Escrow can raise costs, but add simplicity

Why did Jones pay more for his mortgage than Smith? One possible reason is that they borrowed at different times, when market conditions were different. Right now, the market is very favorable, but mortgages priced at 3.5 percent today were priced at 17 percent in 1980. There is nothing borrowers can do to affect the general market.

A second possible reason Jones paid more is that he was a less effective shopper. Borrowers have complete control over how they shop, and I have more than 50 articles on my website designed to help them on one or another aspect of the process. This is not one of them.

A third possible reason Jones paid more is that his mortgage had features that increase risk to the lender, which charges a higher price to compensate. My recent columns examined low credit scores, use of the house as an investment rather than as the borrower's primary residence, cash withdrawals on a refinance, and high ratios of loan amount to property value. Now we'll look at properties other than single-family houses, and waiver of the requirement to escrow taxes and insurance.

Borrowers pay more for their mortgage if the property is other than a single-family unit. A 2-unit property where the borrower will occupy one of the units will be classified as a primary residence rather than an investment, but because the second unit is likely to be rented, from a lender perspective it has some of the drawbacks of an investment property. Many tenants don't take care of their properties as well as owners, even when the owner lives next door.

On 3 and 4-unit properties, lenders view the risk as even greater, and as shown in the table below, they charge more than on a 2-unit property. Further, at loan-to-value ratios, or LTVs, higher than 80 percent, they won't make loans on 3- and 4-unit properties.

Condominium mortgages may or may not cost more than a mortgage on a single-family unit, depending on the LTV and the financial as well as physical condition of the condominium project. The owners of condo units face a risk that owners of single-family units do not have. They are responsible for maintenance of the grounds and buildings, which means that the failure to pay condo fees by some owners imposes a greater financial burden on the others. Ordinarily this is not a problem, but it has become a problem in some projects in recent years.

If condo fee defaults in a development become too high, lenders may refuse to make any loans on units in that project. I have received some anguished letters from condo owners unable to refinance or to sell because of such a lender freeze.

Borrowers with 2-4 unit houses can't do anything to control the mortgage price except to shop carefully. Prospective condo purchasers, on the other hand, can and should assess the risk posed by the condo project by examining its financial status, with particular emphasis on condo fee defaults by existing condo owners.

Another element of cost is escrow. Lenders generally require borrowers to include taxes and insurance premiums in their monthly mortgage payments, which are placed in escrow until the payment date when the amount due is paid by the lender. Mortgages are priced on that assumption. If you want to control the taxes and insurance yourself, you can request a waiver of escrow, which will cost you about one-quarter of a point – or $250 for each $100,000 of loan amount.

This is entirely within the borrower's discretion. I didn't waive escrow on either of my mortgages because I like to keep my life as simple as possible, and adding a set amount to my mortgage payment every month to cover taxes and insurance was as simple as it got. The borrowers who waive escrow either are control freaks or fear that the lender will screw it up, which occasionally happens. When it does, it can be a nightmare for the borrower. I was not deterred by this risk, however, because I felt that the risk that I would screw it up was greater.

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ABOUT THE WRITER:

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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(c)2013 Jack Guttentag

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