Monday, January 09, 2006

Serial refinancing or surreal financing

REFINANCING TO THE RESCUE!!!! First off, I want to say thanks to 'Harm' for suggesting the title for today's post. There was an interesting discussion going on at Ben's blog about this article that made the 'bold' statement that Interest Only Loans Prove Short Term Fix. The article investigates situations where borrowers refinance one interest-only (I/O) loan for another when the interest only period stops.

It seems that people were amazed by this fact. What do you think people are going to do after 2, 3, or 5 years of a nice low fixed payment?!?!? There appreared to be some sighs of despair as people thought "oh no, this thing is never going to end if people can keep refi'ing into another I/O loan". Well, don't you worry. There are quite a few obsticles in the way of simply refinaning again to another I/O ARM.

Let's look at some quick math before we get ahead of ourselves...that is why you come here right??

Note: I'm looking at several rate sheets and using rates that are typical of what is being seen in the market. Whether a borrower is A-paper or subprime, the spread between the rates is just bear with me.

Let's take a $300,000 loan at 5.25% I/O ARM (you can use 2, 3, 5, 7, 10 year I/O period...doesn't matter in this case)

Payments for x-amount of months = (300,000 x .0525) / 12 = $ 1,312.50 a month

Now lets look at those payments when they adjust. Not only do the payments adjust, but you have to start paying the PRINCIPAL off as well (unless you refi/sell/foreclose). Let's say the rate jumps to 6.75% (could be higher, but most have a 1.5% cap on each adjustment) and NOW you have to amortize over the next 28/27/25/23/20 years because you didn't pay any principal during the initial I/O period. So.....

Payment when the 2yr ARM adjusts = $ 1,989.68 a month . . . . .payment JUMPS $677.18 in one month!
Payment when the 3yr ARM adjusts = $ 2,014.80 a month . . . . .payment JUMPS $702.30 in one month!
Payment when the 5yr ARM adjusts = $ 2,072.73 a month . . . . .payment JUMPS $759.23 in one month!
Payment when the 7yr ARM adjusts = $ 2,143.24 a month . . . . .payment JUMPS $829.74 in one month!
Payment when the 10yr ARM adjusts = $ 2,281.09 a month . . . .payment JUMPS $967.53 in one month!

Let's also remember that I'm not even crunching the numbers of how much extra money will be paid in interest over the various periods. That would get really ugly, and besides, most people won't keep these loans that long, or stay with the property that long.

Ok, that's nice SoCalMtgGuy, but these people are going to refi before the adjustment hits. Oh that's right. Before they can refi, they will need a few things:

They will need to have some equity if they plan on refinaning the way they have been the past few years. I'm going to assume they didn't put very much, if any, money down. To show that they have equity, they will need an appraisal. I know there has been talk of appraisers pushing value. It is "easier" to do that in a market that is trending upwards. If the comps are falling, it is very hard to push the value on an appraisal. Some of you are asking why they need some equity to refi. Nobody works in this business for free...not the broker, not the title company, not the lender, and not the escrow company. All of those people want, and need to get paid for their services. So unless this borrower (which can't afford a higher monthly payment) has several thousand in savings to pay the fees, they will need to use the equity to pay for the refinance.

Let's look at some scenarios that might hurt people's ability to refi into another I/O loan:

- property values decline, and they are upside down. They can't refi without coming to the table with money...and if/when they do refi, they will be at such a high rate because of the LTV and higher rates that they won't be able to afford that either.

- lenders have this thing called benefit to the borrower. My lender will not refi an ARM into another ARM until it is adjusting or unless they are lowering payments a few hundred dollars per month or they are taking out enough cash to be at least 2x the cost of the refi. Even if the loan is adjusting, there can be times when there isn't a benefit to spend thousands of dollars to refi to save a few hundred.

- the borrowers that had lower LTV's will be at higher LTV's if prices decline. Higher LTV's will mean higher rates, and harder times for the borrowers.

- all of this assumes the borrower didn't take on extra debt, or have any credit problems. It seems that many people like to buy furniture/stereo/other goods on credit when they buy a new home. That is all well and good...but if you can't pay for those things in a timely manner, it WILL ding your credit score, and that will affect the rate you can get when you look to refi again.

But let's get back to our scenario, and assume that our borrower can get a 7.25% I/O loan on $300,000 and let's assume they paid cash for the refinance.

So, the new Interest Only loan payment is: $1,812.50 . . . . or a payment jump of $500.00 after refinancing.

