Not so many years ago, obtaining a mortgage was a local affair. You’d walk into your neighborhood bank, fill out a few papers, and get your loan — and the money would usually come from the institution you’d walked into.
But over the last 25 years or so, the banking industry has undergone a series of sweeping changes. Mortgage lending has become much more standardized and national, so your local bank is probably underwriting your loan based on Fannie Mae and Freddie Mac standards. Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corp.) supply cash to the primary mortgage markets by purchasing large blocks of loans originated by other lenders. Mortgages that don’t conform to their standards can’t be sold on the secondary market. The bank will hold these rare in-house loans on its books or possibly sell them to another bank directly.
What Is a Mortgage Assumption?
This article isn’t about Fannie or Freddie, but you need to know a little about mortgage lending’s history before we start to discuss mortgage assumptions, which allow new borrowers to assume the terms of in-place mortgages, such as payments, interest rates and pay-offs. Mortgage assumptions were the norm for many years.
There were two kinds of assumable loans: simple and formal. A simple assumption was simple because you didn’t need to qualify for the loan. Nobody ran a credit check (there wasn’t even standardized credit reporting back when simple assumptions were the norm); your income was not verified; and the now-standard mortgage qualifying process was not done. If you could pay the difference between the home’s price and the underlying loan balance, you could just take over that mortgage. It might have looked like this:
- You agreed to buy a home for $80,000, and the current mortgage rate was 9 percent for new loans. The home you were buying had an underlying simple assumption mortgage balance of $50,000 at 6 percent, with 20 years left on the mortgage.
- If you had the $30,000 in cash to give the seller, you could simply assume the lower-interest rate loan and be 10 years into the payoff schedule. You would have a significantly smaller payment than you would have had on a new loan, and more of that payment would be going to principal and less to interest.
- If you didn’t have the whole $30,000, you could try to get the seller to carry some of his equity back in the form of a second mortgage and make a smaller cash down payment
Most mortgages were simple assumption loans. In formal assumption loans, you might be able to assume the underlying loan if you qualified financially, and the lender was allowed to change some terms. Up until the mid- to late 1980s, Federal Housing Administration and Veterans Affairs loans were simple assumption loans. Some people mistakenly believe that the simple assumptions went away because there was a high default rate caused by too many people taking over loans they wouldn’t have qualified for, and couldn’t really afford. In fact, it was much more about banks’ profits.
The Problem of the Reverse Spread
As interest rates went through the roof in the late 1970s and early 1980s, lenders faced a problem with what’s called “reverse spread.” If banks were making new mortgages at 14 percent, they might also be paying 10 percent on savings accounts. That’s a comfortable 4 percent profit margin. But if people were assuming older 7 percent mortgages, they’d keep paying the older, lower rate on those loans while the bank had to keep paying out 10 percent on deposit accounts. And that, obviously, equals a 3 percent loss.
To alleviate this problem, loans started including “due on sale” clauses in their mortgages that took away the automatic assumption option. This doesn’t mean that loans are not assumable today, but it does mean they aren’t easy to assume. Mortgages now state almost universally that the loan cannot be assumed without lender approval. You are free to approach the note holder about assuming an underlying loan. They are also free to tell you to forget about it.
If the loan is in default, you have a better chance of taking it over if the loan is current. And even if the lender sanctions the loan takeover, don’t be shocked if it wants to change the terms.
Many private loans (commonly referred to as land contracts, contracts or contracts for deeds) and mortgages can be written to be assumable if that is what the buyer (borrower) and seller (lender) agree because there are no banks in the middle of those transactions. Some investors also take over a property “subject to” existing financing.
Right now, with interest rates still near their all-time lows, there is, unsurprisingly, little desire among home buyers to assume mortgages. Why take over an older loan when you can get a cheaper new one yourself? But when interest rates rise dramatically again (and they will), you will see assumption come back into vogue. Once money starts getting expensive, buyers and sellers will have to get creative like they did 30 years ago.