Advanced Personal Finance

Every time I think the level of consumer credit in the U.S. can’t get much worse, it does just that. After reading this report about the 7.4% increase in credit card debt in November, I’m starting to wonder again.

For years it seems Americans relied on their houses as an ATM they happened to live in. Cash-out refinances made up about 50% of mortgages issued by Freddie Mac in 2006. By the beginning of 2007, 82% of mortgages issued by Freddie Mac were cash-out.

Now apparently we’ve switched back to our old stand by, credit cards. As the refinance well dries up, more people are needing to carry higher balances to support their lifestyle or cover an emergency in their life. I wonder though, how much longer this can go on.

What’s next?

After the house is mortgaged to the hilt and the credit cards are maxed, what will people do? I wonder what the next source of consumer debt will be, because I’m sure of two things. One, Americans don’t seem capable of reigning in spending to any great degree. And, two, where there is demand, there is supply. Someone will market a product that will allow people to increase their debt load.

So what’s next - widespread car pawning?

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As I’ve mentioned a couple of times in the last few weeks, we’re looking for a new house. We’ve decided to make the move to a lower cost of living area so my wife can stay home for our baby boy just like she did for our daughter.

This past weekend, we traveled to the new location (actually, we went to two different locations, but one was a bust) to look at houses. We encountered something I’d not known about before, but that is apparently quite common. We looked at a couple of new houses being sold straight from the developer. The prices were within our range and the houses looked okay. There was just the small detail that the listings left out.

The only way you can get the advertised price is if you use their lender. If you go with your own financing, the price goes up substantially (think $40-$50K for the houses we are looking at).

How is this possibly legal?

Isn’t there some case law to prevent this kind of bundled pricing? Apparently not, because our agent didn’t seem at all surprised and told us it was typical and accepted.

I’m not a lawyer, but this definitely sounds suspect to me. I can see a class action suit in the making. It seems to me that offering two prices isn’t kosher. Now obviously you don’t have to use their lender, which is in fact one and the same company as the developer at the highest level. But this kind of offer seems to me so anti-competitive that I’m actually shocked by it. But like I said, I’m not a lawyer.

We still haven’t located the right house, by the way.

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There’s a way for a person feeling ‘borrower’s remorse’ to back out of certain home loans. It’s called the right of rescission and you can exercise it on home equity loans, HELOCs, some home refinancings.

The right of rescission gives you three business days to reconsider whether or not you want to take delivery of the money from a loan. If you change your mind in that time, you’re off the hook for loan. You also are entitled to the return of any fees you paid to originate the loan.

Not surprisingly, there are lots of details on exercising the right of rescission. There are timing rules, rules on which types of loans it applies to, and rules on exactly how to do it.

What’s a ‘business day?’

The three day clock starts the day after you ‘close’ the loan. Three stipulations must be met for the clock to start:

• You sign all the loan papers

• You receive all the loan disclosures

• You get a copy of the notice of right of rescission

Usually, all the stipulations are met at loan closing. The clock starts, then, the next business day. Importantly, a ‘business day’ is any day that’s not a Sunday or federal holiday. Saturday counts as a business day, even if the lender isn’t open for business that day.

For example, you sign and receive all the papers Thursday August 30, 2007. The clock starts Friday morning, goes through Saturday, stops for Sunday and Labor Day, and resumes Monday.

Only applies to certain loans

The right of rescission only applies to home equity loans, lines of credit, and refinances with a different lender. You can’t use it on non-primary houses, refinances with your current lender, or when you first take out a mortgage to buy the house.

Things get complicated when you do construction loans and piggyback loans. I’m not a loan officer, so I’m not going to get into those situations.

When you do a ‘cash-out’ refinance, even with your current lender, you can always exercise your right of rescission for the cash out piece. Of course, if the refinance is with a different lender, you can back out of the whole thing.

Exactly how to do it

You have to notify the lender in writing - a phone call won’t do. Interestingly, you only have to get the letter in the mail by the three day cut-off. It doesn’t have to be postmarked by that day. I wouldn’t try backing out of a loan based on that technicality though. If you’re going to do this, I’d make sure the letter got a postmark.

