The True Math Behind Loan Mods
The True Cost of Home Ownership
Most people don't understand the associated costs of true home ownership or if they do, they don't want to. Maybe it was the wrong time, the wrong person, or even the wrong lifestyle choice for you. Let's face it hard times change people and usually for the better. However, most people don't want to experience that change even if they need to. Maybe they set their expectations too high?
Let's go over some of the costs of owning a home in Connecticut to see what I might be inferring. In real estate we associate the fundamental costs as PITI (Principal, Interest, Taxes, Insurance). The principal is the smallest portion of the loan and that's the actual amount that is going into your pocket as equity. The second smallest being the home owners insurance. The other two costs being the largest, the interest and taxes.
If you take the median home price which most people would agree to be $350,000.00 as of the middle of 2023 we can begin to calculate the cost you would have to pay monthly including the average 30 year interest rate of 6.876% at the current time of writing.
Using an amortization calculator, the monthly payment for this comes out to $2,299.48. However, we still need to add in the taxes and insurance. Let's say based on the assessed value of the property the taxes are at annual mill rate totaling $6,000.00. That's another $500.00 per month you can tack on to the principal and interest payment. The average annual cost of homeowner's insurance in CT as of June 2023 is $1,980.55 annually. That's another $165.00 per month to total up the basic cost of home ownership to $2,964.53 per month.
The cost doesn't stop there, more than likely you have either a Mortgage Insurance Premium (MIP) if you went through an FHA Loan or Private Mortgage Insurance (PMI) if you went through a conventional loan. This could be anywhere between $135.00 to $475.00 per month. Yeah, let's keep going.
Let's not forget about property maintenance which investor's calculate out to be 3% of the home's actual value. Thus, $350,000.00 x 3% = $10,500.00 / 12 months to give us another monthly cost of $875.00. You more than likely won't feel this cost at first, until the later years occur and you need to start repairing the property.
So, after everything is said and done the monthly cost associated with a $350,000.00 home comes out to a grand total of $3,974.53 per month.
We won't talk about the cost of utilities and everything else afterwards, you get the point. Now, let's move on to what follows next when you decide homeownership isn't what you thought it would be.
Pre-Foreclosure
Truth is, life is difficult and requires patience. Rushing homeownership is the worst mistake you can make out here, especially seeing as how it requires two dedicated incomes to make it happen nowadays. So, eventually what follows a bad situation is the inevitable process of pre-foreclosure.
What could have begun this predicament in the first place?
A decrease in your credit card balance? A sudden illness you hadn't anticipated? Too many liens on the property due to defaulted credit loans? Trying to stiff the contractor? A car loan you thought you could afford? Not being aware of the social economic conditions happening around you? Bad habits? Basic lack of financial discerning as a result of your parent's contributions, or lack thereof? A sudden job loss?
Unfortunately, it's usually all of the above and don't take it personal or feel special. Bad circumstances happen to everyone out here. The sad reality is that through the life of the loan you will fight all of this tooth and nail trying to protect the home that you have worked so hard for. We can't hold onto material things out here, however. We have to do what's best for us and the people around us.
With all of that said let's go over what the pre-foreclosure process looks like.
After two consecutive months without a payment made by the borrower, the lender will more than likely come to the conclusion that the borrower has no plan on paying the mortgage. The lender will then issue the borrower something known as a Notice of Default. Simply put, it's a polite way of letting the borrower know they are in default of their mortgage and it is now public knowledge to the court.
Thus begins the pre-foreclosure process. From that notice, the borrower then has to move forward with their best decisions on how they would like to repay the lender.
Short Sales
One option is known as a short sale. A short sale is arranged when the lender agrees that the borrower may sell their house for a lower value than that of the loan. This usually occurs in a declining market where the home is now considered 'underwater'. The value of the home has declined beyond the point of the loan amount.
This results in what is known as a deficiency judgement. This is the difference of what you sell the house for compared to amount of the loan. Let's say Matt has a an unpaid loan amount for $280,000.00 and he can sell his house for $250,000.00. The difference he owes the bank after the sale is $30,000.00. The lender can then issue a deficiency judgement for that $30,000.00 and arrange a repayment plan with Matt. If he defaults on the repayment plan, the lender can then start to garnish his wages and collect the money out of his accounts.
