not only owe more than they paid for their home – but more than it is now worth.

Prepayment Penalty. This critical loan feature is essentially a penalty for an early loan payoff. Prepayment penalties generally apply for the first two to three years of a loan. The penalty is typically the equivalent of six months interest. For example, if your payment is $1,500 per month, you may be charged $9,000 for the privilege of paying off your loan early!

Imagine now a homeowner who purchased a home for $400,000 with 5% down ($20,000), and now must sell after two years. Their initial subprime loan balance of $380,000 has ballooned to $392,000 (negative amortization) and their prepayment penalty is $10,000, for a total loan payoff of $402,000. The house is presently worth $350,000. They have to sell because their monthly payment has just increased from $2000 to $3000. After sales commissions and closing costs, their net proceeds would be about $325,000, meaning they will have to come up with over $75,000 just to SELL their home! What to do?

This exact scenario is playing itself out all over America right now. These are good people who chased the American dream and now find themselves engulfed in a nightmarish circumstance with few options. How did this happen?

When closing escrow, borrowers are typically confronted with dozens of documents to sign. If they were to read every document, closing would take days! It’s easy to feel rushed and there simply isn’t time to properly review every document. Borrowers must sign or risk losing their financing. Do borrowers really understand what they’re signing? Did you really fully understand every aspect of your last real estate transaction? Is this a fair process? You decide.

The Federal Truth in Lending Laws (TILA) require that lenders fully disclose the cost to finance your home purchase. Borrowers must be provided with a good-faith estimate of closing costs, and all of the costs of financing, before signing the loan documents.

To help avoid the consequences of the rushed signing of documents, TILA requires that the lender provide you with a notice giving you three business days within which to cancel a loan. The borrower must be given two copies which are completely filled out and clearly indicate the final date and time by which a loan can be cancelled. The loan can be cancelled at any time, and for any reason, during the three day period. TILA also provides for extended notice if the notice to cancel is not provided or incomplete. In the case of an improper notice, the borrower’s time to cancel is extended to three years from the consummation date of the loan.

Should you consult an attorney when buying or refinancing a home? It is always much easier, and less expensive, to avoid traps than to climb out of one! You be the judge!



The information herein is intended to be general in nature and does not constitute legal or tax advice. Send column suggestions to info@SolanoLawGroup.com, fax to Gizzi & Reep, LLP at 707-748-0921 or mail to 940 Adams Street, Ste. A, Benicia.