How do I refinance my underwater second mortgage?

I try to have straight-forward solutions to the problems I bring up in my blog. Unfortunately I don’t have an easy answer for this one. I see second mortgages as the next wave of mortgage defaults that homeowners will have to worry about. Let me explain.

Many of the second mortgages that were offered to consumers were Home Equity Lines of Credit or Fixed-Rate Balloon mortgages. Both of these loans have a form of payment shock that can create an immense amount of hardship for a homeowner down the road. Many homeowners do not know the full risk associated with these two types of loans. I’ll address each one separately.

Man worried about bill

Home Equity Lines of Credit (HELOC)

Let me first state that I’m not against a home equity line of credit.  In fact, I’ve suggested them to many homeowners for various reasons. Here’s how they typically work:

  • The home equity line is a revolving account, so you can charge and pay it down as you like (similar to a credit card)
  • Unlike a credit card, these loans typically have a “Draw Period”, which is a deadline for when you can use the account as a revolving account. This draw period is usually around 10 to 15 years
  • During the draw period, the minimum payment is usually interest-only. Like a credit card, you have the option of paying it down anytime you like, which will reduce the payment for the following bill cycle.
  • The rate is usually an adjustable rate using a fixed margin and the US Prime Rate as the index.  Add these two figures together to determine your rate (Here’s a link to the current US Prime Rate- http://www.moneycafe.com/library/primerate.htm
  • When the “Draw Period” has ended, the loan will convert into an amortized loan with principal and interest payments. The rate calculation will stay the same, but the homeowner must now pay principal. The amortization schedules are typically structured for a fixed period of 10 to 25 years after the draw period. The higher the balance at the moment the loan amortizes, the higher the payment will increase will be.
  • Some lines of credit have a locked-rate feature where you can convert all or a portion of your balance to a fixed-rate loan. Keep in mind that the fixed rate you’ll be offered will likely be higher than the current adjustable rate that the loan is at. In addition, the locked terms are usually a 15-year fixed term, which will increase the payment.

Many homeowners do not know that their draw period is coming to an end. Since most draw periods are 10 years or longer, most home equity lines are not amortizing yet. However, many of these homeowners have not paid down their home equity line and the time before their amortization schedule to begin is rapidly approaching.

Here’s an example of how payment shock can impact the homeowner:

Let’s suppose that a homeowner has a typical HELOC. The loan has a rate of prime + 1%, which currently amounts to 4.25%. The balance on the line of credit is $100,000. The loan allows the homeowner to use the draw feature for 10 years and must pay back the balance in 15 years after the draw period is over. Let’s suppose the homeowner opened this loan in 2005.

Now that we’re in 2012, the homeowner has used 7 years of the draw period, but unfortunately hasn’t paid down the balance. They now only have 3 years left to pay down the balance before it amortizes.  Unfortunately, this isn’t done and the homeowner sees a large payment shock. Assuming the prime rate is still at 3.25% in 2015, this is the change in payment:

Prior to amortization-

4.25% @ $100,000 = $354.17 interest-only

After amortization-

4.25% @ $100,000 = $ 752.28 principal and interest

This payment increase is more than double. What’s worst is that the loan is still adjustable, which means the payment can go up further if the prime rate increases. If the prime rate returns to the same rates prior to the recession (8.25%), the homeowner’s payment goes up to $976.38!  That’s more than 2.5 times the payment it was prior to the amortization period.

You’ve got my attention.  How do I protect myself?

The only sure-fire way to protect yourself is to do everything you can to pay down the HELOC balance during the draw period. You won’t see a substantial difference in payment now, but the difference will come when you’re making an amortized payment. If you’re discouraged by the balance of your HELOC, don’t be. Most homeowners do not have the ability to pay off the HELOC completely before the draw period ends. The key is to pay down the balance as much as possible so the payment shock is reduced.

If this homeowner realizes this and makes an additional $1,000 towards the principal per month and pays the balance to $64,000 before the amortization, the payment shock reduces from $752.28 to $481.46.  Even if the prime rate increases back to 8.25%, the payment is more than $300 less going from $976.38 (not paid down) to $624.11 (paid down to $64,000).

One other note, if you’ve taken the time to refinance your first mortgage, I recommend using your payment savings towards paying down the HELOC.

 

Fixed-Rate Balloons

These loans scare me even more than HELOC’s. They have the largest payment shock and many, if not most homeowners think it’s a normal fixed rate mortgage.

The way these loans work is they are paid like a regular fixed rate loan. However, the final payment is due sooner than the term is calculated for. This means that after the second-to-last payment is done, the remaining balance is due as a lump sum.  The most common balloon loans are 30-year due in 15-year loans. This means you pay it like a regular 30-year fixed payment, but after 15 years, the remaining balance is due in full.

When I ask most homeowners about their second mortgage, they often will say, “Oh no, my loan isn’t a bad loan. It’s a fixed rate loan.”  It’s true – “fixed-rate balloons” technically ARE fixed rate loans. The rate never changes. However, that doesn’t change the fact that a huge lump sum is due at the end of the term.  This is a function of the loan term, not the rate. Most people think the only toxic mortgages are adjustable rate loans.

Here’s an example of how a balloon payment can impact the homeowner:

Let’s suppose a homeowner has a fixed-rate 30 due in 15 second mortgage. Similar to the other scenario for the HELOC, the loan is for $100,000  at 7.5% and was originated in 2005.

Now, the risk of this loan doesn’t come as soon as the HELOC. The above HELOC scenario had a payment shock in as little as 3 years.  The fixed-rate balloon continues with the same payment for another 8 years before things change.

Note: fixed rate balloons were more common in the mid-2000’s than regular fixed rate mortgages without a balloon feature for loans with a 30-year term. This means if you have a 30 year fixed-rate second mortgage from the mid-2000’s, chances are your loan has a balloon payment coming due before long.

Let’s see how the final payment works out:

$100,000 on a 7.5% 30 due in 15 year balloon loan = $699.21 per month for the first 179 payments

The final payment due (remaining balance)= $75,654.62

The final payment is not a typo. The bank really expects you to come up with a single payment equal to over 75% of the original loan balance on a single payment. If you don’t have the cash or the equity to refinance this loan, you’ll be facing a default.

 

You’ve got my attention.  How do I protect myself?

Unlike a HELOC, a partial pay down will not do much to fix this problem. You truly have to commit to paying down the balance completely before the final payment is due. If you’re lucky, you’ll get this done or you’ll get the balance low enough that you can roll the balance to an unsecured loan, even a credit card cash advance. You also may be able to take a cash-out auto loan on a paid vehicle to pay off the balance, or a 401k loan against your retirement. In most cases, I do not recommend cash advancing a credit card or putting a loan on a paid vehicle or retirement fund, but you may have no choice. The only glimmer of hope is that most balloon loans have a due date of 15 years, meaning you may have more time to finish paying off the loan.

 

How do I find out the terms of my loan?

For many of you, you may feel duped learning your loan may have an amortized or balloon payment you weren’t expecting. Yes, of course we should read the documents we sign, but many miss these details. Lenders often do not explain the terms well enough. Hopefully you still have your original loan terms available to review. You can learn about the most important details of your loan on a document called your “Note.” If you cannot find it, call your lender and ask when your HELOC draw period ends and what the term is after the draw period. If you have a fixed-rate second mortgage, ask if your loan has a balloon payment and if so, when the payment balloons.

 

I hope more homeowners with second mortgages find this post soon enough to work toward paying down their balances. Neither of these loans will pose a huge risk if the homeowner discovers how these loans work early enough. The problem is most homeowners do not know the payment shock is coming.

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