The Power and Benefits of a Loan Interest Rate “Buy-Down”

In most real estate markets throughout the country, sellers are trying to cope with a slower moving market burdened with an over supply of competing homes for sale and weak buyer demand. Many potential home buyers can no longer afford the prices of homes in high cost real estate markets like the San Francisco Bay Area in California

 Buyers are struggling with rising mortgage interest rates, tougher loan underwriting qualifying standards, high prices and low affordability. Real estate investors want positive monthly rental income cash flow and a hedge against a softening rental market in the future. 

Solution:

·       A mortgage interest rate “buy-down” allows the seller to expand the pool of qualified buyers and real estate investors.

·       The mortgage interest rate buy-down is a seller strategy with multiple options to maintain the seller’s price position

·       The property is offered for sale at the full asking price with a seller credit to discount the mortgage interest rate or a discounted price without a seller credit to discount the mortgage interest rate

·       It’s a “win-win” for both the buyer and seller

·       The seller can deduct the buy down credit as a selling cost expense

·       The buyer receives a 1098 form from the lender and a tax deduction for the buy down credit – “points” paid for the new loan to purchase the property

·       Higher sales price maintains neighborhood property values

·       The discounted mortgage interest rate helps to ensure the buyer will qualify for the loan

·       The buy-down empowers the seller to compete with new home builders offering substantial buyer incentives

·       The lower monthly loan payment increases the potential for positive rental cash flow for real estate investors 

Why Buyers and Sellers are stuck:

In a slow real estate market, sellers usually experience long protracted marketing time-lines to find a qualified buyer.  An over supply of competing homes for sale leaves the seller with few options except to make consistent and substantial downward asking price adjustments until the property sells. Investors are reluctant to buy income properties with negative monthly rental cash flow. Buyers cannot qualify for financing to move up into a larger home or move to a more desirable location. Buyers relocating from a lower cost area into a higher priced market must make a major lifestyle set back to buy a smaller home in a lesser location. 

The process to solve the problem: 

Sellers can align themselves with a reputable lender to find the best mortgage interest rate buy down program and integrate the buy-down with their marketing and pricing strategies Buyers can obtain a loan pre-approval with a reputable lender using a mortgage interest rate buy down program to increase their purchasing power.   

How does mortgage interest rate buy-down program work? 

The seller uses a credit from the proceeds of the property sale to pay additional loan points on the buyer’s loan. The additional loan points will “buy-down” the mortgage interest rate. The discounted mortgage interest rate applied against the same loan amount will reduce the monthly loan payment. So, there is no “out-of-pocket” cost to the seller. The credit paid to the buyer’s lender is a paper transfer at the close of escrow. The buy-down fee is a debit from the seller’s proceeds of the property sale. 

Review the Example and the type of loan used – five-year interest-only loan.

 Example:$644,000 sales price with the Buyer purchasing with 20%down:

Down payment             20%     $128,800

Loan amount                80%     $515,200

Rate/payment               6.375%                       $2,737 per month 

Option I

$644,000 sales price with Seller credit of $10,000 applied to interest rate buy down:

Down payment 20%     $128,800

Loan amount                80%     $515,200        

Rate/Payment               5.5%                           $2,361 per month      

**This results in a monthly payment reduction of $376. 

Option II

Reduce sales price by $10,000 to $634,000 with the Buyer purchasing with 20% down:

Down payment 20%     $126,800Loan amount                80%     $507,200Rate/Payment               6.375%                       $2,694 per month

*** Your buyer saved only $43 per month In order to achieve the same payment of $2,361 per month by using a price reduction you would have to reduce the sales price by $88,750! (see example below) 

Reduce sales price by $88,750 to $555,250:

Down payment 20%     $111,050

Loan amount                80%     $444,200

Rate/ Payment              6.375%                       $2,361 per month

 While a $10,000 sales price reduction is reasonable, an $88,750 sales price reduction is not. The loan interest rate buy down credit is a win/win for the buyer and seller.  

Review Option I –

Compare the difference in the interest rate and monthly payment between the Example and Option 1 

How much will the buyer save each month using the buy-down loan? 

$376 per month…multiply this monthly savings by 60 months and the buyer saves over $22,560 in five years. If the buyer decides to pay a lower price instead of taking advantage of the buy-down interest rate loan- how much does the buyer save each month if the seller lowers the purchase price by a sum equivalent to the 3% credit, in this case, $10,000? 

Review Option II –

The buyer saves $43 per month or $2,580 over five years. 

The buyer can pocket an additional $19,980 if the buyer chooses to pay the full asking price with the mortgage rate buy-down loan.

 How much would the seller have to lower the asking price to achieve the same discounted monthly loan payment and the borrower financing 80% of the purchase price? 

The seller would have to lower the asking price by $88,750 to achieve the same payment using an 80% loan to value ratio.

(Review the “sales price reduction” example) 

The seller is more than likely to be unable or willing to make such a large price concession.  

Why does the buyer receive a tax credit for the buy-down fees paid by the seller? 

