Noel Cookman, 2012-08-22, Grapevine, Texas
Much of my time these days is consumed by two retired politicians, Dodd (retired and banned from lobbying for another few months) and Frank (finishing out his last term). I have my own nicknames for them but in the interest of good taste, I’ll treat you to silence in that regard. I am nearly consumed because when I am not complying with “Dodd-Frank” or the Wall Street Reform and Consumer Protection Act (several hours per week) I am complaining about it.
More about that in my upcoming seminar “The Truth About Dodd-Frank and How You Too Can Ruin The Financial Landscape of the Greatest Country in the World and Retire with Another Sweet Gig, a $176,000 Annual Salary, and a ‘Cadillac’ Health Plan Courtesy of the Taxpayers.”
For now, it is enough to say that while Dodd-Frank is the most comprehensive financial legislation in history, Texas Equity financing laws impact your client’s mortgage transactions more often than Dodd-Frank apparently does right now. Yet, when I ask for a show of hands at my seminars of those who believe they understand the basics of Texas Equity laws, I get a response somewhere in the zero to .0001% range. Most of us will never personally deal with these financing rules and for those of us who do, such experience is probably limited to once in lifetime. This explains the glazed-over look in the eyes of my seminar attendees when I ask the question.
Texas equity loans (or “Texas Cash Outs”) are comparatively easy to understand; but, few laws or mortgage products are more widely misunderstood. Moreover, it is important to understand a few basic features of the “Texas Equity” in order to see the necessity (and superiority) of the Owelty agreement in a divorce settlement. So, I treat you to some useful information; and, I show you how we have rescued divorcing homeowner-borrowers from the onerous restrictions placed on their properties by previous equity financing, a feat nearly all mortgage professionals will tell you is impossible.
Here is your Cheat Sheet:
1. Texas Equity financing (or “cash outs”) apply only to homestead properties (nearly always primary residences or marital residences).
2. Texas is the only state that has such legal provisions and restrictions on equity financing. There are industry guidelines and limits on equity financing but no other state has a law that so definitively limits equity financing as does Texas.
3. In Texas, “equity” (as applied to mortgage lending) means any monies that a borrower accesses in a mortgage transaction for any purpose other than to satisfy one of the following liens against a homesteaded property: a) purchase money, b) ad valorem taxes, c) Owelty of partition (generally for divorce), d) home improvement loans, and e) reverse mortgages. The other allowable lien is an equity lien; but, financing an existing equity lien triggers another equity loan or “Texas Cash Out.”
The most common use of such equity is simply “cash to borrower.” Line 303 (page 1, last line on left column) on a HUD-1 Settlement Statement most often reveals this. It will say “Cash To Borrower” or there will be some designation to indicate that borrower is receiving, not paying, monies at closing. Parents borrow money for their children’s college tuition or homeowners may simply wish to take a vacation to Aruba. Lenders cannot require borrowers to use funds for a particular purpose (such as purchasing credit life insurance) but they will most often seek to know the major use the borrower intends for the cash. (The key here is for the borrower not to express a desire to fund al Qaeda or to set up a training compound to prepare a private militia to overthrow of the U.S. government). Another common use is the paying off of credit accounts or other outstanding debts not secured by one of those liens mentioned above. Many times, borrowers can greatly alleviate monthly debt-service burdens by rolling a high interest or high monthly-payment debt into a low interest, 30 year amortized mortgage loan.
Borrowers and even mortgage professionals (to use the term lightly), often make the mistake of triggering equity financing for a buyout in a divorce. For reasons you will see, this is very damaging to the borrower and the transaction itself. And, as you have seen, there is another instrument for a divorce buyout (Owelty) provided Texas equity laws have not previously been triggered. Extracting homeowners from these restrictive equity limitations in divorce is what I discuss below in a couple of scenarios.
4. Once a Texas Cash Out lien has been placed on the property, it cannot be removed from title until the loan has been paid for in cash (verses with proceeds from another, newer loan financed by the existing homeowner). Obviously, in the case of a purchase transaction, the homeowner becomes the grantor and then another party who did not have a homestead interest in the property, may take out their own mortgage to purchase the property (hence, “purchase money” lien). [There is another case whereby homeowners may “lift” the Texas Equity restrictions from title – when they convert the property to a rental property or “non-owner occupied” by filing a Texas Homestead exemption on another real property in Texas.] This feature is commonly called “once ‘cash out,’ always a ‘cash out.’”
5. The 80% Rule. Borrowers cannot borrow more than 80% of a home’s appraised value measured at the time of financing. Since any refinancing of an existing Texas Cash Out mortgage necessarily triggers the same “cash out” law, this 80% limit continues until the loan is paid off in cash or as in a sale.
This means that if a homeowner finances $80,000 with a Texas Cash Out mortgage when the house is valued at $100,000 (by an appraisal which the lender accepts as determinant), if and when they come back to refinance that same mortgage and if that property has declined in value to, let’s say, $90,000 then the new maximum allowable loan amount will be $72,000 (80% of $90,000). Depending on what has happened in the market and how long the homeowner has had to pay down the mortgage, the mortgage balance may exceed the maximum allowable loan amount for the new mortgage.
