Mortgage ARM Loan Nightmare + Retire Early

Owning a home can either be the American dream or the American nightmare, it all depends on your current financial situation and how you finance this purchase.

A very large group of people who bought houses over the last few years would never have qualified using the "old" standards. I bought my first house in 1978, and during the lengthy 3 month escrow process, I did not qualify. So I needed my parents to co-sign. This occurred despite the good paying stable job I had. There were no options for me at that time in terms of mortgage financing. It was the 30 yr fixed and only the 30 yr fixed - thank God.

I do not work in the lending or real estate industry and some of the following statements or accusations are based on heresay and not direct knowledge on my part. In other words, I can't prove it.

From 2001 until today there has been a collusion between borrower, broker, lender and Fannie Mae to get the borrower into a house no matter what.

At the bottom of this chain is the borrower - a typical example might be a young couple who has one or two kids, has a combined income of 80k and rent a 3/2 house. They dream of someday owning their own home but know they do not have enough saved for 20% down on a 30yr fixed. Then their luck changes in 2001 - the stock market crashes, 9/11 happens and the fed drops interest rates to prevent deflation and a recession. The young couple starts receiving flyers in the mail from real estate agents and loan brokers. "Why Rent When You Can Own" one flyer says. Another says "Tell Your Landlord To Shove It!". The young couple make one innocent phone call to the real estate agent to see if they really can buy a home.

Next in the chain is the broker - many brokerages are small one-man or women shops(one broker license with many employees who handle processing). You wont see commercials on TV for these brokers but they don't need them. The small broker shops have contacts with all the real estate agents in the areas that they both serve. Real estate IS local! The real estate agent contacts the broker due to the fact that she has found the young couple a "dream home". The home is a 3/2 "cosmetic fixer" starter home for only 500k. The broker will discuss financing options to the couple and submit the information to the lender.

Next up the chain is the lender - the lender provides the money and processing for the transaction. The lender is in constant communication with the broker and also in most cases, uses the Fannie Mae guidelines, or "decision engine" for borrower qualifying.

At the top of the chain is Fannie Mae - a government sponsored (not guaranteed) entity or (GSE). They absorb the note from the lender and package them as bonds and sell to investors.

The young couple aka borrower could never qualify for a 30 yr fixed rate mortgage for the house and they only have about 5k in savings. The broker informs them that “today is their lucky day” because "creative financing" will get them into the house and what really matters is the initial monthly payment. The broker gives them more good news in that they don’t even need a down payment because they will finance this loan with what is called an 80/20. The first loan will be an ARM loan for 80% of the balance and a HELOC or a variation thereof will be used for the remaining 20%. The broker has an even greater present for the borrower – they can qualify for this loan using “stated income”. Meaning, the borrower does not need to document their income, they can just lie about it. The wife is a little cautious and asks about the pitfalls of ARM loans. The broker quietly whispers in her ear - "Don't worry, you can just refinance before the loan resets". She nods her head and smiles.

The borrower at this time is not thinking about those pesky details in the loan docs. They are more concerned with the details of moving and what color granite will be used for the countertops when they remodel their new home. They sign the loan docs as quickly as possible.

As I stated earlier, the broker and lender are in collusion on this loan and are in constant communication and will “fudge” the numbers on this loan in order to meet Fannie Mae’s decision engine program. The lender will not fund unless it can dump this loan onto someone else.

So who wins who loses in this transaction? The agent and broker make money on the transaction. So does the lender. Fannie Mae makes money on the interest from the mortgage or sale to investors. Only the investors in the pooled mortgages or Fannie Mae would seem to have risk but that is marginal compared to the risk the borrower has taken.

All had gone well for our happy young proud homeowner couple at the beginning. They did however max out their credit cards for remodeling etc.

Then a couple things happened that they did not expect: They received their property tax bill. Many who have bought these overpriced homes totally forgot about the massive property tax bills that come due. Then the real tsunami hit, their payment for the mortgage almost doubled.

After a call to the lender they were informed that the new payment is correct and that if they would had read what they signed they would have understood that this is an adjustable rate mortgage. Their ARM had reset on them.

The shock of this can not be overstated. This couple had gambled their financial lives away all because they fell for the scam and did not do their own due diligence in advance. With the new payment and rising costs for everything from gas to electricity to food, they are now unable to make ends meet. Their evenings are now filled with fights over the budget and the ever popular “blame game”. Since they can’t really go after the scam artists because the scam is basically legal, they blame each other.

Last we checked on the young couple, separation and divorce proceedings have started and the house has been vacated. The bank will own it soon enough because now the value of the house is less then the mortgage. The young couple did not ever think that real estate values can go down which makes refinancing the loan into a fixed basically impossible.

I have owned several houses as residences and rental properties since 1978. I sold all but one over the last two years and now enjoy early retirement and debt free living after having moved back into one of the rentals. YES, real estate CAN be a good investment, but it all comes down to the financial details. I have been through it all when it comes to real estate, so I do consider myself an expert.

For any of you young folks that are reading this I want to give you some advice so you don’t fall into the trap that the previously stated ficticious couple fell into:

Save as much money as you can in a cash account.

Only purchase a property when you can put down 20% and qualify for a 30 yr fixed rate mortgage. If you cannot save the 20% down then petition your PMI payment when you have reached an 80% LTV during the loan term.

Take your time and purchase a place that you consider a good retirement type home close to a major city. I recommend a townhome (not condo) as a good first purchase. Consider waiting until this current real estate bubble plays itself out. Keep saving in a cash account during this time. 2008 or even 2009 may be the right time but one never knows where the bottom will be in housing values. You can also begin researching now as to what location you would like to retire to. If the location is away from an area that you are familiar with, then visit there first and spend some time. Remember, your retirement home does not need to be in a resort location. You can visit any resort in the world after you retire. Try to find a townhome that is very close to the main downtown area of the place you want to live. That way you can walk if you want to grocery stores etc. I donated my car two years ago and have not needed one since. My wife, who still works for fun sometimes, still has her car.

As time goes by and you make more money, save for another 20% down on a nice house. This is the place where you can enjoy raising a family etc. Do not sell the townhome, rent it out. Townhomes are easier to manage than SFRs. Only advertise the townhome for rent using the internet such as Yahoo classifieds.

You can now enjoy all the tax benefits of owning a second property and by the way, you are now a business owner. Every penny you spend on the rental is tax deductible. Not bad considering you dont need employees or any other overhead. Just be sure that you can handle any vacancy costs etc. Do not rent to undesirable people. You can't descriminate based on age, sex, race or religion. You can descriminate based on credit report or if you think these people are losers and will not take care of your place or pay the rent. It's easy to get people in, but tough to get them out if they are dead-beats. Thats why I want you to use the internet classifieds to advertise the place for rent. You can pre-screen using email before you even meet them. ALWAYS do a credit check! If you don't like being a landlord you can use a management company to handle things for you, but spend time finding a good company. Usually, the bigger the company the better.

When you are ready for early retirement, sell your house and move back into the townhome – use the tax free money from the home sale to pay off the remaining loan balance on the rental and enjoy life.

I see no need to own more than the two properties. Owning more than two properties puts too many eggs in one basket. You still need money to fund an IRA/401K and keep a rainy-day fund.

The end result of my advice is that you end up in a nice low-cost living structure that allows you to VISIT the places you love whenever you feel the need. Take some time to think about this statement I came up with: Plan on progressing through life by slowly transitioning from "Things" to "Experiences".