Downsizing, Upsizing and Sideways-sizing: How to Manage Multiple Mortgages During Change
Whether you’re looking for your forever home, thinking of buying a bigger home or simply buying and financing a similar property where you now live, it really is a big step. Homeowners today spend more time in their current residence and move less often than they used to. There are multiple factors that lead to this trend. One, housing prices have been on the rise for the few years and the homes they want to buy are more expensive than they used to be. Two, the “easy mortgage” or the home loan programs that required zero documentation have vanished along with the lenders who made them. The only exception to this is hard-equity programs that are reserved for investment properties.
Today, mortgage lenders want to verify stable employment, sufficient gross monthly income and good credit. Yes, there still are programs that cater to those with lower credit scores or use bank statements to verify income and cash flow but overall a return to traditional underwriting has returned and that’s a good thing. The mortgage industry in general has stabilized as lenders offer mortgage programs that fit more in a traditional mode and stay away from anything “toxic.”
Conventional mortgages are those that are guaranteed by the lender. Should the loan go into default, it’s the lender that absorbs the loss. Today, most conventional approvals are issued using guidelines set forth by Fannie Mae and Freddie Mac. When approving a loan using established standards the loan can then be sold into the secondary market either directly to Fannie Mae or Freddie Mac but also to other lenders. Selling loans replenishes a mortgage company’s credit line allowing the lender to continue making home loans.
That said, the mortgage industry today is essentially commoditized as mortgage companies offer the same basic suite of home loan programs. The difference from one lender to the next is not as much the type of loan programs being offered but the customer service and process that differentiate one company over another. More emphasis is placed on the individual loan officer working for the company and less on the amount of advertising a mortgage company employs to gain market share. Lenders can and do add their own approval requirements on conventional loans called “overlays” that increases the quality of their pool of loans. But however much one lender tries to differentiate the company from another, it really all boils down to the type of service received by the consumer and the experience and dedication of the individual loan officer. And it makes it much easier to provide financing strategies based upon which type of mortgage program is being considered.
Okay, let’s say a couple is considering downsizing and buying a smaller home and currently have a mortgage on the property they’re living in. Downsizing is usually the result of someone nearing or in retirement and want to reduce their overall monthly living expenses. Unfortunately there are too many retirees who discover their new monthly income from a retirement fund, savings and social security is squeezed each month and by reducing their monthly payments by downsizing they can breathe easier financially.
Let’s first take a look at someone with a $500,000 home and a $200,000 mortgage. The monthly payments are $1,014 per month on a 30 year loan. The individual has a couple of choices to make. One, can the homeowner find a property and pay cash from the proceeds of the sale? In this scenario, by subtracting $200,000 from a sales price of $500,000 the net is $300,000. But there are also closing costs to consider when selling. If a real estate agent charges a 5.0% sales commission to list and sell the home, that’s another $25,000 deducted from the proceeds of the sale. There are also closing costs to consider for another $5,000 leaving a new amount of $270,000.
If the buyers can negotiate to buy a home at or below $270,000 and pay cash for the property they will eliminate not only the $1,014 per month monthly payment but also the higher property taxes, insurance and maintenance for the $500,000 home. If the buyers want to buy something a little more expensive than a $270,000 home and look at homes closer to $300,000, they’ll need to dig into their savings account to come up with the difference.
When paying cash for a home using proceeds from the sale of a previous residence, from savings or a combination of either, the buyer has the upper hand compared to other offers on the property. When a seller receives an offer on a home and the contract notes there is no financing involved and it’s an all-cash offer, it can take priority over other offers that require a mortgage to be approved. It can take up to 30 days for a traditional purchase money loan to close due to the various services needed in order to fulfill lending requirements. That means an all cash buyer can even offer a little less than the list price and still get the nod. When a seller accepts an offer with financing, the home falls into a “pending” status and that reduces the amount of showings dramatically. It essentially takes the home off the market while the buyers are lining up their financing.
Or, the buyers decide to downsize but keep some of the proceeds of the sale and get a new, smaller mortgage. For example, the buyers apply for a mortgage and instead of paying $270,000 in cash they make a $170,000 down payment and take out a $100,000 mortgage. With a smaller loan amount and using current market rates for a 30 year note the monthly payment would drop to around $449. They can also expect their annual property tax bill to drop by half or more and their insurance premiums will also be lower.
