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January 25, 2001
"I have a friend who
refinances his home every three months. He has refinanced six times in the
last two years. His mortgage broker buddy gives him a kickback of about
$5,000 every time he refinances. He wants me to do the same deal and I'm
tempted, but I'm concerned that it may be illegal or have other bad
consequences."
Your friend is a fool. Do not copy him. He
is borrowing at an exorbitant price and depleting the
equity in his home. The mortgage
broker pockets a fee with every refinance, and is scamming the lenders who write
the new loans.
The market distinguishes two types of refinance transactions.
One is designed to reduce the borrower's interest cost when interest
rates decline. These refinances
fell drastically last year as interest rates rose, and currently there are very
few.
In cost-reduction refinances, lenders allow you to include
the settlement costs in the new loan balance.
For example, if the loan balance is $100,000 and settlement costs are
$3,000, lenders will allow the new balance to be $103,000.
But any loan amount higher than $103,000 would put cash in your
pocket and be considered a "cash-out" refinance.
Cash-out refinances have higher default rates than cost-reduction refinances.
This may be because borrowers reduce their equity, or because their need
for funds reflects financial distress. Whatever
the reason, lenders typically charge higher interest rates or points to
cover the extra risk.
Your friend's mortgage broker is conning the lenders he represents by passing
off a cash-out refinance as a cost-reduction refinance.
He does this by padding the settlement costs and paying your friend the
difference. For example he
reports $10,000 in settlement costs when they are only $5,000.
The extra $5,000 goes into your friend's pocket.
Who is getting conned? Everyone but
the mortgage broker.
The lender is being conned into writing a loan that won�t last long
enough to cover the costs. The
broker deals with a stable of lenders, so he can move the loan from one lender
to another without raising suspicions. Some
borrowers do legitimately pay off loans within six months.
Your friend is bound to stop refinancing at some point, perhaps when his equity
has been entirely depleted. The
last lender in the sequence will own a
cash-out refinance masquerading as a cost-reduction refinance.
But your borrower friend is
also getting conned into paying an exorbitant price for a small loan.
Each time he refinances, he increases the debt on his house by the amount
of the money he puts in his pocket plus the real settlement costs and the
broker's fee. For example, assuming
he takes $5,000 out of the deal and adds $10,000 to the balance on an 8% 30-year
loan, and that he then holds the loan to term, the effective cost of that $5,000
is 17.5%. If he refinances again
after 12 months, it is 83.7%.
Your foolish friend would save money if he simply obtained a home equity loan.
August
27, 2003 postscript
There
is a more sophisticated version of this scam that is attractive because the
borrower's balance does not rise. The broker refinances the borrower into
the highest rate offered by the lender, which carries the largest rebate
(negative points). The rebate covers settlement costs, and the balance is
split between the broker and the borrower. While the borrower loses on the
higher rate, the loan is refinanced about every three months, so the borrower's
share of the rebate is larger than the loss from the higher rate. The
broker moves the loan from one lender to another so that none of them catch on
to what he is doing.
So
long as this game continues, both borrower and broker can profit. The game
will terminate, however, when lenders get wise and stop doing business with the
broker. At this writing, some lenders had begun to require brokers
to repay rebates when a loan is paid off within 6 months. When the game
ends, the borrower is left with his high-rate mortgage.
Copyright
Jack Guttentag 2003
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