Modern mortgage myths

Roger Schlesinger
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Posted: Mar 08, 2007 8:04 PM

There are a number of readers who eventually send in the same questions that led me to this column. I am not sure why there is as much confusion over this financial tool as there is but nevertheless I am going to try to clear up some of the confusion. Much of it has to do with taxation and I shall start with that subject.

Many years ago I was working with a notable celebrity who was having tax problems (not my field) and was in need of some mortgage counseling as this borrower's credit had suffered. As April 15th came closer I was asking about the current income and found that it was derived by this person by adding up the deposits in the check book. I knew that earlier in the previous year there had been a cash out refinance and I asked if that was included in the addition of deposits from the check book. Much to my horror it had been and the belief was that a refinance was income and therefore a taxable event. NO, cash out refinance is a loan to yourself from your equity and never a taxable event. In the aforementioned case this had been going on for years and we quickly amended years of tax returns to relieve an on going IRS probe.

A cash out refinance doesn't affect your property taxes as it doesn't change the value of the property. Some states do have taxes on refinancing (New York for one) but it isn't a tax associated with the change in the value of the property. Property taxes are certainly affected by construction to the property but the loan isn't the trigger, the building permits are.

Can a cash out refinance end up being a taxable event in any way? When you sell your primary residence, if you have lived there for the past two years (simplified for the example) you get $250,000 exclusion if you are single and a $500,000 exclusion if you are married on the profits. You calculate the profits by taking the net sales price and subtracting the cost of the property and the cost of any improvements or additions you made. If your profit exceeds the $250,000 or $500,000 stated above you owe capital gains on the difference. If you have subsequently pulled out most of the money from the house in a cash out refinance then you actually could end up owing money that came from the refinance. Remember, it wasn't the refinance that caused the taxable income, it was the sale.

Writers note: I am not an expert on every state's tax policy on real property so please check with your tax adviser before taking any action that could cause you to have a taxable event.

Qualifying for a loan has many people confused, upset and nervous. This happens because most borrowers are not familiar with the various ways to qualify for a loan. Unfortunately many in this industry aren't familiar as well which can cause much of the confusion.

Let's start with the newest phenomenon in the industry: automated underwriting (AUS). If you have a high credit score and a very low loan to value, 60% or less, you generally will pass if your loan is within the conforming limits, $417,000 for a single family residence. You will receive an approved eligible rating and few, if any conditions. If you have a jumbo loan up to generally $1 million you can get an accept ineligible (not eligible for a conforming loan). The conditions on these approvals can be as little as a verbal verification of employment (we call your employer and verify you are still an employee), a bank statement showing some small amount of reserves or a verification of the deposit you have in your bank for the down payment if it is a purchase.

The automated systems are the most popular for the loan companies and the borrowers as all that is added to the package is the appraisal (the credit report is in the automated system) and you are ready to close.

Next is full documentation, which is tax information, tax returns, W-2’s, 1099's, etc. Hopefully this type of qualifying is waning in popularity as it is time consuming, cumbersome and frequently adds more conditions that it solves. It is a picture of the past, not the future, and lenders are beginning to believe that credit and reserves show more about the borrower than the past earnings history.

We have stated income and verified assets or stated income and stated assets. Both of these methods rely heavily on the credit report, credit score primarily, and the appraisal for a lower loan to value. The borrower is to state the gross income he or she attains which can be an average or the previous year. Obviously the lender knows you are going to state the figures that make you look the best and that is why credit and loan to value is most important. Lenders have a good idea of what is a reasonable income for the type of work that you are doing. Do not overstate your income!

Our last way of qualifying is a "no doc" program, which means you supply your name and address, a credit report and an appraisal. You do not mention anything about employment, retirement, or the amount of money you have as reserves. The entire loan is based on credit and loan to value and nothing else.

The amazing reality of these ways of qualifying is the pricing of the loans. Some lending institutions will give the very best loan terms and rates to the stated, stated program, while others do better with the automated underwriting systems. There isn't a single formula that works with every lender.

Some quick points about mortgages that should be understood and unfortunately are disguised by advertisers for one reason - to mislead. A one percent mortgage isn't an interest rate but a pay rate. The interest rate is much higher and has more than a potential toward negative amortization (adding to your balance instead of reducing it) it will create negative amortization from the start. In trying to determine whether you are saving money you must add the negative portion added to your balance to the actual cash payment you are going to pay each month to determine whether you are saving money or not. Or not should generally win!

Prepayment penalties are usually on sub prime loans and generally cannot be waived on either sale or refinance. They are tax deductible if you have to pay one as they are prepaid interest. (Subject to income tax rules - check with your tax adviser). These penalties can be bought out up front, but are usually too expensive to the borrower. I usually recommend the shortest fixed loan period, 2,3 or five years that will allow you to fix your problems and get on to a better loan. Prepayment penalties, where they are legal. are 2 or 3 years long and then are over.

When asking me or anyone else a question about finance if you wish a general answer, ask a general question; if you wish a specific answer, ask a specific question with all the details. Ask any question whether you consider it dumb or not before making any move in the field of finance because the answer could save you thousands of dollars. Be sure you know what you are doing before you act.