By Lawrance Morrissey
Have you ever heard of a 2/1 (two - one) buydown loan? They're quite popular in the Indianapolis area. Have you ever heard of foreclosure? Of course you have. They're quite popular in the Indianapolis area as well.
The goal of this article is to educate local buyers on the danger of this type of loan and to expose the correlation between 2/1 buydown loans and the near epidemic foreclosure rate in this area.
In 2003, Indiana had the second highest foreclosure rate in the nation at 2.6% of all home loans in foreclosure. Ohio was number one at 2.7%.
A buydown loan is a way to temporarily lower the interest rate on a mortgage loan. In a 2/1 buydown, the interest rate would be 2% lower than the qualified fixed rate for the first year, and 1% lower in year two. On the surface, it actually looks like a pretty good deal. Watch out for the fine print though. Any percent off you "save" in the first 2 years is added back into the loan.
Since many builders focus their efforts on this type of enticement, I'm going to walk through what actually happens to the buyer in this situation.
Interest rates are currently about 6.25% as of this writing, and the average home in central Indiana is about $150,000. The 2/1 buydown is an FHA program that loans on average, 97% of the home price. These are the numbers that will be used in the following example.
A young couple (the Smiths) finds themselves at the models of some new home construction company. They start walking through the professionally decorated models, fantasizing about living in one of these homes. When getting ready to leave, a trained sales rep casually says, did you know you could own this home for about $800/month? The Smiths eyes light up with excitement because they're currently paying $750/month in rent. To the Smiths, the decision is easy. It is assumed that the sales rep does legally gloss over the terms and probably adding something about how it's highly likely the Smiths will be making more money in 2 years anyway. The Smiths, glowing with excitement, completely agree and want to know where to sign.
Year 1: The Smiths would be paying on a mortgage at 4.25% with virtually no property tax. Taxes in Indiana are paid a full year in arrears, and on new construction homes, taxes are only due on the price of the land during the first year. So it would be pretty typical to pay less than $100 in property taxes for the first year in a new construction home. Total payment for the Smiths: $770. Just as promised.
Year 2: As stated in the contract, the interest rate climbs a full percent, |
which added about $88 onto the Smiths payment. Taxes haven't "appeared" to go up yet since the tax bill the Smiths are paying are for the year before. Total payment for the Smiths: $858. Quite a hit, but just $108 more than they were used to paying for rent just a year ago.
Year 3: As stated in the contract, the interest rate climbs another full percent which adds another $92 onto the payment. The new tax bill arrives, and the bill is due for fully assessed taxes ($1,420) from the year prior. Not only do the Smiths owe a current tax bill of approximately $700 that they might not have been expecting, but the mortgage company sends a letter out explaining that they need to escrow an additional $118/month to cover the expected tax bill next year. Total monthly payment for the Smiths: $1,060.
As you can see from this illustration, the Smiths were sold a home based on an $800 monthly payment and in 2 short years, it went up $290 or 28%.
The story gets worse: The Smiths may realize they're in way over their heads and decide to move. Here's another problem: They now owe more on their home than it's worth. That's because the initial prepaid interest was tacked onto the loan. If the Smiths decide to hire a full service real estate company to sell their home, they may be forced to bring an additional $10,500 to closing just to get rid of the house. (Of course, the FSBO Store could have helped the Smiths for as little as $595.)
Foreclosing on the home is almost inevitable if the Smiths can't afford to make the payments or sell through a traditional real estate company.
Sadly, the numbers above are not exaggerated at all; they're quite typical.
I painstakingly read the National Association of Realtors 22 page forclosure study offered on MIBOR's website and the reasons they cite for Indiana's unusually high forclosure rate are: Job marketed conditions, first time home buyers, predatory lending, government backed loans, high loan-to-value ratios, higher loan percentages than the rest of the country and low appreciation. To me, none of these "reasons" are very convincing since many don't differ from the rest of the country.
They do however, acknowledge that despite all the foreclosures, new construction remains at an all-time high. Interestingly enough, they don't even mention 2/1 buydown loans as a possible cause.
When I asked a high ranking official at MIBOR why 2/1 buydowns were not in the report, he replied there was no sufficient data to suggest that it was a major problem, and changed the subject rather quickly.
I find this problem disturbing on many fronts. Do yourself and your neighbors a favor: stay away from 2/1 buydown loans.
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