Are Mortgage Assumptions a Good Deal?
Assuming a home seller's existing mortgage can be attractive when the rate on that mortgage is well below the current market. Such assumption has a value that can be shared by buyer and seller. However, with a few exceptions, conventional loans today must be repaid on sale of the property, and lenders will allow an assumption only at the current market price. FHA and VA loans remain assumable, but the buyer must be approved by the lender or the agency.
Value of Mortgage Assumptions
“I have been offered a deal where I take over the home seller’s mortgage. What are the pros and cons of doing this?”
When a homebuyer assumes responsibility for a home seller’s existing mortgage, it is called an “assumption”. The buyer assumes all the obligations under the mortgage, just as if the loan had been made to her.
The major driving force behind assumptions is the lower interest rate on the assumed mortgage relative to current market rates. If the home seller has a 5.5 % mortgage, for example, and the best the buyer can get in the current market is 7%, both parties can be better off if the buyer assumes the 5.5% loan. An assumption also avoids the settlement costs on a new mortgage.
When market rates are low, we hear little about assumptions. When market rates are well above previous lows, assumptions receive increasing attention.
The value of an assumption depends on the difference in rate, the balance and period remaining on the old loan, the term of the new loan, on how long the buyer expects to have the mortgage, and on the “investment rate” – the rate the buyer could earn on her savings. Assuming that the 5.5% loan has a $100,000 balance with 200 months remaining while the 7% loan would be for 30 years, that the buyer expects to be in the house for 5 years and can earn 4% on investments, the value is about $7,000. Here is a spreadsheet that makes this calculation. Value of Assumptions.
The $7,000 of savings does not include the settlement costs on a new loan. On the other hand, the savings would be reduced if the buyer has to supplement the existing loan balance with a new second mortgage at a higher rate. This could well be the case if the existing loan balance has been paid down appreciably, and/or the house has appreciated since that mortgage was taken out. The buyers who do best on assumptions are those who have the cash to pay the difference between the sale price and the balance of the old loan.
However, buyers should not expect to receive the full value of an assumption. The seller must benefit as well; typically, the parties share the savings. The seller’s share will be in the form of a higher price for the house. Indeed, some economists believe that the full value of the assumption should be reflected in the price of the house, but this is as implausible as the opposite view, that only the buyer benefits.
Lender Attitudes Toward Mortgage Assumptions
The benefit to buyer and seller from assuming an old loan comes at the expense of the lender. Instead of having the 5.5% loan repaid, which would allow the lender to convert it into a new 7% loan, the 5.5% loan stays on the books. Back in the 70s and 80s, lenders couldn’t do anything about this. Mortgage notes at that time did not prohibit assumptions, and the courts ruled that lenders could not prevent them.
Following that experience, however, lenders have inserted due-on-sale clauses in their notes. (An exception is FHA and VA mortgages, which do not contain these clauses, see below). These stipulate that if the property is sold, the loan must be repaid. Even with a due-on-sale clause, the lender may allow an assumption -- keeping the loan on the books avoids the cost of making a new loan – but the interest rate will be raised to the current market rate.
Allowable Assumptions Under Garn-St. Germain
Whether a mortgage includes a due-on-sale clause or not, assumptions are explicitly allowable under the Garn-St. Germain Act of 1982 on certain types of transactions. For example, if the title is transferred after a death or a divorce, the mortgage can be assumed by the owner. Bob Bruss describes a number of transactions of this type on which lenders cannot enforce a due-on-sale clause. See http://articles.latimes.com/1989-12-24/realestate/re-1882_1_first-mortgage-lender?pg=1
Assumptions Using a "Wrap-Around" Mortgage
Raising the interest rate to market removes most of the benefit of the assumption to the buyer and seller. In some cases, they attempt to retain the benefit by agreeing to a sale using a wrap-around mortgage, without the knowledge of the lender. The seller takes a mortgage from the buyer, which may be for a larger amount than the balance of the old loan, and continues to pay the old mortgage out of the proceeds of the new one. The new mortgage “wraps” the old one.
This is a dangerous business, particularly to the seller, who has given up ownership of the house but retained liability for the mortgage. The seller is in deep trouble if the buyer fails to pay, or if the lender discovers the sale and demands immediate repayment of the original loan. I wouldn’t do it, even if I were selling the house to my mother.
Allowing Assumptions at a Price
"Instead of prohibiting assumptions, thereby encouraging wrap-arounds, why don't lenders explicitly allow them for a price?"
Good question. When interest rates are above their lows and new borrowers are concerned that they could go much higher, some would be willing to pay a premium rate for the right to transfer that rate to a home buyer in the future.
For example, a borrower taking a 6.5% 30-year FRM might be willing to pay 6.875% for the right to allow a home buyer to take it over when he sells his house. The higher rate is akin to an insurance premium. If market rates are above 16% when he sells, as they were in 1981, he will save a bundle.
An assumable mortgage has some resemblance to a portable mortgage. If you sell your home and your mortgage is assumable, it can be transferred to the buyer; if it is portable, it can be transferred to a new property you buy. Portability is of no value if you decide to rent, go to a nursing home, or die, whereas an assumable mortgage retains its value in these situations. On the other hand, some portion of the value of an assumable mortgage must be shared with the purchaser. A mortgage that is both assumable and portable would have enhanced value.
Lenders who offer an assumability option will require that any new borrower meet the lender’s qualification requirements. Borrowers purchasing the option will need to be confident that the lender won’t tighten its requirements when market rates increase. The best assurance would be a commitment to accept approval under one of the automated underwriting systems developed by Fannie Mae or Freddie Mac.
Assuming FHA and VA Mortgages
Loans insured by FHA or guaranteed by VA have always been assumable. During periods when borrowers are concerned about future rate increases, this gives them an edge.
FHA loans closed before December 14, 1989, and VA loans closed before March 1, 1988 are assumable by anyone. Buyers who assume these mortgages don’t have to meet any requirements at all, but the seller remains responsible for the mortgage if the buyer doesn’t pay.
Any seller who allows assumption by a buyer without a release of liability from the lender is looking for trouble. Even if the buyer pays, and that is a crapshoot, the seller’s ability to obtain another mortgage will be prejudiced by his continued liability on the old one.
WARNING: The release of liability from the lender must be in writing, and you must preserve the document. This will protect you in the event that the new borrower defaults and the collection agency comes after you – it knows nothing about your release of liability. This happens!
If an old FHA or VA is attractive to a buyer, the seller can request that the agency underwrite the buyer. If the buyer is approved, the seller will be released from liability. At this point, there can’t be many of these loans left with balances large enough to be attractive to buyers.
Assumption of FHA and VA loans closed after the dates shown above requires approval of the buyer by the lender, or the agencies. The process is much the same as it would be for a new borrower. Upon approval of the buyer and sale of the property, the seller is relieved of liability. FHA allows lenders to charge a $500 assumption fee and a fee for the credit report. VA allows a $255 processing fee and a $45 closing fee, and the VA itself receives a funding fee of ½ of 1% of the loan balance.
There are some qualifications in connection with VA assumptions that are discussed in VA Home Loan Assumptions and Release of Liability.
FHA and VA loans that were closed during the low-rate years 2003-2009 will become attractive targets for assumption if interest rates rise in subsequent years. Potential sellers who have one of these loans can use the Value of Assumptions spreadsheet to estimate how much the assumption would be worth to a potential buyer. A fuller analysis will be found at Assumability of FHAs: How Much Is It Worth?