The best case scenario for this borrower is to have enough equity so that they can refinance. Notice that I was kind, and did not add the cost of the refinance to the 300k loan balance. If I did that, the payments would be even higher.

Now that we have looked at the math, let me tell you what I see in the real world. In the industry, we call these people "refi junkies". These are the people who habitually refinance as many as 2-3 times in a year. I remember one credit report where the borrower went from a 360k loan, to a 430k loan, to a 500k loan, to a 565k loan, to a 635k loan, and this was going to be "their last refi...promise" at 710k. That would make 6 refinances in about a 4 year time period. But THIS time they were really going to pay off all their debt and not get into more debt. If you just assume the standard 6 months interest that is charged as a pre-pay penalty, these borrowers wasted a good 60-80k in pre-pay penalties as they jumped from loan to loan. I couldn't do that loan. Their LTV was too high, debt level too high, loan amount too high, and credit score too low to do a loan that would make sense for these borrowers. I do know that they ended up getting a loan after much trouble...but I have no idea if they really changed their ways or not.

Many of you reading this blog are probably scratching your heads in amazement. I have touched on it before, and I will touch again on HOW many of these ARM's are sold. The brokers sell the loan like this: "just get in the market. Get a low payment now, and when it adjusts, you will have equity, so just refinance into another ARM". It is stated so plainly that property will appreciate and refinancing will "automatically" bring lower payments like it has the past 5 years. The broker get an "annuity" from people coming back to them every 2-3 years to refinance. Would you rather make a few grand from the same person every 2-3 years, or would you rather put them in a fixed rate loan where they won't be back for a while?!? There are lots of good brokers that are professionals and will recommend what is best for the borrower, not their own personal pocketbook. There are also lots of brokers that love to churn the loans and make the easy money. A home purchase/refi is a big financial decision. It isn't something you just jump head first into with some broker over the phone. There better be some homework done before you make a financial decision with hundreds of thousands of dollars.

Just take what you learn here, crunch the numbers, and make a decision for yourself. Don't be afraid to ask questions you already know the answer to. This way you will find out if they have integrity and/or are just an idiot. Either way, you won't want to deal with them.

All and all, on paper it looks like there is going to be a massive refi-boom coming again in 2007 for sure. The problem is that many of those borrowers don't intent to refi, they intend to sell. They knew they couldn't make those payment for more than the introductory time period...but they wanted to make the money on appreciation, and then cash out. Even if only 15-20% of the people had that idea, that is still a ton of inventory that will be dumped on the market. Nobody knows for sure what will there is no precedent for the way money has been lent out these past few years.

On a side note, I made some changes to the blog over the past few days. I made the format wider, and hopefully easier to read. At the request of several people who have been reading this blog for a while and who I have been helping over e-mail, I added a 'donate' button. Thank you very much to those of you that have donated! I really appreciate it. It takes a lot of time to write the posts and reply to each of the hundreds of e-mails I have received. No pressure at all (I mean it!)...but it's there if you want to use it.

Keep the comments and feedback coming!!!



Blogger Out at the peak said...

Thanks for putting a good perspective on the borrowers who are due to reset their ARMs this year. Perhaps many of them will be able to refi and be okay, but as you said a 15-20% amount of people who are forced to sell their house would add a lot of inventory. It will probably be a combination of psychology with declining values as well as people who also took out 2nds and cannot afford to refi.

So we should have mounting inventory as both speculators and the FBs run for the exit.

A few weeks ago, you mentioned your company had a coming announcement that seem to be regarding lowering lending standards again. I look forward to a new post that addresses that announcement whether it is going to happen or not. (Love the wide format.)

1/10/2006 1:17 AM  
Blogger ocrenter said...

Socal, you know, I was just talking to someone about a lady who's using I/O 10years to get into a million dollar pad. and of course, when I mentioned it to my wife, she said, why couldn't we have done that.

So here's how I'm looking at it (the unsuspecting borrower): The biggest fear about short term ARMS (2/3/5 years) is that they will adjust along with everybody else in the same amount of time, creating a huge amount of inventory. The end of course is dropping prices and falling equity or no equity and you're stuck with a much higher payment or foreclosure.

But with an I/O that's fix'd for 10 years, you'll ride out the storm. by the time 10 years hit and it is time for rate adjustment, you may be riding another boom, rates may be coming down again. And even if you're not, whatever bursting would have probably been back in recovery.

what am I missing?

1/10/2006 7:42 AM  
Blogger Lou Minatti said...

