The largest source of below-market financing is the multi-billion-dollar pool of existing mortgages where payments may be continued by real estate buyers without a change in terms or conditions. Such financing, which is known broadly as "assumable" mortgages, is available in every community and represents a source of significant dollar savings for many purchasers. An example of a sale involving assumable financing would look like this:
Jones, a buyer, has been shopping for a house in a particular neighborhood and has found two equally attractive $100,000 properties. One home is available with 30-year conventional financing at 12 1/2 percent interest and 20 percent down in cash. The second property has a 9 1/2 percent assumable loan with a remaining balance of $78,000. Jones offers $94,000 for the second home, a figure which includes $16,000 cash down plus the assumption of the 9 1/2 percent loan.
By purchasing the home with better financing, the buyer above has cut his interest expense by three full percentage points, or more than $2,000 in the first year of ownership.
Not only do below-rate assumable loans produce lower interest costs, they also offer two other advantages as well.
First, buyers who might be frozen out of the real estate market by high interest rates often can find affordable housing when they locate property with an assumable mortgage.
Second, assumable mortgages produce faster equity growth. In their first years, monthly mortgage payments are tilted heavily toward interest costs, and only a limited number of dollars remain to reduce the principal balance of a loan. Over time, the balance between interest payments and principal reductions changes, with more and more money going to pay down the principal balance of the loan.
Because loans typically are assumed at least several years after they originate, it means that buyers who assume loans benefit from larger equity reductions each month. For example, in its first year, a 30-year, $75,000 mortgage at 12 percent interest will require monthly payments of $771.46. Of this amount, only $21.46 will be used to reduce the principal balance in the first month. If such a loan were assumed after 60 payments, the monthly cost would be the same but the principal reduction would be $38.99.
After 60 months, the principal balance of the $75,000 loan would be paid down to $73,247.40. On the basis of a principal reduction of $1,752.60 ($75,000 less $73,247.40), yearly costs would be reduced by $210.36 ($38.99 less $21.46 equals $17.53 a month, and $17.53 times 12 equals $210.36.) The economic return on $1,752.60 would be 12 percent annually, but because this yield is not taxed, the true rate of return is much higher.
Within the pool of assumable mortgages are loans with interest costs of 4, 5 and 6 percent. As a rule, the lower the rate of interest, the older the loan. Older loans, in turn, have smaller remaining principal balances, which means that buyers will need more cash or secondary financing to obtain such loans.
For example, a $100,000 home may well have an assumable loan at 6 percent interest, but the principal balance may be just $20,000. To buy this property, a purchaser will have to come up with $80,000 in cash or credit, financing which is not available to everyone and which may be invested better elsewhere when it is available.
Although buyers clearly should search for low-interest assumptions, the benefits of assumable financing are not always certain.
Consider a situation where a property is available for $100,000. There is a $50,000 assumable first trust at 9 percent. The buyer has $20,000 in cash and asks the seller to take back a $30,000 second trust. The seller will do this, but only if the buyer pays 15 percent interest.
If accepted, the result of this arrangement would be an overall interest rate greater than 9 percent. The question is whether the combined rate and monthly payment required for the two loans is a better or worse deal than simply refinancing the property on a conventional basis. It is entirely possible that an assumption with a second trust will have both a higher interest rate and a higher monthly payment than a new loan.
In addition to comparing interest rates and monthly payments, financing costs must be weighed. Is there a modest assumption fee or is a large payment required? How does the expense of an assumption compare with the expense of new financing, including loan application fees, points, and loan origination costs?
The element of time must be considered when comparing assumptions with alternate financing arrangements. An assumed mortgage plus a second trust may have higher monthly costs than a new conventional loan, but the combination package may have a considerably shorter term. This means that, if you intend to hold property for many years, the higher payments actually may be a bargain if there are fewer of them. Each case is different and individual buyers should consider a variety of factors when reviewing assumption opportunities.
NEXT WEEK: Which loans are assumable?