The Specter of Creative Financing
By: A. B. Jacobs
Though not quite as contemptible as obscene four-letter words, the term "creative financing" comes close. Those two words acquired a stigma over the decades. It's the rare advisor that fails to caution homebuyers about the dangers of a risky loan. Unfortunately, after the utterance of the warning, the counselors are remarkably imprecise as to exactly what defines a risky loan. Is a home bought with no down payment and a loan equal to 100% of the purchase price a hazardous way to buy? You'd certainly think so from the articles I read. And what about interest-only loans, where no principal payments are made during the early years? The suggestion normally conjures up predictions of impending disaster.
At the risk of sounding indifferent to living dangerously, I'm not averse to either of these two borrowing techniques. There is really nothing about the zero-percent down payment purchase, so widely derided, that in itself denotes high risk. For over a half century the widely used GI loan, created by the Servicemen's Readjustment Act of 1944, provided military veterans with 30-year fixed rate home loans on a nothing down basis. Countless ex-servicemen profited handsomely from this program.
And as for failure to make principal payments during the early years of a loan, this became, in essence, the normal method of home financing following the Great Depression of the 1930s. Consider the typical FHA loan, by which millions of Americans acquired their residences. The standard 30-year fully amortized fixed rate loan provides that at the completion of the first five years of scheduled payments, about 95% of the original balance remains unpaid. This is because most of the payments in the early years go toward interest. Technically this may not equate to no payments of principal, but it comes pretty close.
This, then, conjures up the question: Exactly what constitutes creative financing, and what are its risks? As to a true example of the practice, consider a device I used extensively in the high interest rate period of the 1970s and 1980s, known as an all-inclusive mortgage (also called a "wrap-around"). In this circumstance, a property is sold with seller's carryback mortgage loan, junior to and inclusive within an existing first mortgage that remains on title. This contrivance, though somewhat unconventional, provides benefits to both buyer and seller if properly structured.
Another instance of creativeness is the contract of sale, also called the "land contract," that is normally employed when a buyer's credit is insufficient to qualify for an institutional mortgage loan. In this case, title to the property remains with the seller until the buyer fulfills some predetermined conditions. Although certain hazards can exist for both parties, if proper precautions are taken it can be a win-win situation all around.
This gets me to the matter we're aiming toward, which in reality is abuse in home financing. It's a subject that easily fills volumes. However, at its heart is a basic discord: the attempt to acquire a home beyond a purchaser's ability. Let me give you an example. Consider the young married couple buying a $180,000 tract house in suburban Baltimore. They are encouraged to make a $9,000 down payment, apply for a new thirty-year first mortgage of $144,000, and finance the $27,000 balance with a second mortgage to be paid in full in five years. That a down payment plus closing costs, totaling $13,000, represents their entire savings in seven years of marriage is a warning. But of even greater concern: Where will the $27,000 come from to pay the second mortgage in five years? Under these circumstances, time becomes their adversary. The problem is not creative financing; it is instead that they are attempting to buy a home beyond their means. A conscientious broker would not encourage such a transaction, nor would a reputable mortgage lender facilitate it.
Though I'm tempted to provide many examples of bizarre financing I've experienced over the years, it serves no purpose. I'll briefly summarize with my admonition to the typical homebuyer. I advocate that you not commit to obligations that strain your limits. It's more sensible to obligate yourself to less than you can handle. Simply put: Choose a cheaper home than you can afford. For another slant on home ownership, you're invited to visit The $900 Home in the Newsletter Archives on my website at http://www.onthemoneytrail.com/.
Al Jacobs has been a professional investor for nearly four decades. His business experience ranges from real estate, securities and mortgage investment, to appraisal, civil engineering, and the operation of a private trust company. He is the author of Nobody's Fool: A Skeptic's Guide to Prosperity, available through Amazon and Barnes & Noble. His monthly financial column, "On the Money Trail," can be found at http://www.onthemoneytrail.com/.