There are many risks when it comes to property investment as a business. I think sometimes people, especially investors forget the steps involved when obtaining a loan and how this process may open them up for risk. There are many concepts to understand mostly because the bottom-line is determined by capitalization (CAP) rates, return on investments (ROIs), and other net operating incomes.
It makes sense that people overlook the smallest detail when financing a property. It doesn't really matter "why" the loan is needed, if you are seeking a conventional loan from your neighborhood bank or turning to private lenders or hard money; it is still very important that you pay careful attention to the loan you are being offered. I understand you are concerned with flipping the property as quickly as possible; but in doing so you are not as attentive to the type of loan. And thus you find yourself in high-risk situation. Often times brokers may steer you into high-risk deals since they may have pegged you to be a risk-taker.
This opens you up to a different class of loan and areas of predatory lending practices which may incur high fees and other terms or conditions that are not always explained up front. Sometimes loans that allow you to flip properties are called rehab loans as they use hard money via private lenders. This not only means steeper interest rates but an area of lending that is not strictly regulated by the federal or local governments. These hard money loans only work to your benefit when they can get you out of a deal quickly. In other words, these loans only serve the lender because of the amount of leverage that increases the return.
This begins a debate where most investors believe that this type of leveraging can be positive because the CAP rate is higher than the interest rate of the loan. This only applies when fixed prime market financing is involved. What many do not know or understand is the features the loans carry. For one, there is negative amortization, meaning that the investment drops in value and even becomes upside down.
Mortgage lenders and their brokers like these deals because they understand the nature of risk but also the personality of the risk taker (i.e. property investor). They act fast when the investor is ready to pounce. Still this leaves little time to mull over critical details of the deal. Savvy investors know that due diligence is needed just as the individual first time buyer should be advised. Anyone entering into a real estate transaction involving financing must be able to recognize the signs of predatory lending. Otherwise, you are entering dangerous territory.
What is Predatory Lending?
Ironically, the mortgage industry does not have a clear definition of this practice and could be a reason this practice continues. Experts and lawmakers have opinions on regulations and proposed laws but this just opens up a myriad of talking in circles. Still there are some general somewhat industry accepted traits to predatory loans as detailed below.
With concern to consumers, keep in mind that most predatory lending happens in the subprime secondary market. Recently this area of lending has tightened standards. For the investor, who may not be up to date on mortgage knowledge, these loans can be made anywhere within the investment financing realm. This is with respect to the primary property and collateralization or blanket financing. In layman's terms, predatory lending is described as having one or more of the following traits. (1) Predatory loans are high in cost when it comes to interest rates and paying points. (2) They result in a large amount of fees. (3) They also only finance with single premium insurance. (4) These loans have prepayment penalties, balloon payments which lead to many homebuyers borrowing beyond their means of paying back the loan. (5) These loans also will more than likely be an adjustable rate mortgage or ARM meaning that the rate will not stay fixed but change, making the payment higher once the grace period is over. Refinancing to a fixed rate near the end of the ARM term generally does not help the situation and leads to a false sense of security on behalf of the borrower.
Many times, these loans have been marketed to people with more than blemished credit by deceptive means on the part of the broker or lender. This can lead to more fees. For this deal to work, the property's value is over-estimated, meaning that it is not worth what the market will bare. Some lenders lie about income and create fake documents to get borrowers approved just for the sake of making a profit. There is usually abuse of credit. People were given loans that would have never passed real pre-qualification. Unfortunately a number of well-respected mortgage leaders subscribed to the these practices, some of which have gone out of business when the mortgage bubble burst in late 2006 and others are currently under federal investigation (anybody know which ones? they may have helped decide the 2008 Presidential election).
While the above predatory traits stick out to many and have become generally accepted, sometimes the practice is more subtle. With the exception of fraud, if one or more of these traits are present in the loan it does not necessarily mean that there are predatory lending practices at work. It is a matter of abuse of these traits and a combination of practices presented together that makes the action deplorable by today's regulations. These loans tell a story of abuse and bad behavior. While a mortgage lender can be in the thick of predatory lending practices with regard to specific loan traits, they still may not be guilty of predatory features as explored below. The action of predatory lending is unfair and usually targeted toward uneducated minorities whom lack the resources or support system to make sound financial decisions.