6. The 3% limit on closing costs. Texas law limits closing costs on equity loans to 3% of the new loan amount. This doesn’t bite anybody on the back side unless their loan amount is less than about $175,000. Appraisers do not reduce their fees to inspect and report on properties being financed as equity loans. They don’t care, it’s the same amount of work. Doc prep attorneys don’t charge less – actually they charge more because of the extra work required. Underwriting fees are the same. Title policies are even higher than for regular refinances. If fees total $4,000 but your loan amount is only $100,000, where does the extra $1,000 come from? (The difference is $1,000 because the 3% limit on $100,000 is only $3,000 but the costs are $4,000). The lender must get it by charging a higher interest rate and getting “premium” from the investor to pay these extra costs. Low loan amounts create a vicious cycle of costs that are relatively too large to fit within legal limits. At floor loan amount threshold – around $80,000 or so - borrowers don’t get return phone calls from lenders who would otherwise be happy to take their application and fund their loan.
7. There are many other provisions like the 12 month rule that disallows borrowers from taking out an equity loan more frequently than once in a 12 month period. My favorite is the exception for Agricultural Exempt properties which cannot be financed with an equity loan unless it is used for milk production. This came in handy when I obtained an equity mortgage for a great Texan lady whose land was registered as “Ag exempt” but happened to have a few goats on hand. If you could only have seen her face when I informed her she would need to start milking them before we could do her loan.
This generally outlines the most common limitations we deal with in equity financing in Texas. But, how does this affect the divorcing borrower?
#1 - The Classic Buyout
First of all, when Susan calls a typical lender and says that she and John are divorcing, that she is keeping the house and that she must refinance it to get his name off the mortgage as well as get some “cash” to pay John for his “equity” most loan officers begin to drool. What do you think is their first calculation? No, it’s not debt ratios. Nope, it’s not loan to value (LTV) ratios. And it ain’t closing costs or taxes or insurance. It’s their commission check. (Because of Dodd-Frank, this calculation is quite distorted to the detriment of the consumer but, I digress).
The second calculation is probably the 80% calculation. “What is your loan balance?” “What do you think the house is worth?” (You have to start somewhere). Let’s peek in on a conversation.
Susan: We owe about $150,000 and I think that the house is worth about $200,000. I need about $25,000 cash to buy him out.
Loan Officer: [some clicking sounds in the background] . . . uh, er, um, let’s see here now. $200,000 huh? I can get an equity loan for $160,000 (80% of $200,000). With closing costs of $5,000, if you waive escrows and come up with your own taxes and insurance in a few months, we can get you . . . uh, $5,000.
Susan: But, I need $25,000.
Loan Officer: Well, I’m so sorry Susan. You’ll just have to call Noel Cookman at 817-454-4555 ‘cause I have no idea how to get you the $25,000 to buy out your husband. And by the way, did your attorney not tell you about Mr. Cookman? This is odd indeed.
The simple solution is that equity laws are not triggered by an Owelty lien. The key, of course, is to craft language in the decree that not only establishes that Owelty interest but avoids a few choice words like “equity” or “equity interest” that would then trigger an equity lien.
Susan, finally reaches Noel Cookman who constructs her loan properly, works with the attorneys to pre-underwrite the decree and brings her to the closing table a few days after final divorce. She borrows about $175,000 plus closing costs on a $200,000 property, John gets the $25,000 for his interest in the property and they are now and actually divorced, not still joined at the mortgage or the house.
#2 – The Already-Present Equity Loan
What of borrowers and properties that have already been encumbered by equity financing? The perpetual nature of equity lending now means that the 80% limit is perpetual as well. Let’s take the same situation above except a couple of years ago, John and Susan had paid their mortgage down to $125,000 but borrowed money on a 2nd home equity loan, $35,000 to finance a year or two of college for their young adult child. But, they have paid their mortgages down to a first lien balance of $120,000 and $30,000. That’s about how amortization works and the total balance of the two loans is now $150,000. Susan still needs $25,000 for a total of about $180,000 ($150,000 1st lien + $25,000 2nd lien + $5,000 closing costs). But that’s 90% of $200,000. Because of the 2nd equity lien on the property, the limit still applies. What shall we do?
I first did this (what I am about to tell you) in 2004, not knowing for sure if it would work but not seeing any rational or legal reason why it would not. And we’ve been doing it ever since.
First we had to discover $25,000 in John’s or Susan’s retirement account. (Through the years, various sources have been used but, in my first case, it was a retirement account). Susan had it and we simply constructed the transaction and terms of the divorce thusly:
1. Susan withdrew $25,000 from her 401(k) on our promise that if she did what we said, when we said to do it that we would replenish her funds.
2. Susan took this $25,000 and paid off the entire balance of the 2nd equity loan. (Remember, the equity restrictions remain until the loan is paid off in cash that is not from another mortgage loan transaction).
3. Poof – like magic, the Texas equity restrictions are gone from title. The property is now free to receive the other categories of liens so long as everyone on title agrees.
4. The buyout to John is not $25,000 but $50,000.
5. We draft a Proceeds Allocation Letter (which is consistent with the decree which also tells John what he must do with the $50,000) that reads “Dear Title Agent, please take my $50,000 and wire $25,000 to Susan’s 401(k) account and $25,000 to my checking account.”
6. The retirement funds are replenished within 60 days and no penalties or taxes are charged or subtracted because it’s considered a “rollover.” Susan listened to us and didn’t withdraw these funds until we signaled her to do so, staying within the 60-day window. (You see, there’s another 60-day window you probably didn’t know about, eh).
It’s not magic but it looks like it. And so far as I know, divorce is the only likely event wherein such a transaction can be thusly structured. There really is a silver lining in every cloud.