Subprime borrowers: the mandatory rainy-day fund
The financial burdens of homeownership aren’t just about the mortgage, there are other direct burdens, such as property insurance and real estate taxes, that have to be paid. Yet such is our fixation with the monthly loan nut that we overlook or actively resent the escrows:
Gotta make it every day
Yet the escrows are a shock absorber, like car bumpers and boat fenders, seemingly gratuitous until you suddenly, really need them, as illustrated in this very helpful Washington Post column by my long-time professional colleague Ken Harney [Full disclosure, for whom I hosted some resyndication seminars back in the Pleistocene Era — roughly 1983 — Ed.]:
I worked with Ken back in the days of overhead transparencies
As financial regulators and Congress probe more deeply into delinquencies and foreclosures in the subprime home loan market, one contributing factor is receiving increased attention: the lack of mandatory escrow accounts.
We think of mortgages as having a first lien — they must be paid before anything else — and in fact that is the lingo, but they are primed [superseded in economic precedence — Ed.] by two other liens, one of legality, the other of practicality:
· Real estate taxes, by law, have a claim ahead of the mortgage.
· Hazard insurance premiums, by market practice, since a hurricane or tornado trumps any paper.
As Ken describes it:
When a borrower fails to pay real estate taxes, local governments can file liens against the property and force its sale to obtain the unpaid amounts.
Rhymes with clean, spelled like mien
The lender then faces financial loss if the sale proceeds are not enough to pay off the mortgage. Escrows for insurance also are designed to protect the homeowner against loss in the event of a fire or other damage, and to cover the lender’s security interest in the property.
Most lenders, knowing their dual vulnerability, quite rightly insist that borrowers undertake
· To fund escrows for both taxes and insurance
· To place those escrows in deposit with the lender
· To make monthly payments that accompany the loan payment
This seems harsh and anti-accommodating — it raises the borrower’s monthly cost and thus keeps some people out of homeownership.
Escrow accounts are set up by lenders to guarantee the timely payment of property-tax bills and insurance premiums. On top of principal and interest charges for the mortgage every month, the lender also collects money to be paid when tax bills and insurance premiums come due during the year.
They raise the borrower’s costs. But …
In that sense, escrow accounts are a safety net for homeowners and lenders alike.
What if I don’t want a safety net?
We don’t need any safety net!
Enter the too-friendly lender, who waives all that mumbo-jumbo:
According to some industry estimates, most subprime mortgages closed during the housing boom years carried no escrows for property taxes and hazard insurance.
Again we see the agency risk of a mortgage broker working under an originator.
Subprime lenders dispense with mandatory escrows to keep monthly payments low.
If your goal is to get signatures on dotted lines, and you have no thought beyond that moment, you do such things. That makes you the borrower’s friend.
That is in stark contrast to the prime mortgage market for consumers with good credit, where mandatory escrow accounts are routine.
You seem awfully young for a subprime lender; are you sure I don’t need escrows?
Doesn’t it?
“It’s an upside-down world,” said Michael D. Calhoun, president and chief operating officer of the Center for Responsible Lending, a consumer advocacy group. “The people you’d think need an escrow the most aren’t required to have them, and the people who need them the least are forced to use them.”
There’s another, more disreputable, reason why some mortgage brokers want to waive the escrows — so they can jack up the interest rate without busting the borrower’s monthly payment cap:
It’s important to put a cap on the payments
To what uncharitable use might unscrupulous mortgage brokers redirect the waived payments? To higher interest charges:
That’s an important lure because the interest rates they charge often are 3 percentage points [300 basis points, akin to turning a 7.00% loan into a 10.00% rate — Ed.] above prime market rates, and many clients already have high debt and modest incomes. But the lack of escrow accounts also places heavy responsibilities on the borrowers to accumulate enough money during the course of the year to pay tax and insurance bills, and to know when those bills come due.
Have you been keeping up with your insurance bills?