There is also reverse red-lining, sometimes blatant questionable connections between people involved in the deal and also a failure to completely disclose the details of the transaction. At the closing table, there is the pressure to finish and little recourse or suggestion of stopping the deal. It is unlikely the borrower has consulted an attorney. There is a clear breach of duty. The broker or lender may charge outrageous fees and higher interest rates than first presented. They may also tack on un-needed credit or life insurance polices as part of the monthly mortgage payment. This in turn creates a loan that can negatively amortize. Along with any prepayment penalties and balloon options, this creates a loan full of bad news and is bound to fail.
Other common behaviors consist of loan flipping, fraud on the part of the contractor and fake appraisals. These outlandish practices have come under investigation by the United States Department of Housing and Urban Development (HUD). This organization has cracked down nationwide with a campaign strategy to combat predatory lending. Still these practices and undercurrents are not just indicative of the mortgage industry. It has spread to other areas that touch the housing market like construction contractors, appraisers and title companies.
What can we do and look out for?
Part of the issue with predatory lending and identifying its presence within a deal is the non-conformity or lack of regulation. There is no cut and dry, clear analytical equation that can flag predatory behavior. It is a matter of realization and judgment. Usually it is after the fact by which traits pop up and when combined with unscrupulous behaviors during the deal. Hopefully not too late for something to be done; either stepping out of the deal and getting a new broker/lender or reporting the broker/lender to HUD. Investors and consumers should constantly be aware and ask questions if something does not seem correct or is too good to be true. Ask for advice and when in doubt call your local chapter of HUD. I say this from experience. There are times that people really want to buy a home and will stop at nothing to get a loan and not think about the type of loan they are signing up to. These are the people that brokers, especially prey upon. They prey upon the underserved, credit challenged, uneducated and minorities.
In this respect, it can be assumed that most people who obtained loans before 2006, also fall into a subprime category and may have loans with predatory features. They have been deceived and lied to at the closing table and they may not understand the repercussions. It is a sad state of affairs when people begin to socially accept predatory lending as normal. Below are details of behaviors that borrowers let people getaway with mainly because they are desperate for a home.
First there is the blatant use of fraud, of out right lying throughout the whole loan process. Brokers have been known to lie about their client's income, debt and assets in order to get a bank to approve the loan. There are known pressure tactics to get someone to co-sign who has no connection to the borrower or is in no way obligated to take the loan out for the borrower. This practice even goes as far as forging signatures on loan documents. The sales tactics do not stop but also there is the pressure to get the deal done and many times without proper disclosure and legal representation. Along with fraud, there is the lack of disclosure or conveying to the point of borrower understanding of interest rates and points. Now HOEPA defines a high cost loan as one that exceeds 8 percent of the Treasury note. Some states like New York do not allow this happen. To be on the safe side, consult your local Housing Authority.
Another detail the broker/lender may rush over is the concept of points. Many consumers do not know what a point is. More educated borrowers may ask and have an understanding of the point system. Points are the cost for the use of credit by the borrower in terms of a percentage (1 percent) of the mortgage loan. Many brokers in the hay day increase the points because they would make higher commissions. Some states guard against this by allowing only a range of points that they can charge. This does not even include the amount of fees that seem to be found within a predatory loan. The normal home buyer will generally not keep in mind the closing costs needed for the deal to happen. Points will also, a good amount of the time, include high broker fees but also outrageous legal fees found in conveyance and recording fees as well as high appraisal costs. When looking at the closing HUD statement it is important to look for likely duplicates or bundled expenses. This is a trick for charging double and for many brokers, a common practice. To have an understanding of what parameters these fees should encompass, keep in mind, they should not be more than 5 percent of the total loan amount. With that in mind, one should also been aware if the loan instead of going down with each payment over time, looks like it will actually get larger; this is called negative amortization. This happens because the payment does not cover the principal and interest and therefore interest is added to the principle. The larger principle will then lead to higher interest compounding over time. Sometime in the future when the borrower wishes to sell there home they will actually owe much more than what they borrowed and in many cases will owe more than the house is worth!
