Seller-assisted financing of mortgages, the mainstay of the home real estate market in 1981--will come under national "truth-in lending" consumer protection safeguards for the first time ever, if the Federal Reserve Board gets its way.
The Fed proposed a new regulation this week that would force hundreds of thousands of real estate brokers to spell out key details of "creatively financed" mortgages to prospective home buyers, before they sign binding sales contracts.
The proposal attempts to remedy a major consumer problem in real estate: buyers' unfamiliarity with the risks involved in "balloon" financing, "interest-only" second mortgages, and other non-traditional techniques.
Banks, S&Ls and professional mortgage brokers have been covered by federal truth-in-lending rules for years. They are required to give borrowers a disclosure statement that clearly explains the annual percentage rate they're about to be charged (including all points and fees), the lump-sum amount they'd owe if a balloon payment comes due, and other relevant facts about the financial burden they're taking on.
Regulated banks and S&Ls, however, account for a decreasing fraction of home real estate financings. Industry surveys show that anywhere from 40 to 80 percent of all home resales are now seller-financed. None of those transactions currently comes under truth-in-lending regulations.
That "opens the door to some very scary situations for buyers and sellers," according to Dolores Steinhauser, an economist with the Federal Reserve Board, based in Atlanta. "A growing number of consumers aren't covered by even the minimal protections that they should have."
Steinhauser recently conducted research on "creative" mortgages and found that many seller-financed buyers "apparently have little idea of what they've gotten into" -- especially in below-market-rate, balloon-type arrangements due in two to three years.
(In short-term balloon financings, the entire principal debt on a mortgage comes due at once, on the final date of the loan. The borrower must either refinance the loan or default and face possible foreclosure.)
"People rush into these (seller-financed) transactions full of hope that somehow interest rates will be lower when that big balloon payment comes due," said Steinhauser. "They look at the 11 or 12 percent they're walking away with, not the 18 or 19 percent rate at which they might have to refinance. They also assume that the property will have risen in value during the term of the loan. But neither assumption is necessarily a safe one in the 1980s."
Buyers and sellers in custom-tailored mortgage transactions ought to at least receive the disclosures they'd get from a regular bank, argues Steinhauser. The real estate brokers who typically arrange the terms of seller take-back financings of first or second mortgages "have no motivation to warn either party," she says. "They want the sale to go through -- so they don't want to introduce anything that might scare away the buyer."
The Federal Reserve's proposed new regulation would change all this. Real estate brokers who helped arrange more than five seller-financed transactions a year would be required to make the same sort of truth-in-lending disclosures to prospective buyers now performed by banks. A one-page disclosure statement would have to be presented to the buyer before the contract (or purchase offer) was signed by the seller.
If the required disclosure was incorrect, or was not made by a broker or agent covered by the regulation, the broker could be subject to civil penalties of up to $1,000.
Here's an example of how seller-financing disclosure might work, provided in advance to this column by the Fed staff:
A purchaser agrees to assume a seller's $75,000, existing 7 percent mortgage and the seller provides a second mortgage of $45,000 at an interest-only rate of 13 percent for five years. The sale price is set at $150,000, with $30,000 down.
The truth-in-lending statement provided the purchaser in this case would alert him to the fact that the total finance charge on the deal was substantial ($29,000). It would also warn him that five years from the date of contract, he'd owe the seller an amount higher than the $45,000 he borrowed originally on the second mortgage -- despite having made payments on that mortgage of $500 a month for five years.
Total costs to the consumer in this relatively simple, commonplace, seller-financed transaction would be nearly $180,000.
(For more information on the Federal Reserve's proposal, contact Susan Werthan, staff attorney, Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve System, Washington 20551. Comments from the public and industry will be accepted for the next 45 days.)