An assumable mortgage is a mortgage contract whereby there are no terms preventing a buyer of the house from assuming the contract of the seller (mortgagor).
In layman terms, it means that when a buyer buys a house from the seller, instead of obtaining his own mortgage from a lender to complete the property purchase, the buyer takes over the existing mortgage of the seller on the house in question.
The buyer then assumes all obligations and responsibilities of the seller. Becoming the new mortgagor in the process.
A mortgage contract that does not prohibit this activity is an assumable mortgage.
There is a common misconception in this field where people generally think that mortgages generally prohibit this act by default and that it has to be specifically stated that assumption is allowed for a loan to be assumable.
On the contrary, mortgages are actually assumable by default. Lenders on the other hand insert terms and clauses into the contracts to directly or indirectly prohibit third parties from assuming the loans.
Advantages of assumptions
There are some very big reasons why buyers would prefer to assume a loan rather than get a new one.
And you don’t need to be a genius to see that they make a lot of logical sense.
The first being that the existing mortgage has a very attractive interest rate that is no longer available in the current market.
This could be due to the time when the loan was approved belonged to a period when interest rates were depressed. And the seller had the financial foresight to lock down a long term FRM at low interest rates.
So even as interest rates rise over the years, the seller had the luxury of boasting about low rates throughout the period.
If current market rates are at 8% and the seller’s loan is at 5%, a smart seller can even demand that a buyer pays 6% for assuming the loan and bank in the 1% difference himself.
This is a classic wraparound deal. And both parties will still be better off.
In this event, a promissory note will have to drawn up for the seller to protect himself.
However, there is still an ongoing argument in the lending industry about whether this is legal or illegal.
But it should go without saying that in low interest rate periods, there would be little interest in assumptions as a buyer can probably get a comparable loan in the open market… or even one that has better better terms and better rates.
But there is something else to consider.
Another benefit of assuming a loan is that the buyer avoids all the expense items associated with accepting a loan.
These can include:
- Application fees
- Credit report purchase fees
- Appraisal fees
- Prepaid interest charges
- Underwriting fees
These cost items can really add up. Why pay for them when you don’t have to?
Value of assumption
Because assuming a mortgage can grant cost savings to a home buyer, we can actually put a value to an assumption as long as some variables are available.
The value will depend on factors such as:
- Rate difference between assumed mortgage and a new loan
- Balance and term remaining on the existing loan
- Expected term on a new loan
- Length of time a buyer expects to hold the mortgage
- Rate of savings which is the investment rate
The value determined will not take into account the settlement costs associated with a new loan.
This also means that should the buyer take on a second mortgage to supplement the existing one, he is going to incur the wrath of loan costs.
This can occur when the mortgage balance is low compared to the home value. Thus being insufficient to cover a significant portion of the purchase price agreed between buyer and seller.
For example, if a property worth $100,000 is sold at market value, and it has a outstanding mortgage of just $20,000. Assuming a down payment of 10%, the buyer would still be short by $70,000 should he assume the mortgage. This $70,000 will have to be topped up with cash or via a second mortgage.
In this case, unless the buyer uses cash, he would still have to pay loan costs if he assumes the existing loan.
As you can observe, every dollar saved by the buyer is a dollar lost by the bank. Because if there is no assumption, the buyer would have to get a new loan and pay higher interest rates.
In addition to that, loan settlement costs as well.
This is why lenders insert clauses into contracts that protect their own interest and deter assumptions.
Saying that, it is well known that many lenders allow assumptions even though they have due-on-sale clauses in the existing mortgage.
However, the lender might demand that the new borrower be qualified and agree to a repricing of the loan.
Depending on the reasons for the buyer to assume the loan, it might then be counterproductive to go ahead with the assumption.
Paying premium for assumability
Every homeowner or investor should be able to see the value with assumable loans. The only party that would probably deny that is the lender.
Yet lenders are never stupid. After all they spend millions of dollars each year to hire the smartest minds in the world to run their operations.
Identifying the added value assumability brings to the table, lenders sometimes do expressly insert an assumable feature into their mortgages… in exchange for a higher interest rate.
Assumability has slowly become a tool to upsell.
For example a mortgage that is offered to the public at 5% but it’s 5.5% with a guaranteed assumability feature subject to the new borrower passing the qualification screening.
The capitalistic world is pragmatically crazy. I know.
But everything makes sense when you look at things from both sides of the fence as either party has to look out for their own interest.