Updated December 17, 2010
This article examines how a homebuyer’s financial illiteracy affects his risk of losing his home by foreclosure, and the need for selling agents to educate their buyers about the mortgage decisions they make.
Counseling to protect and educate: lender beware
Consider a prospective first-time homebuyer beginning his search for a home. Before he contacts an agent, he drives around prospective neighborhoods and finds an area he likes. After he identifies his preferred neighborhood, he contacts a local real estate agent and makes an appointment to meet.
On their first meeting, the agent determines the homebuyer is ready to buy his first home. The agent also learns the characteristics of the type of home the homebuyer wishes to purchase and the sort of neighborhood he would like to live in. The homebuyer tells the agent he has heard on the news mortgage rates are low and it is a great time to buy a home.
The agent asks the homebuyer a series of questions, as part of his initial counseling of any homebuyer, to pinpoint the hard facts supporting the the homebuyer’s emotional desires and qualify the homebuyer as truly able to undertake the responsibility of homeownership:
- Does the homebuyer have funds for a down payment? The amount of the homebuyer’s savings and the homebuyer’s income, along with the homebuyer’s willingness to pay for or avoid mortgage default insurance, will set the price the homebuyer is able to pay. On conventional loans, the prudent minimum required down payment is 20% of the purchase price of the property if the homebuyer is to avoid the high cost of mortgage default insurance, known as private mortgage insurance (PMI) or, on government-insured mortgages, mortgage insurance premiums (MIPs). Loans insured by private mortgage insurers (PMIs) generally require a 10% down payment (15% on condominiums) whereas loans insured by the Federal Housing Administration (FHA) require a down payment of at least 3.5% of the purchase price of the property. [For more information on the additional costs associated with an FHA-insured loan, see the July 2010 first tuesday article, The true costs of a default-insured mortgage.];
- Does the homebuyer understand the various mortgage financing available to him? Though the media has made much of the unsustainable nature of adjustable rate mortgages (ARMs), in the recent years since the Great Recession, the share of ARMs in the mortgage market, while still in the single digits, continues to increase steadily. Thus, the homebuyer needs to understand (or be taught by his agent) the difference between a volatile ARM loan and the more stable conventional fixed rate mortgage (FRM) loan. The risk of loss associated with each is hugely different. In addition, the agent needs to ascertain the level of the homebuyer’s understanding of credit, amortization periods, pre-payment penalty provisions, loan points, lender fees, closing costs and much more. [For more information on the increasing use of ARMs, see the June 2010 first tuesday article, California home sales data for June 2010 and the March 2010 first tuesday article, The danger of an ARMs build-up.]
- Does the homebuyer know the loan amount is set by the lender’s income-to-payment ratio? After considering how much down payment the homebuyer can provide, the homebuyer must pay the remaining amount of the purchase price as a monthly loan payment of principal and interest on a mortgage loan acquired to fund the purchase of the property. If the down payment is less than 20% of the purchase price, property taxes and hazard insurance are paid to the lender as impounds monthly, and the payment of all four components (principal, interest, property taxes and hazard insurance) is collectively known as PITI. Additionally, other housing-related expenditures, such as ground lease payments, improvement district bonds and homeowners’ association (HOA) dues are also included in a lender’s calculation of housing costs. Typically, lenders only allow a homebuyer’s total housing payment to the lender to be a maximum of 31% of his gross monthly income. Though a homebuyer’s home purchasing power is increased when interest rates are low, the amount of his income will control the maximum amount of his monthly payment and, in turn, the amount of money he can borrow, limited by the 31% income-to-payment ratio. [For more information on the homebuyer’s purchasing ability, see the May 2010 first tuesday article, Homebuyer purchasing power.]
- Will the homebuyer be able to pay the increased utilities and maintenance of a home? In the both euphoric and stressful process of purchasing a home, many buyers do not consider the costs of homeownership beyond the immediate outlay of a down payment —the capital investment aspect — and the amount of his monthly loan payment. All the ongoing ownership costs taken for granted as the landlord’s responsibility — such as the cost of repairing an air conditioning unit, a water heater, a roof or performing general property maintenance, plus property taxes and hazard insurance if not impounded with loan payments — suddenly becomes a surprise drain on the monthly income of the homebuyer who does not take them into account when he endeavors to become a homeowner.
After a thorough counseling session in which the agent questions the homebuyer and explains basic home financing arrangements and the cost of operating a property, the agent provides the homebuyer with a client welcome package which contains a written explanation of the terms and concepts they discussed in their initial meeting, and more.