Okay, what if they don’t sell the home and want to keep it as a rental or maybe keep it listed longer and hope for a better price? In this example, if they take out a new loan and finance $100,000 while keeping the $1,014 monthly payment until sale of the previous home, they will have to qualify with both mortgage payments. And further, they’ll need to come up with the funds needed for the down payment and closing costs for the new home. That’s $170,000 plus closing costs. They may have that much in a savings or retirement account but the account will take a hit and not replenished until the previous home is sold. Or, the buyers don’t have that much available or they don’t want to touch any retirement account.
In this event, the buyers can take out a bridge loan. A bridge loan is a short term loan secured by the existing home and the funds from the bridge loan are used for all or part of the required down payment and closing costs to buy the next home.
And just like having to qualify with both mortgage payments on both houses the borrowers will have to qualify with the bridge loan payments as well. But this can be a judgment call by the lender’s underwriter. An underwriter, the individual responsible for making the sure loan being evaluated adheres to proper lending guidelines, knows both the bridge loan and the current mortgage are only temporary and the higher-than-normal debt ratios won’t be around very long. Mortgage guidelines as they relate to affordability aren’t hard and fast rules in most cases and the underwriter has some leeway here.
For example, the underwriter is presented with information that shows the real estate market is rather healthy and the time it takes to sell homes similar to the buyers is relatively short, in 60 days or less. If the home is competitively priced for a quick sale, it could take less than 30 days to sell. Such information is supplied by a real estate agent or even an appraiser which makes comments on current real estate market conditions. The underwriter can also be provided a copy of a listing agreement on the $500,000 home showing the home is actively being marketed and should soon sell.
For example, let’s say the existing mortgage payment is $1,041, the new one will be $449 and the short term bridge loan will have monthly payments of $500 per month for a total of $1,990 plus taxes and insurance for both properties is $800 per month for a $2,790. If the borrower’s gross monthly income is $5,500 the housing debt ratio is 50. That’s much higher than the standard 38 most lenders want to see but by subtracting $1,041 and $500 and ignoring the soon-to-be-gone payments the new ratio is $449 divided by $5,500, or 8. Many bridge loans don’t require monthly payments either and simply accrue interest instead.
Here’s a different story. Debt ratios will be higher because the new mortgage will be bigger. Upsizing is typically someone’s second or third home and won’t be considered a retirement home. Upsizing almost always requires the sale of the existing property because there needs to be a down payment and closing costs primarily from the sale of the existing home. Carrying two mortgage payments along with taxes and insurance can be hard to qualify for due to the additional mortgage payment. Besides, unless the buyers have saved up enough funds to be used for a down payment without needing to sell right away, a sale is almost necessary.
If buyers can however afford two monthly payments but only have enough money for say a 10% down payment,
then a “piggyback” might be an answer. A piggyback is a term lenders use to refer to secondary financing. The buyers can take out two mortgages instead of one. The first mortgage is the bulk of the financing and the second mortgage is the difference between the first lien and the down payment. Once the previous home is sold, the second mortgage is paid off leaving only the first mortgage. Like a bridge loan, this can be structured as a temporary transaction or the buyers can elect to keep the second mortgage and pay it down over time. Or, buyers can take out a short term bridge loan to be used to buy and bigger home.
The strategy for buying a home of similar size and price of the current home is pretty much the same when upsizing. There will be some qualification issues because there are two house payments to make, at least temporarily. However, in both instances of upsizing and sideways sizing, the offer will be contingent on the previous home being sold. The sales contract might read something to the effect to “My offer is $270,000 and contingent upon my current home being sold.” This is the kicker most sellers will take issue with, especially in a healthy real estate market. The sellers may not want to accept an offer based upon another home being sold. Your real estate agent can help craft such an offer and advise whether or not a contingent offer might be accepted.
Finally, I need to remind you that there really are no hard and fast rules regarding debt ratios and having two mortgage payments at the same time. A lender’s requirement is to make the determination the buyers can temporarily handle the payments. Such a determination might point to the amount of liquid assets available to the borrower after the pending sale has been completed. This means beyond having enough funds for a down payment and closing costs but additional funds referred to as “cash reserves” which might be used if needed for the costs and maintenance of the second home. For example, the underwriter might see there will be another $200,000 in various cash and retirement accounts. Having an excellent credit profile is also a solid compensating factor when evaluating an application with high debt ratios. In all, if it makes sense to the underwriter and the loan is still eligible for sale in the secondary market, handling multiple mortgages won’t be an issue.