Another trait of predatory lending is the balloon payment. What does this mean? While the life of loan reflects a longer amortization period, there is also an acceleration of a balance due that will need to be paid earlier usually between 2-5 years into the loan. This is usually sold to people who think their incomes will increase greatly in a short period of time. Because the monthly payment is so low in the beginning, many people forget that balloon payment will be due in 2-5 years. Over this 5 year period many events can happen that can affect a home owner's credit thus making them un-financeable. This in turn can lead to them losing their home even if they can afford to make the monthly payment all because they cannot secure another loan.
Predatory loans also seem illegal because they forget about the borrower's legal rights to litigate via arbitration. They also require a borrower to pay for an insurance policy as part of the closing. Many may not be able to avoid the balloon payment because they can't sell the property or there is a prepayment penalty which incurs when the loan is paid off prior to the scheduled agreed term. This is not to say that the property is even worth what was when originally purchased. Many banks and brokers alike have been known to give loans to be borrowers who were not credit qualified by creating loan programs that required little or no documentation.
The only action that can precipitate change is knowledge (i.e. education of the borrower). Lenders and brokers alike should be proactive in ending this behavior allowing their sales campaigns to be built around aiding the consumer in the buying process, not misleading them. I believe the connection is possible especially right now with the current condition of the stock and housing markets. Real Estate professionals need to equip themselves with knowledge for their clients but also share resourceful and correct information. Only by doing this can the housing market rebound. With this in mind lenders need to facilitate this by creating lending programs that are regulated and socially accepted!
There should be more enforcement of such behavior on the part of each state and also the federal government. Still it is in the hands of the consumer because if they continue to accept such predatory lending behaviors, RE professionals will continue with the status quo. There needs to be balance and consumers need to voice their opinions and hold their state and federal representatives accountable. It is my belief that educated consumers can have a profound impact that can result in positive changes including making investors and home buying more affordable and less daunting.
It is All about Perception
Consumers seeking home loans should be cautious beware. Property investor should also know better. After all this is their bread and butter. It pays to know what you are doing. With this in mind, the same sympathy especially from the court system is not that easily available to the investor. The investor should know, in a business levied by risk is seen as having more knowledge at their disposal and a better understanding of how business works within their specialized market. The investor should have more awareness and understanding of their actions. Case in point, the typical contract in real estate deal or referred to as the HUD 1 is presented under the assumption that each party has equal bargaining powers.
Let's face it this is not always true of the typical consumer because they may not understand the need to have an attorney or resource unlike a bank or brokerage firm. Typical consumers don't have a law firm drafting the paperwork for them. Investors know that this is a must because it is not personal and instead business. Once again, it cannot be reiterated enough that the investor must be aware and pay careful attention to their financing choices.
Still Predatory Lending is a Two Way Street
Most of the time the action of predatory lending will be seen on the side of the lender or broker but an investor must be careful in situations where they become the bank. In this situation, you need to make sure you live up to state and federal laws and your own moral code of conduct. You want to be mindful of making sure the loan is not overvalued but fair especially if it is a rent to own deal. You want to make sure all fees are outlined and disclosed on the HUD 1 sheet. Never orally agree to anything. Do not include undisclosed loans, gifts or other items of value. If you are using a broker or third party, make sure their yield spread does not exceed state levels. Finally keep in mind that refinancing is not the answer. This is common practice on the part of the lender to regain business. They want you to refinance over and over. They will say you should take advantage of historical low rates. It only starts the process all over again with new fees, terms and probably a modest reduction in interest rate and in the long term will reduce the return on investment.
Clearly it is next to impossible to trust anyone during the transaction as there is the possibility of bait and switch. This happens usually when the broker markets and sells one type of loan package and delivers something entirely different at closing. This usually means higher rates, higher fees and sometimes more cash to close. You will want to steer clear of special loan programs that look like they are catering to the underserved or uneducated. More than likely, these loans have predatory traits. It has been found that minority communities have higher rates of predatory lending and that the elderly are also easily targeted by the reverse mortgage. In this business, awareness and knowledge are everything.
0 comments:
Post a Comment