Financing the Purchase of a Home
Big Mistake #13: Failing to Understand the Meaning of the Financing Provisions in the Contract
The financing provisions of the purchase agreement are among the most important and complex provisions in the contract. Unless they are completely understood and used to your advantage, they can expose you to substantial unexpected costs.
For example, in the usual case in which a homebuyer must obtain financing for the purchase of a home, the typical contract form provides a blank for filling in the interest rate that the purchaser expects to pay on the loan. Almost invariably, however, the printed contract form then says “or market rate available” at the time of settlement. Very few purchasers realize the consequences of this provision. What it means is that, once you sign the contract, you have to accept whatever interest rate is available at the time of settlement, even if interest rates have gone through the roof since the contract was signed! It is highly unlikely that the seller or the real estate agent will tell you, the unwary purchaser, that you have a right to put a cap on the maximum interest rate you are willing to pay for the loan.
Financing Contingency. It is of the utmost importance to the purchaser that the contract state that it is contingent upon the purchaser obtaining any financing specified in the contract. If the contract does not say so and the purchaser fails to qualify for the financing he needs to buy the property, the purchaser would be in default under the contract. In that case, you might not only lose your deposit but also have to pay damages to the seller and the real estate agent for breach of the contract (for further details on default provisions in contracts, see Big Mistake #16).
Types of Financing Available. In contemplating the types of financing that are available, a purchaser has an almost unlimited menu of choices. Interest rates vary widely for different types of loans. There is even some variation, from lender to lender, for the same type of loan. The duration of the loan may be anywhere from a few months to thirty years. Most loan to value ratios range between eighty and ninety percent but some are even higher and some lower. Fixed rate loans are generally offered at substantially different interest rates from adjustable rate mortgages. The timing of adjustments and the annual caps, if any, on adjustable rate mortgages vary widely.
The number and diversity of loan products is just too great and too changeable to allow a detailed treatment in this booklet. Suffice it to say that, unless a purchaser is knowledgeable about financing and the pros and cons of the various loan types available, he will need an advisor whose interests are not in conflict with his.
Allocating Financing Costs. Once a general and preliminary decision is made as to the type of financing which the purchaser desires, the financing provisions of the contract can be completed and agreed upon between buyer and seller. In drafting the final terms of the financing provisions of the contract, however, it is necessary to allocate various costs between buyer and seller. The people drafting these financing provisions frequently fail to anticipate all of the costs that may be imposed by a lender and, consequently, they fail to provide in the contract sufficiently detailed provisions allocating these costs between the buyer and the seller.
The various types of charges imposed by lenders upon buyers and sellers typically amount to thousands of dollars. Invariably, these costs and charges go beyond the imposition of points. Unless the contract carefully anticipates and allocates these charges, a dispute between the buyer and seller is almost certain to arise at settlement when the buyer and seller find out, for the first time, that they are expected to pay unforeseen charges. Settling on the purchase or sale of a home does not rank high among the most pleasant and stress free experiences in life. For both buyer and seller, tension and anxiety come from many sources. Usually, the real estate agents are a little antsy, too. Consequently, finding a few hundred (or a few thousand!) dollars of unexpected costs on the settlement sheet can really throw a match on the gasoline. Obviously, it is in the purchaser’s best interest to try to anticipate all of these costs and charges and to attempt to shift as many of them as possible to the seller.
If the purchaser is not knowledgeable concerning financing and if the purchaser also has no one in the transaction early on to assist him in shifting these costs, there is a good chance that the purchaser will end up paying more than he needs to pay at settlement. In the typical situation where all of the real estate agents in the transaction are legally obligated to represent the seller’s interests, the risk to the purchaser is obvious.
It is worthwhile to spend a moment discussing the various types of costs and charges occasionally imposed by lenders in connection with mortgage financing. This is useful for two purposes: first, since the careful borrower/purchaser will want to shop for a loan with several lenders, it will give her a good checklist of potential charges to refer to when comparing the loans offered by the various lenders. Secondly, by anticipating all of the various types of charges that might be imposed by a lender, the purchaser is better informed and better able to negotiate the allocation of those charges between the purchaser and lender.
Types of Financing Costs and Charges. Various lenders impose a wide variety of costs and charges in connection with their loans. Different lenders may also charge widely different amounts even for the same items. Almost all lenders charge points in connection with their loans. Obviously, the contract needs to specify carefully how many points are to be paid by the buyer and seller.
Almost all lenders also require payment by the purchaser of credit application fees and appraisal charges. The amounts charged by different lenders for these items vary widely.
Some lenders charge for things like “document preparation” or “document review.” Other lenders do not. Other fees and charges imposed by some, but not all, lenders include things like “tax service” fees, “amortization schedule” fees, “inspection/compliance” fees, “photo” fees, and “warehousing” fees. It is emphasized that this list is exemplary only and is not intended to be exhaustive. The creativity of some lenders is almost unlimited when it comes to devising new names and rationales for additional fees to charge to the parties at settlement.
Usually, the lenders will impose these fees on the purchaser/ borrower. However, when you get to settlement, you will sometimes see these charges on the seller’s side of the settlement statement. Putting ambiguous terms in the purchase contract pertaining to the allocation of these charges between the buyer and the seller is a disservice to both parties because it exposes both of them to all kinds of unfair and excessive charges which may not be properly disclosed until it is too late to object to and avoid them. Phrases in the purchase contract such as “seller (or buyer) will pay customary lender charges at settlement” are almost guaranteed to lead to an argument at settlement.