SoCal, do you have any statistics on where these serial refinancers/FBs are concentrated? I think we all know the areas most infested by them, but I'd like to know if this is common elsewhere.

1/10/2006 8:16 AM  
Anonymous Anonymous said...

On average a 30 year note is held for 7 years then the property is sold. Hence one of the reasons why I/O may make sense for many borrowers.

1/10/2006 9:13 AM  
Blogger SoCalMtgGuy said...

jim a

thanks for your post. You are correct on many points. There are plenty of people that have fixed rate mortgages and that are just "making their payment" and are not wrapped up in the "frenzy" that has been going on. They still have the "old school" mentality of paying off their mortgage and not having a mortgage payment in retirement.

That said, you misunderestimate the effect of the bubble on 'sane' people. You state that only the "stupid" are buying these days and using "stupid" loans. Forget that I'm subprime/alt-a for a minute. Look at Countrywide's October 2005 report are far as option-arm production go. They are averaging 3 billion a month in option ARM volume...and it jumped to 8 billion in one month. (I use Countrywide because they are the #1 company in industry, and their financials seem to be realeased in an easy to understand manner).

I am an "sub a" rep as you state, but that doesn't mean I don't see what is going on with other loans. On many occasions, I end up pricing "a-paper" loans. What you have to understand is that things are not as cut/dry as they were in the past. A-paper is doing loans down to 620 fico scores, subprime is doing loans into the 700's, and Alt-a is kind of a "jack of all trades" for most borrowers. Some a-paper lenders are even going below 600 fico on the option-arm.

More and more people are refinanacing into option-arm loans as that is the only way to get a "lower" payment at this time.

All of that said, I don't think it has to be a majority of the population to have dire consequences. If you remove 15-20% of the "idiots" out of the market, that is a lot of demand that can, and has been pushing properties to higher values.

We wouldn't even know what a "housig bubble blog" is, if people were getting 30year fixed rates, with money down, with verified income loans. Even stated loans wouldn't have that much of an impact if people needed to come in with money down instead of doing 100% stated loans to buy property.

I hope that helps some...I know I sort of hit several topics.


1/10/2006 9:24 AM  
Blogger SoCalMtgGuy said...

bubblicious brooklyn.

Most loans have a pretty steep "margin". Some lenders have the margein=the rate, others set a margin that is usually 5-7% (fluctuates). This margin is usually added to the 6-month LIBOR rate.

Most loans have a 1.5% cap per adjustment, and a lifetime cap of 7-8%. You can fall a little bit on either side of these numbers.

Helicopter Ben would have to slash rates quite a bit to save lots of people. Not to mention that if property values decline even 5-10% that is going to make it much harder for a lot of people to refi. Even the people with equity will be at a higher LTV, and have higher rates.

We won't even get into the psychology that buyers will be confronted with. "why am I busting my butt to make a mortgage payment on a property that isn't making me money anymore??" People don't mind living frugal if they are making thousands a month on appreciation. That becomes a crappy 'mental' situation when you are upside down.


1/10/2006 9:32 AM  
Blogger ocrenter said...

tyler, true. however, for guys in very high tax brackets, even a slightly higher mortgage interest still beats the rent payment. And with the 10 year I/O, you'll be moving before the 10 years come up.

so what am I missing?

(I'm playing the devil's advocate here if you guys can't tell)

1/10/2006 9:32 AM  
Blogger SoCalMtgGuy said...


If you are going to do an ARM, might as well get it fixed for a longer period of time. That said, I would think it kind of sucks to make a payment for 10years and STILL owe the same amount. Not to mention that nobody has a crystal ball and can see that far ahead. I bet 99.9% of people would "guarantee" that property will be worth more 10 years from now, but again, there are NO guarantees.

I think a "smart" person might do well with a 10yr I/O loan. I would suggest they make principle payments along the way, and use the low rate they have locked in to their favor.

The problem with the 10year rates right NOW is that with the yield curve basically flat/inverted so the rates might actually be the same or higher than a 30yr fixed payment...the only benefit you are getting is the I/O...which will make for a lower payment.

The people that got the long term I/O a few years ago will probably be just fine. I have a friend that has one. He did 100% financing on a 700k condo. He COULD have put 400k down, but the money was so "cheap" he took the 100% route. I classify him as one of the more "sophisticated" people out there. By the way, he went full doc, had tons of assets, and a low DTI with his payment. He did a 10yr I/O in the low 5's if I remember correctly. He can pay extra principle if/when he chooses for the next 10 years and be in great shape no matter what the market does.

I hope this helps some...