The lender is required to issue a 1098 form to the borrower for points paid on the purchase loan. The seller is not the lender’s customer. Therefore, the buyer receives a significant tax deduction of which could make the property purchase even more attractive. 

How do lenders benefit from these buy-down loans? 

1.    It is easier for a buyer to qualify under a discounted loan interest rate and the bank receives upfront “pre-paid” profit from the additional points paid on the loan. 

2.    The discounted interest rate can make it easier to put a second loan behind the discounted first loan and therefore, the buyer can use a smaller down payment to purchase the property – like an 80-10-10 loan. 

3.    The discounted monthly payment can offset additional monthly association fees for buyers purchasing a condominium. 

Is it possible to buy down an adjustable rate loan? 

The interest rate index and margin are added together to create the “note rate”. The buy-down of the margin will lower the note rate and, therefore, the related monthly mortgage payment. The benefits of a margin buy-down in a rising interest rate environment include lower monthly payment increases. 

Is it possible to buy-down the interest rate in a loan refinance? 

The buy-down fee (points) in a refinance is built-in by obtaining a larger loan amount above the existing loan amount. You can reduce the monthly mortgage payment through a buy-down refinance loan. Buying down the interest rate on a new first loan may enable the buyer to qualify for “piggyback” second loan financing to minimize the buyer’s down payment requirement. A lower monthly loan payment on the discounted first loan leaves qualifying room for the buyer’s debt-to-income ratio for the monthly payment on a second loan.  Also, a lower monthly loan payment leaves qualifying room for a buyer’s debt-to-income ratio to pay monthly condo association fees 

Here is a strategy to enable buyers to find sellers willing to pay the buy-down loan fees….

·       Team up with a Realtor to search for properties listed on the MLS for at least 30 to 45 days

·       Look for properties that are vacant and are still listed at the original asking price

·       Occupied properties are OK, too

·       Ask your lender to prepare a loan interest rate “buy-down” outline like the handout for this conference call

·       Draft a full price purchase offer with your Realtor

·       Ask your Realtor to contact the seller’s agent and make it a requirement that your Realtor meet with the seller and the seller’s Realtor in person or on a 3-way conference call including the seller’s agent to present your offer

·       Ask your lender to be on “stand-by” to answer any questions that may come up during the presentation of your offer    

Real Estate Finance: One of the World’s Leading Experts on Credit Derivatives Explains The Secondary Market Credit Crunch

This article was forwarded to me from one of my clients who is retired from Moody’s and S & P…this is one of the most clear and concise explanations I have read on the current state of affairs in the secondary market as related to the credit crunch. Read on-

Satyajit Das, one of the world’s leading experts on credit derivatives, is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch — and I expected him to defend and explain the practice. This is not a defense of the practice.

Das says “massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way”.  Das is not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times…    as an optimistic era of too much liquidity, too much leverage and too much financial engineering…   slowly and inevitably deflates.

Like an ex-mobster turning state’s witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen (mostly banks and hedge funds that pay him consulting fees) that the jig is up. (read old pals as Moody’s, S&P, etc. of supermodels fame)

Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, Das points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn’t understand; and financial engineers who built towers of “securitized” debt pools with mathematical models that were fundamentally flawed.

Das’ view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and start thinking about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global “liquidity factory.” Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlays derivative securities many, many times their size. Here is basically how it works…

Banks “originate” loans, “warehouse” them on their balance sheet for a brief time, then “distribute” them to investors by packaging (pooling) them into derivatives called Collateralized Debt Obligations, or CDOs, CLOs and similar instruments. In this scheme, banks don’t need to tie up as much capital, so they turn it around and simply put more money out on loan.

The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door — a task that was accelerated in recent years via fly-by-night credit brokers now being accused of predatory lending practices. Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at much lower interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds at the much lower rates.

So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing. In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to find or identify let alone rerun or even recalibrate default probabilities with the same math models that built them.

Turning $1 into $20

This liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money “rose in value”, players could borrow more money against the same assets, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house. But the homeowner can only do it once.  

These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper — the short-term borrowings of banks and corporations — which was purchased by supposedly low-risk money market funds.

According to Das’ figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.

When you add it all up, according to Das’ research, a single dollar of “real” capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of actual real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion — or eight times total global gross domestic product of $60 trillion.

Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn’t know what they were buying or what any given security was really worth. The math models had long been put away because the underlying assets were simply undetermined.

A painful unwinding

Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the mathematical models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today’s money markets.

Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been “orphaned,” which means that they can’t be sold off or used as collateral. Remember the underlying assets were simply undetermined.

One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It’s a vicious cycle. In this context, banks’ objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Now it may seem hard to believe, but much of the past few years’ advance in the stock market was underwritten by CDO-type instruments which go under the heading of “structured finance.” I’m talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks — the works.

So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says. That is why he considers the current market volatility much more profound than a simple “correction” in prices. He sees it as a gigantic liquidity bubble unwinding — a process that can take a long, long time.  While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did last Wednesday, the evidence is not at all clear.

The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks. Lower rates will not help that. “At best,” Das says, “they help smooth the transition.”  So, will we just muddle along through this or is something big coming?