Obviously, where unexpected charges appear on the settlement sheet, it creates a problem whether those charges are assessed to the buyer or the seller. However, since the seller is not a party to the financing agreements between the borrower/purchaser and the lender, sellers are particularly vulnerable and upset when they see such unexpected lender charges on their side of the settlement sheet. You can expect a dispute to arise when this happens. Consequently, it is in the interest of both buyer and seller for the purchaser to inquire carefully with each lender to make sure that the lender discloses in advance all of the charges to be imposed on both buyer and seller in connection with the loan.
Choosing a Lender. Early on in the home buying process, one of the real estate agents in the transaction will usually “pre-qualify” a purchaser for a certain amount and type of financing. “Pre-qualifying” the purchaser means obtaining some basic financial information about the purchaser in order to make a preliminary and general determination concerning the price of the home and the type of financing the purchaser wants and can afford. Sometimes, a purchaser will begin to shop for a lender even before submitting a purchase offer on a home. Usually, however, the final decision on a lender is not made until after the purchase contract is ratified by the buyer and seller.
The first consideration in choosing a lender should be the reputation of the lender for reliability and integrity. When money is plentiful and available at low cost, the marketplace is flooded with new lenders. At such times, it is relatively easy to get into the mortgage lending business. Customers are plentiful and profits are high.
In periods of financial instability, however, especially in a market where interest rates are rising and the cost of money is high, problems with inexperienced, underfinanced or downright dishonest lenders increase. Lenders find that they cannot deliver on their commitments to borrowers and they seek to avoid their commitments entirely or seek ways to increase the charges to the borrower to cover the lender’s additional costs of lending.
In general, the mortgage market is very competitive and it is not likely that you will find the rates and terms of one lender to be significantly superior over those of another. I believe that the more prudent and conservative approach for most borrowers is to deal with a well known and well respected lender with a track record of reliability rather than to try to save a few dollars by dealing with the “Unbelievable Rates Mortgage Company” whose rates and terms are so much better than everyone else’s that they seem to be just too good to be true. If the money markets take an unexpected turn for the worse, you may find out that that is exactly what they were.
The Loan “Commitment”. After a potential lender and type of loan have been selected by the purchaser, the purchaser will submit a formal loan application which will disclose a wide variety of credit information to the lender. At some point thereafter, assuming that the lender approves the loan, the lender will issue to the purchaser a loan “commitment.”
In evaluating any loan commitment, there are at least four important issues that need to be addressed. First, of course, as discussed above, the loan commitment should specify all of the rates, terms, fees and charges to be imposed in connection with the financing. Second, the commitment should specify clearly any contingencies which allow the lender to decide at a later time not to make the loan. Third, the commitment should specify whether or not the interest rate is “locked in”. Fourth, it should state the time period for which it is good.
In general, any loan commitment will be conditioned upon the occurrence or nonoccurrence of certain contingencies. The more contingencies there are in the commitment, the less of a “commitment” it really is. Some “commitments” are so conditional that they really state only that the lender will make the loan at settlement if the lender still wants to make the loan when the time for settlement arrives.
With respect to the decision of whether or not to “lock in” the interest rate, it is easy to state the guiding principle but it is like the classic advice to someone who wants to make money in the stock market: “buy low – sell high.” The principle is easy to state but difficult to apply to a specific situation.
As a basic proposition, you should lock in the interest rate when mortgage rates are, generally, on the rise. You should not lock in but allow the interest rate to “float” where mortgage rates are tending down. Unfortunately, there is no way of telling for sure whether the prevailing tendency to go up or down will continue tomorrow (or even for the rest of today). Even though, on any given day, there may be a consensus among knowledgeable people who are constantly “in” the mortgage finance markets, those “experts” more often disagree among themselves as to which way rates are going and, sometimes, they are all fooled by an unexpected turn of events.
What a prudent purchaser needs to focus on, I believe, is the fact that most lenders are in the lending business every day and are likely to know a lot more about the probable direction of interest rates than you are. If you and the lender have to “bet” on which way the market is going, the probability is that the lender is going to be right more often than you are. The “betting” of the borrower and the lender is a zero sum game, that is, whoever “wins” the bet gains an amount equal to the amount lost by the loser.
Consequently, in my opinion, a prudent purchaser/borrower will decide whether or not the quoted loan is an acceptable one and, if it is, will lock in for as long as the lender will allow, even if the lender requires you to pay something to lock in.
This brings us to the fourth issue, that is, the length of the commitment. Most lenders will not make a loan commitment for longer than sixty or ninety days. Depending of the conditions of the market at any given time, a lender may not be willing to give a commitment for more than thirty days. You should be aware that, once the commitment expires, all bets are off and the lender may charge whatever the market will bear. Of course, if interest rates have gone down, you may benefit from the expiration of the commitment, even if it costs you your commitment fee. Figuring out the exact economic consequences of these variables is very complicated and would require far more space to explain than is available in this booklet.
Be especially wary of the length of the loan commitment period when buying a new home, particularly when interest rates are on the rise. I have seen it happen so many times that I cannot believe it is purely an accident that, where interest rates are rising, the builder somehow fails to have the house ready for settlement until just a few days after the loan commitment has expired. This typically happens where the builder has an arrangement with a particular lender for a “package” of loans for the purchasers in a particular development and it would cost the lender and/or the builder additional money to honor the original commitment at the old, lower rates.
Seller Financing. If the financing terms of the contract call for the seller to take back a note for part of the purchase price, make sure that all of the important terms of that financing are specified in the purchase contract. At a minimum, these would include the amount of the loan, the interest rate, the length of the loan, the monthly payments, whether or not the loan is fully amortizing or leaves a balloon payment at the end of the term, whether or not there is a right to prepay without penalty, whether or not the note is assumable by another purchaser, provisions for notice and opportunity to cure any default, any late charges or other penalties, and rights of the noteholder to require any escrows for taxes and/or insurance premiums.