Is a homeowner better off with an FHA loan?
Q. Assuming the same interest rate, is there any way in which a homeowner is better off having an FHA rather than a conventional mortgage?
A. Having an FHA mortgage is potentially advantageous to a homeowner if she intends to sell her house, and if market interest rates are significantly higher than they were when she borrowed the money to buy it. The advantage is that an FHA mortgage is assumable by a house purchaser who is qualified under FHA standards. This means that the below-market rate can be transferred to the buyer, with the benefit shared between buyer and seller.
In contrast, conventional mortgages today contain "due-on-sale" clauses, which means that with a few exceptions, the loan balance must be repaid when the property is sold. Lenders may allow assumptions but only at the current market price.
The dollar value of an assumed mortgage has three major components. One is the upfront saving, consisting of the points and other settlement costs that are avoided by the buyer. The second component is the present value of the difference in loan balance at the time the buyer repays the loan. The third component is the present value of the payment differences over the same period. This is not an easy calculation, but a spreadsheet on my website ("Value of Assumptions") makes it easy.
It does not take a large increase in rates to make an assumption attractive. For example, assume the home seller has a 3.5 percent mortgage with a $200,000 balance that has 200 months to go. If the best the buyer can find is 4.5 percent on a 30-year mortgage, and if the buyer sells after 60 months, the present value of the benefit attached to assumption would exceed $10,000, plus the settlement costs avoided. I calculated this using the spreadsheet.
The major limitation of an assumed mortgage is that the buyer's down payment may be larger than is convenient or possible, depending on how much of the original loan balance has been paid off and how much the house has appreciated in value. In addition, the monthly payment may be beyond the buyer's capacity because it must be calculated over the period remaining.
The buyers who extract the most benefit from assumptions are those who have the cash to pay the difference between the sale price and the balance of the old loan, and have the income necessary to carry the monthly payment over the shortened term.
Sellers transferring mortgages to buyers need a release of liability. Any seller who allows assumption by a buyer without a written release of liability from the lender is looking for trouble. If the buyer defaults, the collection agency will come after the seller unless she can produce the written release. Even if the buyer pays, the seller without a release of liability may be unable to obtain another mortgage because of her continued liability on the old one.
In the 1970s and '80s, conventional loans were also assumable, but lenders put a stop to it when they began to include due-on-sale clauses in all loan contracts. While due-on-sale clauses are not enforceable on nonmarket based transactions such as a transfer of ownership within a family through inheritance or divorce, they are enforceable on all market-based transactions.
Avoiding due-on-sale on a conventional mortgage with a "wraparound"
In some cases, buyers and sellers attempt to circumvent due on sale requirements and keep an old conventional mortgage alive with a "wraparound" mortgage. Without the knowledge of the lender, the seller takes a mortgage from the buyer, which may be for a larger amount than the balance of the old loan, and continues to pay the old mortgage out of the proceeds of the new one. The new mortgage "wraps" the old one.
For example, S, who has a $140,000 mortgage on his home, sells his home to B for $200,000. B pays $10,000 down and borrows $190,000 on a new mortgage given by S. This mortgage "wraps around" the existing $140,000 mortgage because the seller as the new lender continues to make the payments on the old mortgage. Collectively, buyer and seller benefit by retaining the old low-rate mortgage.
As interest rates rise, we will see more wraparound mortgages because the benefit from keeping old mortgages alive increases.
This is a dangerous business, particularly to the seller, who has given up ownership of the house but retained liability for the mortgage. The seller is in deep trouble if the buyer fails to pay, or if the lender discovers the sale and demands immediate repayment of the original loan.
Home sellers with FHA mortgages have no need for wraparounds.
• Contact Jack Guttentag via his website at mtgprofessor.com.