1/10/2006 9:46 AM  
Blogger HARM said...

Helicopter Ben would have to slash rates quite a bit to save lots of people. Not to mention that if property values decline even 5-10% that is going to make it much harder for a lot of people to refi. Even the people with equity will be at a higher LTV, and have higher rates.


I second that and would go a bit further. I'd say that property values don't even need to decline to start hurting serial re-fiers --they could just stop appreciating. Once you've got zero nominal appreciation and need to refi your 106% LTV (financing costs rolled in) I/O mortgage and your I/O period is up, you're f@cked!

1/10/2006 11:04 AM  
Blogger ocrenter said...

thanks for the comments. very good inputs all around.

basically we are looking back and seeing if we should have done things differently. What happened was we purchased a condo using 30 year fixed, of course, we ended up with shady neighbors. we ended up selling for a nice profit and we are now renting.

looking back, what we should have done was one of the I/O ARM 2/5/10 years, got into a better place and not have to sacrifice life-style. of course, one would make the arguement that 2-5 year fixed to ARM would be more worrisome, but that's where the 10 year I/O ARM becomes quite attractive.

1/10/2006 11:09 AM  
Blogger SoCalMtgGuy said...


yup. I try to err on the side of giving the benefit of the doubt in most situations.

There is going to be lots of pain for lots of people...I just think late 2006, and in 2007 is when it will really start to show up.

It will take a while for this thing to pan out.

Stay tuned...


1/10/2006 11:10 AM  
Anonymous Anonymous said...

Thanks for pointing out something I never thought of:

That there are actually people out there who would "buy" a home w/ no real money on the assumption that they could just sell at high profits before their loans reset.

That is something that seems SO irresponsible that I never would have factored it in to my way of viewing this whole situation.

But, upon seeing all the other things that people have been doing with no real money to back it up (just a hope and a dream!), it now seems perfectly reasonable to add this folly to the long and getting longer list.

I'd love to see the numbers on how many people did this.

1/10/2006 5:59 PM  
Anonymous Anonymous said...


You have a great site here. Your comments are very interesting because of your unique insight to the industry. What in your opinion has made people buy a payment rather than look at price? It seems there has been a huge shift in mentality of not caring about price at all.I guess most people don't figure on having the loan that long and just bank on prices going up. This is scary s**t. I'm just not sure what has caused this mess. I'm from sacramento and the idiots have pushed prices out of sight. There is no value in the home at these prices. I might have to pith a tent on the american river this summer because I refuse to overpay for these insane prices.


1/10/2006 6:22 PM  
Blogger SoCalMtgGuy said...


you nailed it. People only care what they have to pay TODAY to get the appreciation TOMORROW.

There was no longer a need to put money down. The bank finances the whole deal, and so far, everybody has been a "winner" on the appreciation front.

The banks, lenders, brokers, RE agents, title companies, escrow companies, home furnishing companies, construction companies, and many others have enjoyed the ride.

The problem is that these loans have never been tested on a grand scale over the longer term. Eventually the payments jump dramatically on every one of these "creative" loans. See this post on LEVERAGE
that I did a little while ago.

Yes, there are lots of people with fixed rate mortgages, but if you remove even 10-20% of the people from the "market" that depend on these loans, property will have nothing to do but go down.

If there was no stated income loans to 100%...this market would NOT be where it is today.

Lots of people looking for the quick and easy buck. And like the stock bubble...many people got it/have it...but many more will get burnt in the end.


1/10/2006 6:38 PM  
Anonymous Anonymous said...

"I remember one credit report where the borrower went from a 360k loan, to a 430k loan, to a 500k loan, to a 565k loan, to a 635k loan, and this was going to be "their last refi...promise" at 710k."

Sounds like a microcosm the entire US economy ...

1/10/2006 7:17 PM  
Anonymous Anonymous said...

Just curious as to when I/0 started becoming available in the last several years, or have they always been around, just rarely used until 01-02? Also, ARMs - have they been around forever?

by the way, just sold my rental property in oregon. feeling very good about it right now.

1/10/2006 8:21 PM  
Blogger SoCalMtgGuy said...


ARMs have been around for a long time. I/O really got popular in 2002. To give you an idea, less than 1.5% of all loans were I/O loans in 2000 and 2001...then they started to take off.

The last time I/O was popular was in the 1920's.

Congrats on the sale of your rental property.


1/10/2006 8:30 PM  
Anonymous Anonymous said...

ocrenter -

I live in OC as well. I used a 10/1 IO stated/stated ARM to buy my home in early 2005. 5.75%, no points - SoCalMtgGuy can tell from that info alone what kind of money I put down and what my credit score is.

