When a homebuyer assumes responsibility for a home seller’s existing mortgage,
it is called an “assumption”. The buyer assumes all the obligations under the
mortgage, just as if the loan had been made to her.
The major driving force behind assumptions is the lower interest rate on the
assumed mortgage relative to current market rates. If the home seller has a
5.5 % mortgage, for example, and the best the buyer can get in the current market
is 7%, both parties can be better off if the buyer assumes the 5.5% loan. An
assumption also avoids the settlement costs on a new mortgage.
For years, we heard little about assumptions because market rates were so low.
Now that rates are above their lows, and may rise further, we can expect that
assumptions will receive increasing attention.
The value of an assumption depends on the difference in rate, the balance and
period remaining on the old loan, the term of the new loan, on how long the
buyer expects to have the mortgage, and on the “investment rate” – the rate
the buyer could earn on her savings. Assuming that the 5.5% loan has a $100,000
balance with 200 months remaining while the 7% loan would be for 30 years, that
the buyer expects to be in the house for 5 years and can earn 4% on investments,
the value is about $7,000. A spreadsheet that makes this calculation is available
on my web site.
The $7,000 of savings does not include the settlement costs on a new loan.
On the other hand, the savings would be reduced if the buyer has to supplement
the existing loan balance with a new second mortgage at a higher rate. This
could well be the case if the existing loan balance has been paid down appreciably,
and/or the house has appreciated since that mortgage was taken out. The buyers
who do best on assumptions are those who have the cash to pay the difference
between the sale price and the balance of the old loan.
However, buyers should not expect to receive the full value of an assumption.
The seller must benefit as well; typically, the parties share the savings. The
seller’s share will be in the form of a higher price for the house. Indeed,
some economists believe that the full value of the assumption should be reflected
in the price of the house, but this is as implausible as the opposite view,
that only the buyer benefits.
The benefit to buyer and seller from assuming an old loan comes at the expense
of the lender. Instead of having the 5.5% loan repaid, which would allow the
lender to convert it into a new 7% loan, the 5.5% loan stays on the books. Back
in the 70s and 80s, lenders couldn’t do anything about this. Mortgage notes
at that time did not prohibit assumptions, and the courts ruled that lenders
could not prevent them.
Following that experience, however, lenders have inserted due-on-sale clauses
in their notes. (An exception is FHA and VA mortgages, which do not contain
these clauses, as discussed next week). These stipulate that if the property
is sold, the loan must be repaid. Even with a due-on-sale clause, the lender
may allow an assumption -- keeping the loan on the books avoids the cost of
making a new loan – but the interest rate will be raised to the current market
rate.
Raising the interest rate to market removes most of the benefit of the assumption
to the buyer and seller. In some cases, they attempt to retain the benefit by
agreeing to a sale using a wrap-around 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.
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. I wouldn’t do it, even
if I were selling the house to my mother.
Instead of prohibiting assumptions, thereby encouraging wrap-arounds, why
don't lenders explicitly allow them for a price?
Good question. When interest rates are above their lows and new borrowers are
concerned that they could go much higher, some would be willing to pay a premium
rate for the right to transfer that rate to a home buyer in the future.
For example, a borrower taking a 6.5% 30-year FRM might be willing to pay 6.875%
for the right to allow a home buyer to take it over when he sells his house.
The higher rate is akin to an insurance premium. If market rates are above 16%
when he sells, as they were in 1981, he will save a bundle.
An assumable mortgage has some resemblance to a portable mortgage. If you sell
your home and your mortgage is assumable, it can be transferred to the buyer;
if it is portable, it can be transferred to a new property you buy. Portability
is of no value if you decide to rent, go to a nursing home, or die, whereas
an assumable mortgage retains its value in these situations. On the other hand,
some portion of the value of an assumable mortgage must be shared with the purchaser.
A mortgage that is both assumable and portable would have enhanced value.
Lenders who offer an assumability option will require that any new borrower
meet the lender’s qualification requirements. Borrowers purchasing the option
will need to be confident that the lender won’t tighten its requirements when
market rates increase. The best assurance would be a commitment to accept approval
under one of the automated underwriting systems developed by Fannie Mae or Freddie
Mac.
Loans insured by FHA or guaranteed by VA have always been assumable. During
periods when borrowers are concerned about future rate increases, this gives
them an edge.
FHA loans closed before December 14, 1989, and VA loans closed before March
1, 1988 are assumable by anyone. Buyers who assume these mortgages don’t have
to meet any requirements at all, but the seller remains responsible for the
mortgage if the buyer doesn’t pay.
Any seller who allows assumption by a buyer without a release of liability
is looking for trouble. Even if the buyer pays, and that is a crapshoot, the
seller’s ability to obtain another mortgage will be prejudiced by his continued
liability on the old one.
WARNING: The release of liability must be in writing, and you must preserve
the document. This will protect you in the event that the new borrower defaults
and the collection agency comes after you – it knows nothing about your release
of liability. This happens!
If an old FHA or VA is attractive to a buyer, the seller can request that the
agency underwrite the buyer. If the buyer is approved, the seller will be released
from liability. At this point, there can’t be many of these loans left with
balances large enough to be attractive to buyers.
Assumption of FHA and VA loans closed after the dates shown above requires
approval of the buyer by the agencies. The process is much the same as it would
be for a new borrower. Upon approval of the buyer and sale of the property,
the seller is relieved of liability. FHA allows lenders to charge a $500 assumption
fee and a fee for the credit report. VA allows a $255 processing fee and a $45
closing fee, and the VA itself receives a funding fee of ½ of 1% of the
loan balance.
FHA and VA loans that were closed during the low-rate years 2000-2003 will
become attractive targets for assumption if interest rates continue to rise.
Potential sellers who have one of these loans can use the spreadsheet on my
web site to estimate how much the assumption would be worth to a potential buyer.
November 17, 2003
