For many years, home loans were freely assumable because interest rates were relatively stable and the value of money was not eroded rapidly by inflation. Lenders who paid 4 percent and 5 percent for savings accounts and other short-term deposits could lend money profitably for 30 years at 6 percent and 7 percent interest. Assumptions were practical under such conditions because the interests of neither lenders nor borrowers were harmed.
This system worked well until the late 1970s. At that time, the cost of short-term borrowing began to rise above the return that lenders were receiving from their mortgage portfolios, and huge losses were the natural result.
Why did the system change? Inflation meant that the public no longer could preserve the spending power of its dollars by making short-term deposits at low rates. Mortgage interest rates went up as lenders were forced to pay more interest to attract short-term deposits and accounts.
Just as importantly, dollars that at one time would have been deposited with mortgage lenders were being diverted elsewhere. The lending industry was transformed into the financial services industry, where more players competed for the public's money. Billions of dollars, for example, were shifted from banks and savings and loan associations to money market funds and other new investment choices, a process known as disintermediation in the financial community.
The increase in short-term funding costs meant that lenders had multi-billion-dollar mortgage portfolios paying 4, 5, 6, 7 and 8 percent interest that were underwritten by short-term borrowing at rates of 12, 13 and 14 percent and even higher. To limit their losses, lenders began to restrict the assumability of new loans. New mortgages made in the lender's usual form began to commonly include a due-on-sale clause (also known as an alienation clause), which provided that the entire loan would be payable at the time the property was sold or, alternatively, that mortgages could be assumed but only with the prior written consent of the lender.
As restrictive clauses became more common, lenders were able to reduce their portfolio of outstanding assumable mortgages and thus lower their exposure to changing market conditions. While original borrowers with fixed-rate mortgages could get loans at current market rates, such rates could not be freely passed along to future buyers. In effect, the burden of inflation had been shifted somewhat from lenders to borrowers.
Not surprisingly, due-on-sale clauses raised, and continue to raise, a number of issues. Are such clauses in the public interest? If not, can lenders enforce them? Are there ways to evade due-on-sale restrictions? A variety of lawsuits have resulted from efforts to avoid due-on-sale limitations.
While new mortgages routinely contain due-on-sale clauses, the pool of old loans that are assumable encompasses millions of mortgages. Here, in general terms, is a catalogue of commonly assumable loans:
* FHA mortgages. About five million loans with a face value of more than $125 billion have been insured by the Federal Housing Administration. FHA mortgages, including those being made today, are assumable at their original rates and terms. According to the FHA, a lender can charge a $45 assumption fee if the original borrower remains liable for the loan. If the original borrower elects to be released from the mortgage, the lender can recover actual costs.
Note that FHA-insured loans made through state financial agencies in recent years contain selective due-on-sale clauses. These loans may be assumed at their original rates and terms providing the new buyer is financially qualified to participate in selected state housing programs that typically are directed to meet the needs of low- and moderate-income households as well as certain individuals who have not owned property. It is estimated that there are about 100,000 restricted FHA loans.
* VA mortgages. There are more than four million loans with a face value of nearly $125 billion that have been guaranteed by the Veterans Administration. Such loans, including those made at this time, are assumable at their original rates and terms, except for loans made recently through state housing programs where a selective due-on-sale feature is in force.
* Silent loans. Conventional loans not containing due-on-sale clauses are freely assumable at their original rates and terms.
* Due-on-sale loans. In some circumstances, a lender may elect not to enforce a due-on-sale clause. For example, the Federal National Mortgage Association (Fannie Mae), which has bought pools of home mortgages worth billions of dollars, will not enforce due-on-sale clauses on loans purchased before Nov. 10, 1980, resale refinancing (so-called blend loans) that is assumed within one year of origination, window-period mortgages (see the following) or adjustable-rate loans, provided that the new buyer is creditworthy.
* Window-period states. In California, Arkansas, Colorado, Georgia, Iowa, Michigan, Minnesota, New Mexico, Utah and Washington, due-on-sale clauses cannot be enforced until Oct. 15, 1985. This date may be pushed back even further if changes are made by individual state legislatures.
* Consent loans. In those instances where a loan is assumable with the consent of the lender, such consent may be obtained by having a creditworthy buyer and raising the interest rate, charging fees up front or issuing new mortgage documents that will require certain payments to the lender.
The question here is whether an assumable mortgage with a market interest rate is a bargain. Because the rates for both conventional and assumed loans with current interest rates will be substantially the same, one must consider the expense of an assumption fee (a charge made by a lender at the time of an assumption to at least cover the cost of paperwork and frequently to raise the lender's yield from the mortgage) and all other charges versus the cost of new financing, including items such as loan application fees, origination charges, and points.
Questions to ask:
* Is the loan freely assumable?
* If the loan is assumable, is there an assumption fee? (As a matter of negotiation, try to get the other party to pay this cost or at least share the expense.)
* What actions will be required to satisfy a lender whose consent is needed for an assumption? Will interest levels rise? Are new mortgage papers required? NEXT WEEK: Assumptions and liability.