For people who find finance impenetrable, there is a comfort in believing that a lender, who ostensibly has no motivation to lend you more than you can repay, is giving you the money: This must be all I have to pay, thinks the borrower, because otherwise they’ll be at risk. So borrowers presume that the opening payment is the ongoing payment, or they are talked out of worrying about the future in their understandable hunger to be homeowners.
Roy Rangel, a broker with Statewide Mortgage and Lending in
Borrowers who thus discover the need for taxes or insurance may be shocked but scrape together the money somehow. That weakens them for the next shock: a rising debt service payment requirement.
When those borrowers’ regular principal and interest payments jump by 40 percent or 50 percent from their artificially low introductory levels, “then they’re in really big trouble, they are drowning,” Rangel said.
Help! My payments have increased 40%!
People fixate on the interest rate because lenders dangle it, when what they really should watch is the total monthly payment:
Rangel recently refinanced a loan for a young couple on the verge of foreclosure. They had bought their first house in 2004 with a “2/28″ subprime adjustable rate loan at 7%, meaning it had a low rate for the first two years. With no escrow account, the monthly payment was just $703. After the first two years, their payment jumped to $857.
That’s a 22% hike in payments, almost certainly tipping them into the red. There was another whipsaw:
“But the real trouble,” Rangel wrote in an e-mail, “was the fact that they did not have an escrow account.” Their insurance carrier abruptly withdrew from the business of insuring property hazards, leaving them with no coverage. Their lender then “force placed” substitute insurance costing $1,700 a year, nearly double the premium they had before.
The point here is not the savings aspect, it’s the forward purchase: those who were escrowing for insurance would have been buying it twelve months ahead, with monthly payments, so even if the premiums jumped, the borrower would have had time to prepare for this, or shop for another carrier. In this example, the boost represents another $70 per month (more or less), so their payments were now 32% higher than when they got it.
Almost certainly, had the couple realized where the stabilized payments would come to rest, they would not have bought, or could not have been financed. They were, in a word, lured into over-committing. And, contrary to our previous advice, they probably didn’t alert their lender beforehand:
Also, because they hadn’t paid their property taxes, the lender paid them, leaving the couple owing an additional $5,000.
Let’s presume that means another $416 per month, and use that figure later.
To recoup the $5,000, Rangel said, “the lender increased their monthly payments to $1,646″ — far beyond what the couple could afford.
All of that is mechanical — the lender, who is also an innocent party, albeit one with much greater staying power, simply had to clear the real estate tax lien, and probably put the repayment of that advance on a faster schedule. How could the couple extricate themselves from imminent foreclosure?
Rangel was able to refinance the loan — including the $5,000 extra — by putting the couple into a fixed rate, FHA-insured mortgage at 6.25%, with a mandatory escrow account and a monthly payment of $1,130.
Presumably the couple went into this thinking that they could cover $1,120 per month ($703 of mortgage plus $417 of taxes). By the time the rate hikes and taxes had been factored in, they were facing $1,646, 47% higher than they anticipated. They got out because they refinanced at a lower base rate, and probably with a longer repayment period, and got their total payments back in line — in fact, probably lower than before; we lack full details on the insurance.
Striking here is how government — in this case, the FHA — cracked the credit conundrum by extending more favorable terms to a less creditworthy buyer. This is a beautiful example of the value-additive effect of government intervention at the margin between the credit threshold and the un-creditworthy.
Let’s just pour in some credit enhancement
Federal financial regulators have begun focusing on the subprime industry’s frequent omission of escrow accounts. In proposed guidelines issued March 8, regulators from the Federal Reserve, Treasury and other agencies said lenders should disclose and explain upfront to credit-impaired borrowers that without an escrow, the burden is completely upon them to pay all property taxes and insurance premiums in a timely manner, and that such payments “can be substantial.”
That kind of Miranda Warning is all well and good, but it can be sped through without comprehension.
Consumer advocates, however, say Congress ought to consider forcing subprime lenders to use escrows.
“I think the failure to escrow on subprime mortgages is an abusive practice,” Calhoun said. “We think escrowing should be mandatory.”
Everyone should have a financial safety umbrella
