5 Risky Real Estate Deals

As posted on June 12, 2009 on SmartMoney.com

By AnnaMaria Andriotis

Despite efforts to crack down on risky lending practices, sketchy housing deals are making a comeback.

In the throes of the subprime meltdown, most mortgage lenders tightened lending standards, requiring borrowers to have credit scores of at least 700 and down payments often of 10% or more. But as the credit crunch takes a toll on consumers' credit scores and cash positions, those questionable lending practices are beginning to pop up again.

“[S]ince early this year…a new wave of people are finding ways to scam [home buyers],” says Dani Babb, founder of The Babb Group, which offers real estate consulting to consumers, and dean of business at Andrew Jackson University.

Combine such risky deals as 100% financing and piggyback loans with skyrocketing interest rates and fees and it could spell disaster -- both for borrowers' bottom lines and
the economy, says Chip Cummings, president of Northwind Financial, a Grand Rapids, Mich.-based training and consulting firm for mortgage and realtor firms.

Here are five risky financing offers that prospective home buyers should watch out for:

1. Practice: Hard money lending

Hard money loans may seem attractive to those who've had a run of bad luck, but it will cost them dearly.

Most hard money lenders don’t place an emphasis on a borrower's credit score or employment status and will even offer loans to borrowers who've been rejected for government-backed or private mortgages. On average, these mortgages charge interest of anywhere from 10% to 14% and can require the borrower to pay up to five points, or 5% of the loan, upfront, says Leonard Baron, adjunct professor of real estate investing at San Diego State University. (One point equals 1% of the loan. Currently, the average mortgage rate on a 30-year fixed is 5.81% and typical mortgages charge from 0 to 0.5 points, says Keith Gumbinger, a vice president at HSH Associates, a mortgage data firm.)

And, in return for taking on the extra risk, many hard money lenders require the borrower to make a down payment of around 30%, says Baron. Some may even offer mortgages with zero money down, but require the borrower to put up collateral – like their car, says Babb. The problem here is that these loan contracts are often so confusing that some borrowers don't realize they are signing away their assets, she says.

Bottom line for the borrower: Not only will you pay sky-high interest, but borrowing from a hard money lender has the potential to dig you into a deep financial hole should you fall behind on payments, says Baron.

Risk for the economy: Hard money loans make up less than 1% of the mortgage market, says Baron.

“But the number of people turning to them could grow if the credit crunch continues,” he says.

2. Practice: Advances on the First-Time Homebuyer Tax credit

The First-Time Homebuyer Tax Credit, which offers up to $8,000 to qualifying buyers who purchase a home through Nov. 30, is a generous perk worth taking advantage of. But it can also get some home buyers into deep trouble.

In late May, the Department of Housing and Urban Development (HUD) said it would permit FHA-approved mortgage lenders to offer eligible borrowers an advance based on the tax credit. Borrowers, in most cases, are still required to make the standard 3.5% down payment required for FHA-insured mortgages, but they can add the value of the credit to the down payment or they can use it to pay for closing costs, says Cummings.

Repayment rules vary, but depending on the lender, borrowers will have to pay the loan each month, pay a lump sum when they receive their tax credit or make payments
over several years. And, in most cases, they'll be paying interest, too. (HUD recommends that lenders refrain from charging fees that surpass 2.5% of the tax credit.)

Bottom line for the borrower: If a borrower needs to rely on an advance of their tax credit to afford the purchase, then they'll probably have a hard time affording both their loan payments on the advance and the mortgage payments, says Cummings.

Risk for the economy: “We’re building a house of cards like we did before,” says Cummings. “We’re getting people into homes that they can’t necessarily afford with no equity, which is artificially propping up the market.” A new ripple effect of foreclosures could occur in the next two years as a result of this practice, he says.

3. Practice: Zero-down financing

Believe it or not, it’s still possible to buy a home with zero money down, says Babb.

Recently, more than 10 states, including California, New Jersey and Pennsylvania, created state loan programs that give borrowers the 3.5% down payment they’ll need for an FHA-insured mortgage as a second loan. And in the private lending sector, piggyback loans – when a buyer purchases a home using two mortgages – are slowly returning. In this case, lenders refer borrowers who can’t come up with a down payment to other lenders who can give them a second mortgage for that amount. These second mortgages often carry sky-high interest rates, some near 25%, says Babb. In other cases, buyers try to persuade a seller (especially if they’re eager to unload their home) to loan them the down payment and promise to repay it over time, says Cummings.

Bottom line for the borrower: For piggyback and zero-down loans like these, keeping up with two mortgage payments each month can be tough and could force the borrower to eventually walk away from the home, especially if the home's value drops and they have no equity in the property, says Gibran Nicholas, chairman of the Ann Arbor, Mich.-based CMPS Institute, which trains and certifies mortgage lenders and brokers. Sellers who agree to front the down payment, meanwhile, could find themselves high and dry if the buyer is unable to pay it back.

Risk for the economy: With banks getting even stricter about whom they lend to, sellers eager to unload their homes and buyers who want to take advantage of low real estate prices are likely to see more unscrupulous lending practices such as these occur, says Cummings. And that could potentially stall or even derail the housing market's recovery.

4. Practice: Unlicensed lenders failing to properly disclose their identity

Many mortgages brokers who lost their license during the real estate bubble for creating fraudulent documents or failing to disclose fees have returned to the market -- and they're underwriting FHA-insured mortgages, says Babb. To become an FHA lender, they just register under different names – such as their spouse’s.

Bottom line for the borrower: Many of these lenders are charging high fees and interest rates, says Babb. Some even charge fees for information on mortgages, like whether or not a borrower would qualify for an FHA-insured mortgage, information which is typically free, says Babb.

Risk for the economy: The government doesn’t have the time or manpower to track down these fraudulent lenders, so preventing borrowers from being lured into expensive mortgages will be difficult, says Babb.

5. Practice: Trying to buy a home that recently changed hands

In an effort to avoid foreclosure, some homeowners are giving ownership to a relative or friend by signing a quit claim deed -- a practice that's permitted in most states, says Cummings. The relative or friend then agrees to make the monthly mortgage payments until they can sell the home. Anyone looking to buy that home, however, may be in for a surprise. Depending on the type of mortgage they were pre-approved for, prospective buyers may find out late in the process that they are unable to purchase the home and lose the mortgage.

The problem is that, in some cases, government-backed loans, such as FHA-insured mortgages or a VA home loans (for veterans), won't allow borrowers to purchase a home that has been owned by its current owner for 90 days or less. The buyer, however, may not know that their loan will be retracted until they’re far into the purchase process, says Cummings. Realtors typically research this information once they receive the listing and will often inform the buyer, but buyers generally won’t be aware of this if the home is being sold by the owner, he says.

Bottom line for the borrower: The buyer risks losing the home they’re interested in -- and the mortgage. They can try to get a private mortgage in the secondary market, but they’ll need a bigger down payment than if they use an FHA-insured loan.

Risk for the economy: This could further slow the amount of time it takes for houses to sell and could spark desperate borrowers to sign up for risky loans, says Cummings.