The Borrower's "Sophie's Choice"

A great irony of the subprime era was that tax and insurance payments were escrowed for borrowers with money in the bank and proven credit, yet those who lived paycheck-to-paycheck did not have to include T&I in their mortgage payments.

Escrowing T&I is an industry best practice from the early days of mortgage lending. At that time, when there weren’t any subprime loans, it was a simple observation that once-a-year payments, like property taxes and annual hazard insurance premiums, could be collected from the borrower as part of the regular monthly loan payment over the course of the year. This creates a relatively painless way of making sure that monies needed to meet lump sum annual tax and insurance obligations on the home will be met.

This method is tried and proven, and it’s the standard. If you’re a typical homeowner with good credit and assets, T&I will almost always be added into your monthly payment, and you’ll have to negotiate out of it and usually pay a small fee if you don’t want that money escrowed. It’s a prudent practice.

Obviously, T&I escrow makes the borrower’s monthly payment bigger. Therein lies the problem. Subprime lenders want to make more loans, because they make fees for originating loans, and more loans equals more fees. They don’t really care if the borrower defaults on those loans, because that’s the investor’s problem, not the originator’s problem. So subprime lenders stopped escrowing T&I.

By not escrowing T&I, subprime borrowers got a lower monthly payment. That meant that they qualified more easily for a loan, and the subprime originator got its wish—easier qualification meant more loans could be made.

The downside of not escrowing T&I for subprime loans is that when the taxes come due on a property, this is a borrower who does not have the money in the bank to make the tax payment. So the borrower then has to choose between paying the taxes to keep the property from being sold hastily, in a public auction, and paying the mortgage. This is a borrower’s Sophie’s Choice, because on one hand, you risk losing your property, and on the other hand, you risk losing your property. There is no good choice when you don’t have the money in the bank and your taxes come due. The servicer is required to advance the money to pay your taxes, so that the loan’s collateral is not lost at public auction, but that payment accrues to the borrower’s loan balance. This puts the borrower behind in payments, and deeper in debt. And remember, the reason the borrower got this loan is because the payment was low enough to qualify for—this borrower could not have qualified if the added debt burden of taxes were built into the payment.

The same is true of insurance payments. Don’t pay your insurance, and the servicer will force place insurance. That’s what the servicer has to do. The property has to be insured, so that if it burns or something else happens to it, the collateral value backing the loan doesn’t evaporate. The type of policy that servicers carry is called force place. Force place insurance is like anything else that you purchase in an emergency setting, with no background work that might otherwise result in a more reasonable charge. It’s expensive, in other words, and it’s generally non-negotiable. The insurance company offers a policy to the servicer that asks no questions—the only thing the servicer needs to submit to get the insurance is the property address. The insurance company takes on a lot of risk with that approach, because they are insuring something they don’t even have a picture of, so they charge a lot of money. And that money gets added to the borrower’s debt, and, once again, the borrower, who got the loan because it didn’t include the insurance he couldn’t afford, now has to face the reality of paying for insurance one way or the other, and in this case, the borrower has more debt and is behind. The reality is, the loan required insurance, regardless of whether it was escrowed or not.

This industry is struggling with a deluge of regulations intended to correct what went wrong in the mortgage meltdown. A simple regulatory fix would be to mandate that taxes and insurance be escrowed on all loans. If anything, borrowers with assets and strong credit should be the ones who qualify to avoid escrowing T&I, not those with a tougher financial situation.

Fewer people would qualify for loans if this were the case, and perhaps that’s just as well. Otherwise, it’s going to be Groundhog Day for us, once again, when lending comes back to life, and people start responding to offers to own a dream home they can’t afford. This industry has a short memory, which I can attest to based on the origination fraud we’ve seen already, in this new era of lending. It won’t be long before the borrowers who can least afford it are offered a T&I-free loan payment, to induce them to take out a mortgage they should not sign.

I’m not a big fan of regulation, but this is an instance where a law would absolutely make an immediate difference, not just to the industry’s future, but to the lives of people who would otherwise sign up for something that is going to be a bigger burden than they are prepared to face. The worst possible outcome for all—borrower and investor—is for the borrower to lose the home. Escrowing T&I will make a world of difference.