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Logistics of a New Loan

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Posted On: 06/16/2010

QUESTION:

When refinancing at the end of an owner-financed two-year agreement, what's the purchaser's responsibility to get a new loan?

ANSWER:

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In this situation a home was sold, and the owner took back financing in the form of a two-year loan. This transaction is astonishingly risky.

Imagine that the property was sold for $300,000 and the borrower bought with 5 percent down - $15,000. This means there's a $285,000 mortgage that will have to be repaid in two years.

The Federal Housing Finance Agency reports that between April 2007 and January 2010 home prices nationwide fell 13.2 percent. If the property is now worth $260,000, then to refinance the buyer must pay off the existing $285,000 mortgage - and that means bringing additional cash to closing.

How much? In rough terms the refinancing will look like this with an FHA loan: The property is worth $260,000 so the borrower can get 96.5 percent financing. With 3.5 percent down the borrower will need $9,100 in cash at closing. The loan amount will be $250,900. The remaining debt is close to the original loan amount of $285,000 because there's been little time to amortize. The borrower needs to pay the difference between $285,000 and $250,900 - about $34,000 in cash. Closing costs are extra. In total, the borrower will likely need more than $45,000 in cash.

Essentially, the first loan is nothing but a giant balloon note. Not only is it dangerous for the borrower, it's also deadly for the owner-turned-lender. If the borrower cannot pay off the debt then the lender will foreclose. Once the old owner gets back the property he or she now has a home that is worth substantially less than $300,000 that still needs to be rented or sold again.

What to do? Both parties made a risky deal. The option with the smallest downside is probably to extend the loan for another three to five years.

(c) CTW Features

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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