Refinance not always best move for distressed homeowners

"Two months ago I lost my job; I have since been late on my credit cards; most of them are maxed out; and I am two months late on my mortgage payments. I had a chance to refinance early on, but the rates were very high so I turned them down; now I can't refinance at any rate. A friend of mine has offered to lend me the $30,000 I need on a second mortgage at 15 percent, plus I must pay all the fees, and I must repay him in full after three months. To repay him, I would have to refinance at that time. Should I?"

No! The only thing this deal can do for you is delay the inevitable for a few months, at the cost of a substantial amount of your remaining equity.

I assume you have equity in the house because your so-called friend knows that you won't be able to repay him in three months. The only way he can get paid is from a foreclosure sale, or by purchasing the house from you. In either case, there must be enough equity in the house to cover the first mortgage balance and arrears plus the amount owed him by you.

There is no possibility that you will be able to refinance in three months. Your equity will be reduced by the second mortgage and your credit won't be significantly different, even if you have paid off all your overdue credit cards. The process of rebuilding your credit will take years, not months.

Your best option now is to sell the house ASAP and retrieve as much as possible of the equity you have in it.

Can You Choose How Your Payment is Allocated?

"On my mortgage, I pay only part of the interest, with the unpaid portion added to the balance. If I have extra cash, how should I apply it, to the interest or to the principal?"

You don't have that option; in fact, no mortgage borrower does. The allocation of a mortgage payment between interest and principal is determined mechanically from the definitions of "interest" and "principal."

Interest is the amount the lender is due for the period covered, usually a month, and is calculated from the interest rate and the loan balance. For example, if the loan is for $100,000 and the rate is 6 percent, the monthly rate of .5 percent is multiplied by $100,000 to get $500 of interest due.

Principal is the payment minus the interest, and it is also equal to the change in the loan balance. If the borrower pays $600, for example, then $500 is interest and $100 is principal. The balance is reduced by $100, which is called "amortization." If the borrower pays $400, the principal is -$100, and the balance rises by $100, which is referred to as "negative amortization."

In your case, the payment doesn't cover the interest; let's say it is $300, which means that the principal payment is -$200. If you find another $400 to add to the payment, it would raise the total payment to $700, of which $500 would go to interest and $200 to principal. There is no discretion involved. There never is.

Is the APR Reduced If the Home Seller Pays the Fees?

"My boss tells me that fees ordinarily included in the APR, such as points, when paid by the home seller, must nevertheless be included in the APR. I don't understand this since I thought that the APR allows the consumer to compare the cost of doing business with one lender versus another lender? Since fees paid by the seller don't affect the borrower's cost, why should they be included in the APR?"

Strictly speaking, the APR, or annual percentage rate, measures not what the borrower is paying, but what the lender is charging. Who pays the charge is not relevant. The general presumption is that the borrower pays it, directly or indirectly. If the home seller pays it directly, the borrower pays it indirectly in the price of the house.

Involvement of a third party in the transaction does not affect the comparability of the APR in comparing the cost of borrowing at different lenders. The willingness of a seller to pay some specified amount of loan fees to get his/her home sold is not limited to a particular lender. If he/she pays it for lender A, he/she will also pay it for lender B. Hence, such payment does not affect the integrity of the APR as a measure of the cost of funds.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

Copyright 2006 Jack Guttentag