The Cash-Out Mortgage Refinance Scam
October 6, 1999, Reviewed July 21, 2009
"My niece spent most of last summer working on a house for a poor family under the Habitat for Humanity program, and was so proud when the family moved in. But the family hadn't been in the house 6 months when they refinanced their loan, and now they are facing the need to make a very large payment and may lose the house…Are we making a mistake in encouraging everybody to become a homeowner?"
Probably. Home ownership is for people with long time horizons who want to build equity. Those who are fixated on today, and on how much cash they have in their pockets today, are poor candidates for homeownership. (See Who Should Not Be a Home-Owner?) They are easy prey for scamsters who take their equity by dangling cash under their noses. This legalized thievery has victimized a number of low-income people who obtained homes under the Habitat for Humanity (HFH) program.
Beneficiaries of the HFH program must have below-average incomes and must contribute a certain number of hours of labor to the construction or rehabilitation of their house. The lure is that they are able to buy a house at a knock-down price, and to finance it with a 0% mortgage. You can’t get a better mortgage than that. Yet a minority of them foolishly agree to refinance it into a mortgage carrying a high rate -- 14% is a typical rate on these deals -- because they are offered cash in their pocket, and sometimes a lower monthly payment.
Here is an illustration of how this scam works. The house provided by HFH is worth $90,000 and HFH has arranged for a 0% loan of $48,000 to be paid back in monthly installments of $200 over 20 years. Under the refinancing, the loan amount is raised to $78,000, with $48,000 repaying the old loan, $10,000 covering loan fees, and $20,000 going into the owner's pocket. The monthly payment on the new loan is only $150. Getting $20,000 in cash plus a lower monthly payment makes it look like a can’t-lose deal to the owner, who doesn’t understand what ownership means.
The sad fact is that the owner has traded $42,000 of equity -- a house worth $90,000 less the mortgage of $48,000 -- for $20,000. The new mortgage has a rate of 14%, which is typical for deals of this type, and a balloon payment equal to the unpaid balance is due after 2 years. Since the $150 payment falls well short of the interest, the loan balance the owner is obliged to pay after 2 years will grow to almost $99,000. At that point, the owner will lose the house.
People who contribute the money and sweat required to make the HFH program work are understandably infuriated by these predatory practices. HFH could eliminate the scam by incorporating a prohibitively large prepayment penalty in the loan contract with the borrower. The penalty could equal the owner’s equity, i.e., the difference between the loan balance and the current appraised value of the house. The penalty would eliminate the con because a refinancing would trigger a transfer of the owner’s equity to the first mortgage lender, leaving nothing for the scamster. The penalty would not apply in the event of sale of the property, since the purpose is to prevent refinancing, not sale.
Prepayment penalties historically have been used to protect lenders from borrowers looking to refinance high-rate mortgages in declining rate markets. Some states restrict prepayment penalties as a type of borrower protection. As far as I know, however, prepayment penalties have never been used to protect borrowers against their own folly, so this would be a first.
In states that now restrict prepayment penalties, new legislation would be required that would eliminate the restriction in cases where the penalty is triggered by a refinancing into a mortgage carrying a rate higher than the existing rate. It would not be difficult to design a rule that would protect HFH borrowers without opening the door to prohibitive prepayment penalties in the conventional market.
Postscripts: One reader suggested an alternative approach to the prepayment penalty, which has considerable merit. In addition to the first mortgage, the lender could take back a second mortgage, also without interest, equal to the remaining equity. The second mortgage would be forgiven after some period of time, say 7 or 10 years. This would prevent the scam, but it would also prevent the owner from selling at a profit until the second mortgage was forgiven.
A second reader wondered what the scam was if the lender only collected was was owed on the loan? Even if the lender collected only $90,000 of what was owed at the end of two years, the annual return to the lender is 24.7%.
"My niece spent most of last summer working on a house for a poor family under the Habitat for Humanity program, and was so proud when the family moved in. But the family hadn't been in the house 6 months when they refinanced their loan, and now they are facing the need to make a very large payment and may lose the house…Are we making a mistake in encouraging everybody to become a homeowner?"
Probably. Home ownership is for people with long time horizons who want to build equity. Those who are fixated on today, and on how much cash they have in their pockets today, are poor candidates for homeownership. (See Who Should Not Be a Home-Owner?) They are easy prey for scamsters who take their equity by dangling cash under their noses. This legalized thievery has victimized a number of low-income people who obtained homes under the Habitat for Humanity (HFH) program.
Beneficiaries of the HFH program must have below-average incomes and must contribute a certain number of hours of labor to the construction or rehabilitation of their house. The lure is that they are able to buy a house at a knock-down price, and to finance it with a 0% mortgage. You can’t get a better mortgage than that. Yet a minority of them foolishly agree to refinance it into a mortgage carrying a high rate -- 14% is a typical rate on these deals -- because they are offered cash in their pocket, and sometimes a lower monthly payment.
Here is an illustration of how this scam works. The house provided by HFH is worth $90,000 and HFH has arranged for a 0% loan of $48,000 to be paid back in monthly installments of $200 over 20 years. Under the refinancing, the loan amount is raised to $78,000, with $48,000 repaying the old loan, $10,000 covering loan fees, and $20,000 going into the owner's pocket. The monthly payment on the new loan is only $150. Getting $20,000 in cash plus a lower monthly payment makes it look like a can’t-lose deal to the owner, who doesn’t understand what ownership means.
The sad fact is that the owner has traded $42,000 of equity -- a house worth $90,000 less the mortgage of $48,000 -- for $20,000. The new mortgage has a rate of 14%, which is typical for deals of this type, and a balloon payment equal to the unpaid balance is due after 2 years. Since the $150 payment falls well short of the interest, the loan balance the owner is obliged to pay after 2 years will grow to almost $99,000. At that point, the owner will lose the house.
People who contribute the money and sweat required to make the HFH program work are understandably infuriated by these predatory practices. HFH could eliminate the scam by incorporating a prohibitively large prepayment penalty in the loan contract with the borrower. The penalty could equal the owner’s equity, i.e., the difference between the loan balance and the current appraised value of the house. The penalty would eliminate the con because a refinancing would trigger a transfer of the owner’s equity to the first mortgage lender, leaving nothing for the scamster. The penalty would not apply in the event of sale of the property, since the purpose is to prevent refinancing, not sale.
Prepayment penalties historically have been used to protect lenders from borrowers looking to refinance high-rate mortgages in declining rate markets. Some states restrict prepayment penalties as a type of borrower protection. As far as I know, however, prepayment penalties have never been used to protect borrowers against their own folly, so this would be a first.
In states that now restrict prepayment penalties, new legislation would be required that would eliminate the restriction in cases where the penalty is triggered by a refinancing into a mortgage carrying a rate higher than the existing rate. It would not be difficult to design a rule that would protect HFH borrowers without opening the door to prohibitive prepayment penalties in the conventional market.
Postscripts: One reader suggested an alternative approach to the prepayment penalty, which has considerable merit. In addition to the first mortgage, the lender could take back a second mortgage, also without interest, equal to the remaining equity. The second mortgage would be forgiven after some period of time, say 7 or 10 years. This would prevent the scam, but it would also prevent the owner from selling at a profit until the second mortgage was forgiven.
A second reader wondered what the scam was if the lender only collected was was owed on the loan? Even if the lender collected only $90,000 of what was owed at the end of two years, the annual return to the lender is 24.7%.