If you have money to put down, it's not a bad way to go. As you mention, 10 years is long time, and that type of loan sure can free up some cashflow. And, as you also mention, the loan is also a helpful tool when it is time to fill out that Schedule A (I'm in that lovely 32%+ tax bracket). But, as others note, there are risks involved.

The primary risk is exactly what the others point out - you could end up underwater. Your head would have to be in the sand if that wasn't as clear as day - you aren't obligated to pay principal.

If that happens during the IO period, you'd better make sure you can either carry the property through or have enough buy your way out, should you have to sell. If that happens at the end of the IO period, you'd better be able to make that new payment.

But, there are ways to attenuate that risk. Foremost is to make sure to use a substantial DP. In my case, I'm currently at around 60-70% LTV, depending on the current vagaries of the local affliction known as homebuying. The other is to make sure you are keeping substantial reserves. I currently have about 20% of my home's value liquid and semi-liquid.

But, ss SoCalMtgGuy has noted, these loans are, like everything else, right for some people and wrong for others.

For me, it has freed up some cash flow that I am investing at a current ~6% clip (beating my mortgage rate, hence I'm not paying the principal down). And, given my self-employment, it helps to have a relatively lower mortgage payment when I have a "bad" month.

Just my two cents. I will now duck and run, because you will get absolutely doused with gasoline and torched on this board - or Ben's board - if you so much as intimate an IO loan can be useful. But, the fact is, for me it has been.

1/10/2006 11:41 PM  
Blogger SoCalMtgGuy said...


I have said it before and I will say it again, I have NO problem with the I/O loans and stated loans when the borrowers know the risks and have a PLAN!

You are the "sophisticated" type borrower who is using the loan because it makes good financial sense. Why use your money, when you can get a better return elsewhere?

I have no idea what you put down, or your fico score based on the info given.

That said, let me tell you how you are different than most.

1. you put money down
2. you have plenty of cash in reserves
3. you are actually saving/investing the money instead of using the money to buy more "lifestyle" items.

I have a problem with people doing I/O loans when they have to use stated income to 100%.

Again, these "exotic" loans have their proper places when used responsibly. Unfortunately, they are not always used responsibly, or by responsible people.

I'm not all black or white...or doom and gloom. I just want people to crunch the numbers and have a plan before they make a major financial decision.

Thanks for posting!


1/10/2006 11:48 PM  
Anonymous Anonymous said...

I too bought in OC early 2005. 5.75 fixed 30yr, 100% and stated. I thought f you went IO or ARM you get better rates? Correct me if I am wrong.

1/11/2006 1:41 PM  
Blogger SoCalMtgGuy said...

in at the peak...

I don't see how you got a stated, 100% 1-loan, 30yr fixed, at 5.75.

Even in 2005 that loan would only be possible through a non-conforming loan, and the rates were never that low.

You might have an 80% loan at that rate, but you will have a 2nd behind it.

IF you did get that probably paid several points to buy the rate down. Not enough info there for me to really know.


1/11/2006 2:03 PM  
Blogger SoCalMtgGuy said...

sensible lender...

I think you can also attest to the fact that the spread between a-paper and subprime rates got a lot closer than most people think.

Everybody thinks subprime is all high rates and bad credit. I remember when most of the full doc rates were in the 5's and stated rates were in the 6's...for subprime.


1/11/2006 4:57 PM  
Anonymous Anonymous said...


If the homeowners got their I/O loans 3 years ago and they are now about to adjust, they have had significant gains in the asset price already. Now supposing they didn't take it all out already (many did, I admit), they might just be able to pull off another I/O with a refinance.

Then again, you gotta be crazy not to get out of the loan when you already see that the asset price inflation has stopped. Prices are stagnated and in some parts already down from the peaks. Everybody is talking about high inventories and low demand for mortgages.

For those flippers who recently got bought their RE investment properties, they are just plain fucked. There is no doubt about that anymore.

1/12/2006 2:01 AM  
Blogger SoCalMtgGuy said...


Even if they refi today into another I/O loan, they will still have higher rates than 3 years ago (for the most part).

Millions of different situations.

I will tell you that lots of people tapped the equity, or plan to tap the equity at this refi.

It will be interesting to see how it all plays out, but refinaning into another I/O loan that usually has a pre-pay can be risky at this stage of the game.


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12/03/2009 7:07 AM  

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1/09/2013 11:45 PM  

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