The national mortgage settlement has a potentially ghastly surprise for some who refinance under its terms. They could end up doubling their interest rates.
Five big banks filed legal settlements yesterday with the federal government and the attorneys general of all states except Oklahoma. Ally, Bank of America, Chase, Citi and Wells Fargo had been accused of mistreating mortgage customers. As part of the settled lawsuit, the banks will spend billions of dollars on loan modifications, short sales and refinances.
The feds and attorneys general agreed to a set of refinancing rules that favor banks over borrowers. This especially is the case for underwater homeowners who currently have mortgages with rates below 5.25 percent, and who want to refinance. Many of these borrowers will be steered into five-year adjustable-rate mortgages. And after the first five years are up, the interest rate can rise far above the rate on the original mortgage.
Here's a scenario: You have a 30-year fixed-rate mortgage at 5 percent. That's a nice rate, but a family just bought the house across the street with a 4.25 percent mortgage. So you ask your bank to refinance you under terms of the legal settlement.
Your bank offers to reduce your rate to 4.75 percent or 4.5 percent -- whatever percentage it takes to cut your monthly house payment by $100.
That's all the bank is required to do, and it's not an awesome deal. And then it gets downright awful, because that rate reduction lasts only five years. Then your rate will rise -- and it can exceed the original 5 percent rate that you had.
Under this scenario, the lender could jack up your interest rate into the double digits eventually. The bank can increase the interest rate by half a percentage point each year until your rate is a full percentage point over the rate the average home purchaser is getting.
I don't know if that's the intention, but that's the way the settlement is worded.
The settlement says the loan can have "a maximum ending interest rate of 5.25 percent or PMMS + 100 basis points." It doesn't say "whichever is less."
The PMMS is an interest rate index calculated every week by Freddie Mac. It reflects the average interest rate offered in a survey of about 125 lenders nationwide. Last week, the PMMS was 3.88 percent, so PMMS plus 100 basis points would be 4.88 percent.
Eventually the economy will recover, and the PMMS will rise. Five years ago, in March 2007, the PMMS was 6.16 percent. Who's to say it won't return to that level five years from now? Then the PMMS plus 100 basis points would equal 7.16 percent.
I see nothing in the legal settlement that would prevent a bank from perpetually indexing the rate on a refinanced mortgage to PMMS plus 100 basis points. Imagine refinancing out of your 5 percent mortgage, only to find a decade later that your rate has climbed to 7 percent. It's theoretically possible to go from a 4.5 percent interest rate in the first five years to an interest rate of 10 percent in the 16th year.
Maybe, if you get stuck with such a loan, you will be qualified to refinance after your home's value recovers. In an age when banks make much of their profits from fees instead of from interest income, your lender probably would welcome another refi and the fees that it generates.