Equitable Sale
Another option during the pre-foreclosure process is the exact opposite of the short sale situation and is hopefully available to us. An equitable sale occurs when you have a sufficient amount of equity in the property to positively relinquish the home and pay off the lender. Matt bought his home for $250,000.00 in a progressive neighborhood and since the origin of the loan the property has accrued $50,000.00 in equity because of the demand of the neighborhood. He owes $230,000.00 on the loan, but cannot continue to make a $3,000.00 payment due to a declining market in his profession that he could not extrapolate. He sells the home for $300,000.00 with a $70,000 return and uses some of that money to pay the arrearage to the lender. He then safely pivots into a rent.
Loan Modifications
The final option and the main point of this article (which will be touched upon here briefly and then later on in the next section) is a loan modification. This extends the term of your loan, thus lowering the payment amount. In result, the borrower must now change their current rate to the new marketable rate. Sometimes this works out to be a lower rate and sometimes this adds more salt to wound by increasing the current rate. The point of this is to open up more cash flow to the buyer to hopefully, stay on track with the new repayment plan set by the lender.
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However, if none of these three options are pursued and ninety days pass since the notice of default the borrower will then receive the second notice which is known as the notice of trustee sales. This document notifies the borrower that his home will be put up for auction within a certain date, usually within a month of time. During this time frame is usually when it will be made public knowledge to private investors and Realtors that you are in the foreclosure process and your home will show up as lis pendens, or rather litigation pending. So, the entire foreclosure process from start to finish is usually six to eight months, starting from the first month of the missed payment all the way to the auction sale.
However, this process could be precipitated through what is known as an acceleration clause. This article you may find on your original loan contract allows the lender to seize the property usually within three months. Remember, the borrower may hold equitable title to the property, but the lender holds legal title to the property until the loan contract is satisfied. Thus, any action you take to repaying this loan during the pre-foreclosure process must be disclosed to the lender first and through a licensed real estate agent.
With all of that in mind, let's take a further look at loan modifications as a solution.
The Interest In Loan Modifications
This easy refinancing method could save you from an impending foreclosure to your home for the moment, however it only delays the inevitable. The Federal Housing Administration has established a 40 year mortgage as a solution to 'financial hardship'. In short, this opens up more cash flow to the homeowner extending the term of the loan, thus decreasing the payment. However, with what little cash flow this provides the borrower, the yield of interest over a 10 year period drastically increases to the lender. The borrower will inevitably default on the mortgage as the equity in his property will also decrease in the downturn of the economy; so will his income.
It doesn't take a lot of ingenuity to figure this little charade out as to whom will benefit the most from this. I think the laughable part of this is the fact you have to qualify for it. I will be using the 40 year FHA mortgage to demonstrate, here's the math:
Matt buys a $350,000.00 home in mid-quarter 2023. He worked his entire life to save up the $70,000.00 down payment and $10,000.00 in closing costs. Collectively these costs associated with owning a home, being the most secure way of maintaining a good loan structure, will total the price of a ten year old Bugatti. This brings his loan total to $280,000.00 with a current marketable APR of 7.334%
Here's how this will play out:
Using an amortization calculator you can see, Matt will be paying $1,700.00 in interest alone in the first year and the total interest over the life of the loan will be a whopping $413,386.09. Now, these costs Matt had anticipated, however all of the additional costs associated with home ownership he had not. He also didn't expect his wages to be garnished in the midst of a recession.
With all of these unexpected factors occurring, Matt must make some harsh decisions in regard to his life. Along with the job market crashing and his wages being garnished, this made his home go underwater in equity as a result of declining home values. His home is now worth a mere $220,000.00. Ultimately, he can't refinance the amount of the loan, but he can refinance the same rate with the 40 year mortgage as opposed to the original 30 year term he had initially signed on for.
Let's see how this 40 year mortgage will play out:
Comparatively, the 40 year mortgage will result in a lower monthly payment, yes. Only marginally by $117.73, this more than likely won't save you from a foreclosure. What's worse is that the principal, which is the equity going into the home, is what is being shaved off of the payment. With less equity going into your home over an extended period of time, the probability that you will default increases even if that marginally lower payment saves you.
However, the true evil is the total difference in interest paid to the bank even if you make it through the next forty years. This amounts to a $174,618.40 increase in interest for a ten year difference.
Foreclosure and bankruptcy ironically would be Matt's best decision here after the substantial decrease in equity. Even if the loan modification could save his mortgage, he would be considerably better off cutting his losses and pivoting into a much more affordable rent. However, let's say Matt was only short $20,000.00 equity and decided to take a deficiency judgement. Well, what is worth more? Another five to seven years out of the housing market in result of Bankruptcy, or paying off the $20,000.00 to the bank.
We all value our time out here differently, and now may be the best time to talk to a local Realtor about your current neighborhood's market data.
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