November 17, 2003, Revised December 20, 2005, October 2, 2007
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. Conventional loans
today, however, 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.
Benefit of Mortgage Assumptions to Buyers
“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.
For years, we heard little about assumptions because market rates were
so low. Now that rates are above their lows, and may rise further, we
can expect that assumptions will 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.
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 2000-2003
will become attractive targets for assumption if interest rates continue
to rise. Potential sellers who have one of these loans can use the
spreadsheet on my web site to estimate how much the assumption would be
worth to a potential buyer.