Since this letter must get to the right place, make sure you have a good address for the lender and the right department at closing. If multiple parties took out the loan (e.g. husband and wife), they all must sign the rescission letter.

So the next time you take out a home equity loan for that new car and then realize you’ll be paying on it for ten years and reconsider, keep this post on hand. Seriously, though, if you sign for a loan and later read some evil clause in the inch-thick packet of papers you got at closing, this might come in handy.

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We prepay our mortgage. I’ve written about before about my thinking on the matter. Basically, for me the psychological benefit of having the mortgage paid off outweighs the potential financial cost. But, as Lazy Man commented on that post, there is a possible cost.

I figured out our cost in real dollars for paying off our mortgage early. Assuming a $200,000 mortgage at 6% and $200 extra per month going either to investments paying 8% or the mortgage balance, it costs $77,671 to prepay(tax consequences have been neglected, mostly because I’m too lazy to include them). I pay off the mortgage nine years early, but at the end of 30 years, I’m poorer by $78,000.

Or am I?

The assumptions in this example are important. The key one is the rate of return. Just recently, I figured out and wrote about the effect of volatility on return.

Basically, it’s not completely realistic to assume a steady 8% return from investments in things like stocks. You can do that with fixed-rate instruments like CDs and savings accounts or retiring debt (like a mortgage or credit card). But you really can’t just assume a smooth 8% (or any other percent) return on equities.

This is something Suze Orman and I actually agree on. The return on investment from prepaying your mortgage is a sure thing. Not so with stocks. ‘Long term,’ yes, stocks average better than my 6% mortgage. It just depends on how long you have to wait for that average.

So thanks go to Lazy Man for making me consciously think about and calculate the effect of our prepaying our mortgage.

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With the deterioration of the housing market, there’s been an increased interest in ’short selling’ homes. I didn’t know much about short selling, so I did a little research. I should say up front that I don’t have any personal experience in this topic (thank goodness); here’s what I learned, though.

What is a short sale?

I covered the definition of a short sale in a previous post, but this is a refresher. A short sale is the sale of a house that has a mortgage greater than the current market value of that property. The bank agrees to forgive the outstanding mortgage balance after the sale completes. Short sales aren’t a given - the borrower must negotiate with the lender the accept the short sale.

Why would the bank agree to a short sale?

A short sale is isn’t so much a win/win as it is a lose less/lose less for both parties. The borrowers don’t have a place to live anymore. The lender’s don’t get paid back all they’re owed. On the other hand, the property doesn’t go to foreclosure, which is good for both of them.

In a foreclosure situation, especially in a down market, the lender can expect to recover less than if the property is sold short. Maybe they’d recover 75% 50% in an auction, but 85% in a short sale. It’s obviously not ideal for the lender, but at least they don’t have to sell the property.

The drawbacks for a borrower

As you would expect, there are several drawbacks to short selling for the borrower. Perhaps the biggest one is that they no longer have a place to live and any money they did put into the house is gone. Also, a short sale is going to show up on their credit report. It’s hard to say exactly what the effect will be on credit score, but anecdotally it’s somewhere in the neighborhood of a 80-100 point drop. That’s nowhere near the penalty for a foreclosure, but still significant.

There’s also another pitfall - taxes. The IRS treats the forgiven mortgage amount as income, so you’re going to pay taxes on that amount. When you’re talking about mortgage-size amounts of money, this could be very significant.

Other things to note about short sales

There are several other points about short sales to note. First, a lender might balk at paying the commission for a broker, which could complicate things.

Second, it takes some work to convince the lender to accept a short sale. You’ll have to be several months behind on payments and most likely have to show evidence of significant hardship that caused you to get so behind. Your mortgage resetting to a too-high-for-your-budget payment isn’t good enough. If you’ve lost your job, divorced, or have medical bills, you’re in a better negotiating position. Well…regarding the short sale, that is.

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