The disconnect between the American Dream and the American Reality
Homebuyers who took out subprime loans (read: ARMs) during 2006 and 2007 were recently asked to answer five simple mathematical questions as part of a study by the Federal Reserve Bank of Atlanta (the Fed):
1. In a sale, a shop is selling all items at half price. Before the sale, a sofa costs $300. How much will it cost in the sale?
2. If the chance of getting a disease is ten per cent, how many people out of 1,000 would be expected to get the disease?
3. A second-hand car dealer is selling a car for $6,000. This is two-thirds of what it cost new. How much did the car cost new?
4. If five people all have the winning numbers in the lottery and the prize is $2,000,000, how much will each of them get?
5. Let’s say you have $200 in a savings account. The account earns ten percent interest per year. How much will you have in the account at the end of two years?
20% of those who scored in the bottom quarter on this five-question math exam had gone through foreclosure, compared with 5% of those in the top quarter. The respondents who scored in the bottom quarter were behind on their mortgages 25% of the time, versus the top quarter who were behind on their mortgage 10% of the time. [To take the quiz yourself, click here.]
Additionally, the researchers further compared their results with mortgage data available on these buyers and found 70% who did poorly on the questions (the bottom quarter) were first-time homebuyers. In contrast, first-time homebuyers accounted for only 33% of the highest-scoring group (the top quarter).
Another report released by the Financial Industry Regulatory Authority (FINRA) and the U.S. Treasury revealed 2% of the individuals questioned did not know whether their mortgage loan was an FRM or an ARM. 20% were not aware if their mortgage loan was interest-only, or if it had an interest-only option, and 10% of the total number of respondents with mortgages did not know the rate they were paying on their mortgage.
A clear disconnect exists between a homebuyer’s actions and his understanding. This is not surprising. After all, the idea of the house with the white picket fence is an easy sell for agents: Americans are bombarded with this idea from an early age by all of society. The government’s campaign pushing homeownership as public policy (primarily encouraged by the tax code and government-guaranteed mortgages) makes it seem a natural progression for an individual to move out of the parental nest into an apartment, and then in a decade or so, to move out of the apartment into a single family residence (SFR).
The “minor” details in between – locating and negotiating the price of a home, shopping for mortgages, maintaining property — are left out of the idyllic picture. This “tire-kicking” mentality (so named for the anecdotal practice of using the superficial kick of a tire to determine whether or not an entire car is sound to purchase) makes individuals feel as if they are entitled to homeownership (if not actually compelled by peer pressure), but does not give them the skills or knowledge to obtain it in a sustainable way.
A well-intentioned, but naïve suggestion for lenders
The Fed attributes the relationship between a homebuyer’s mathematical ability and the occurrence of mortgage distress to a fundamental weakness in personal budgeting skills and the general population’s inability to plan for future expenditures — the underlying principle (and principal) behind a mortgage payment (and credit card usage). They have a novel if not intuitive solution to a homebuyer’s lack of financial acumen: a math test, given by lenders to loan applicants as a tool to assess the risk of foreclosure posed by the applicant.
In the Fed’s well-intentioned ivory tower, such a thing could be accomplished. In reality, it will not happen; buyers and lenders are in diametrically-opposed, adversarial positions — lenders simply will not inhibit in any way their ability to collect fees and interest over so small a concern as protecting a homebuyer’s solvency. Lenders have inside knowledge about how mortgages work and how they will affect those who enter into them and do not voluntarily make it known. Hence, the asymmetry of information: if the homebuyer knew what the lender knew, he would not take out that loan.
As early as 1982 when the U.S. Treasury authorized banks to make ARM loans, the great industry-insider joke was the non-efficacy of ARM loans, which were referred to as Zero Ability to Pay (ZAP) loans and RIPOFF (Reverse Interest and Principal for Optional Fast Foreclosure) mortgages. Lenders knew, but did nothing and will continue to obfuscate the deadly truth for their own gain. Thus, until the effects of this asymmetry of information between the lender (the insider) and the homebuyer (the consuming public) are corrected by government oversight and public education, it will continue to wreak havoc on homebuyers and real estate markets alike.
All this is not to say the homebuyer is blameless; he is as complicit in his own misfortune as any other party to a toxic mortgage transaction for his failure to diligently seek out instructive information prior to agreeing to a loan. The homebuyer’s indifference to his own financial plight stems from the lack of practical mathematical ability and financial savvy — a failure of family members, secondary and post-secondary educational institutions to inculcate these skills in potential homebuyers prior to their foray into the world of jobs and homeownership. Education and loan transparency are the keys; the holders of these precious keys are the gatekeepers to real estate: the brokers and selling agents representing the buyers. The Fed has now indicated it will help to that end. [For more information on the Fed’s new consumer protection regulations, see the October 2010 first tuesday Legislative Watch.]