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   ARTICLE   |   From Scotsman Guide Residential Edition   |   February 2007

Keeping It in Reserve

Payment control is the name of the game with mortgage-reserve funds

With unstable rates and declining property values, it has become increasingly difficult for loan officers to refinance their clients’ mortgages without increasing the homeowners’ monthly expenses. This is especially true when homeowners increase their loan balance by taking cash out during a refinance.

One of the simplest ways a loan officer can help lower a homeowner’s monthly mortgage payments, however, is by establishing a mortgage-reserve fund (MRF) as a component of a conventional refinance or second mortgage.

A reserve fund can accomplish many of the same goals for homeowners as an option ARM without the FICO restrictions and the higher interest rates. Although it is easy to establish and execute, its proper use does require proper knowledge.

The basics

A mortgage-reserve fund is a dedicated account from which homeowners’ mortgage payments are deducted automatically. In effect, a reserve-fund loan is a self-managed option ARM.

Typically, the account is first established with a deposit of funds drawn from homeowners’ equity. These funds are intended to subsidize mortgage payments for a predetermined time.

By self-managing these payment subsidies, homeowners with good credit can get a more competitive interest rate than they would with an option ARM. Plus, homeowners with low credit scores can still qualify for a loan program that offers similar results.

Consider this example: Borrower A refinances his $80,000 mortgage and takes out $20,000 in cash. He now has a $100,000, two-year fixed-rate 30-year mortgage at 6.5 percent. His out-of-pocket payment for the next two years is $632 a month.

Borrower B refinances her $80,000 mortgage, takes out $20,000 in cash and sets aside an additional $7,200 to establish a reserve fund. She now has a $107,200, two-year fixed-rate 30-year mortgage at 6.5 percent. Her out-of-pocket payment for the next two years is $378 a month.

Consider the following:

Borrower A

  • Loan amount: $100,000
  • Interest rate: 6.5 percent
  • Mortgage payment: $632
  • Less fund disbursement: $0
  • Adjusted monthly payment: $632

Borrower B

  • Loan amount: $107,200
  • Interest rate: 6.5 percent
  • Mortgage payment: $678
  • Less fund disbursement: ($300)
  • Adjusted monthly payment: $378

In this example, $300 was contributed to Borrower B’s monthly payment from the fund. That is, the $7,200 set aside to establish the reserve fund divided by 24 months equals $300 per month. By adjusting the initial size of the fund, homeowners can engineer the size of their payments, regardless of the interest rate.

Additionally, because the reserve fund can be paired with any loan, there effectively is no credit-score restriction. Conversely, if borrowers have a superior credit score and can qualify for a low conforming rate on a five-year ARM, they can engineer a lower monthly payment on their own, without the interest-rate premium typically associated with an option ARM.

The setup

Establishing a mortgage-reserve fund takes two simple steps. Let’s continue with Borrower B.

  1. Borrower B will get a check for $27,200 from escrow. She takes that check to her current bank, deposits it and asks the bank to transfer $7,200 of these funds into a new savings account. This account will act as the fund. A savings account is preferred to a checking account because it makes it harder for homeowners to use these funds for other purposes.
  2. After a couple of weeks, Borrower B will receive her welcome package from loan servicing. This will contain information needed to set up automatic payments from the fund.

There are two ways to set up automatic payments: 1. The homeowners’ bank can set it up; or 2. They can ask the lender’s loan-servicing department to arrange it.

In the first case, Borrower B would provide her banker with the lender’s contact information and the loan number, with instructions to pay the lender the full $678 payment commencing with the due date.

Alternatively, she can ask her servicer to arrange automatic withdrawals of the monthly payment by providing them with the bank’s routing number and the fund-account number. Many lenders will do this for free.

In Borrower B’s case, the full $678 mortgage payment will then automatically be made from this account each month. Instead of writing a check to the lender each month, the homeowner simply writes a check or transfers funds of $378 into the reserve-fund account. The $300 difference is made up by the $7,200 used to establish the fund, and it should last for 24 months.

Additional advantages

There are many additional advantages to making mortgage payments through a dedicated MRF account. If homeowners make their contribution to the fund late in any given month or if the payment is short, their mortgage still will be paid automatically and on time.

On the other hand, just by making larger payments than required, home-owners can extend the useful life of the fund. Depending upon the institution with which the MRF is deposited, the account also could earn interest income.

Most important, homeowners will have access to these funds if an emergency arises.

•  •  •

Setting up a reserve fund can be a simple process. In light of the benefits it can provide homeowners, it can be worth it for brokers to discuss this option with their clients. For homeowners with imperfect credit who require both cash out and a lower payment, working with them to establish a mortgage-reserve fund may be the only workable solution. 


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