Hidden Risks in Conventional and FHA Home Loans
Home buyers are faced with a choice between a conventional or FHA loan when they are looking for a mortgage. Both of those choices, however, have some high costs and risks associated with them. You can avoid these hidden costs and risks by choosing an alternative path: Islamic home financing.
Identifying the Hidden Risks of a Traditional Mortgage
One of the biggest drawbacks of taking out a traditional mortgage loan on a home is the inequity of the situation. A traditional mortgage loan creates a lender-borrower relationship that is inherently inequitable; all of the power is on one side of the equation. As the one in need of assistance, the customer — who is now characterized as a borrower — must agree to the money lender’s terms.
As the lender, banks and mortgage companies of course seek maximum profit. This manifests in part as additional fees. If you run into hard times and you’re late with a payment, you will have to pay a late fee in the form of an extra percentage on top of the payment you owe. On the other hand, if you wish to pay your mortgage off early, you may be charged a fee for that too.
In addition to the high costs, all of the risk falls on you alone with a traditional mortgage. If you can no longer pay and your home goes into foreclosure, you are responsible for the full cost of the home plus many more fees. Similarly, in the case of a natural disaster or eminent domain (which is when the government seizes part or all of a property for public use), losses are yours to bear alone. In contrast, under Guidance Residential’s co-ownership program, the risks are shared.
Islamic Financing—Equitable and Transparent
In contrast to a traditional mortgage, with Guidance Residential’s model of Islamic financing you enter a contract not as a borrower but as a co-owner. Your role is that of a respected partner. All costs are clearly listed in your paperwork, and fees are capped. If you are late with a payment, you will not pay an additional percent on top of what you already couldn’t pay; rather, you will be charged only a fixed administration fee to cover the cost of reaching out to you for your payment. If your home is destroyed by a natural disaster or seized by the government through eminent domain, we — as co-owners — share the risk with you. And if you wish to buy out our share of the home early, we are thrilled, and we certainly do not charge you a fee for it.
Delving Into the Details
Let’s take a look at these fees and risks in greater detail.
Late Payment Fees and Foreclosure
In a traditional mortgage loan, if a homeowner loses their job or runs into some other financial difficulty and falls behind on their mortgage, late penalties are immediately applied to each late payment — typically up to 5% of the payment owed. On a $2,500 mortgage payment, that equals $125 each month you are late. Only a portion of that goes to the administrative expenses of reaching out to you for the payment; the rest is profit. In other words, the bank profits from your financial distress.
With Guidance Residential, if you make a payment late, you pay only a small fixed fee to cover administrative costs of reaching out to you. We do not charge a percent of your payment, and we don’t profit from our customers’ difficulties.
If a homeowner begins to miss numerous consecutive payments, now they are facing foreclosure. With a traditional mortgage, the loan servicer will begin sending increasingly urgent notices. How many months can you get behind on your mortgage before foreclosure? Generally, after you miss three payments, you will receive a demand letter that notifies you that you have 30 days to catch up on your payments. After that, preparations are made to sell the home.
With a traditional mortgage, if the home sale doesn’t cover the amount you owe the bank, in many states the lender can — and will — come after your personal assets to pay the difference. They would have a court order a deficiency judgment against you, which would allow seizure of personal assets and/or property, such as a savings account or a car. Homeowners have been surprised with court action even years later — with interest continuing to accrue the entire time.
With Guidance Residential, in the case of foreclosure, the home will be sold, as with a traditional mortgage. The difference is that our only recourse is the property itself. We do not pursue the customer’s personal assets to make up for the loss. The customer is better protected under this arrangement.
Mortgage Prepayment Penalty
Homeowners in more fortunate circumstances often want to make extra payments toward their mortgage when they have some extra funds on hand. But some older mortgages include a prepayment penalty to discourage that, because when you pay your mortgage off early, you save on interest, and this costs the lender money. The penalty removes the incentive to pay off the principal early so you will pay it back slowly over the full term, allowing them to collect their full interest.
Guidance Residential charges no prepayment penalty. You can make extra payments at any time. We are thrilled if you own your home in full ahead of schedule.
The Rules of Eminent Domain
Eminent domain is a less well-known risk but it’s a striking example of the difference between the approach of a traditional mortgage and co-ownership Islamic financing. What is eminent domain? It is the government’s right to take private property for public use. Here’s an example of eminent domain: If the county or state decided it needed to build a road through your property, they have the right to do so — and even to force you to sell your entire property to them — as long as they pay you an amount they determine to be justified. While roads may be the most common example, eminent domain has been used for a wide range of other purposes, from constructing public buildings to establishing public parks to building up land to prevent erosion along a river. If the government decides it is necessary, the law permits them to do it.
In a traditional mortgage, the loss from eminent domain is yours alone to bear. Most mortgages include a condemnation clause that allows the mortgage holder to take the compensation that was paid to you to pay off your mortgage. If the government takes your entire property and pays you $100,000, your mortgage holder likely can then take all of that money to pay off your mortgage, leaving you with nothing.
In contrast, in a co-ownership situation, we share both rights and responsibilities. In the situation described above, we would share the $100,000 with you according to our ownership percentage of the property. If you now own 30% of the home, you would receive $30,000 from that payment, which is $30,000 more than the homeowner described above with a traditional loan. If you owed Guidance more than our portion of the payment, we will take the loss.
Natural Disaster Risk Sharing
Homeowners are required to buy homeowners insurance. In the case of a disaster such as a hurricane, insurance will pay for repairs. The difference between Guidance Residential and a conventional mortgage is seen if the home is completely destroyed.
With a conventional mortgage, if the home is destroyed beyond repair, the bank will be paid first. In the unlikely scenario that anything is left over, the customer will receive the rest.
With Guidance Residential, on the other hand, the insurance proceeds will be split between the two co-owners in proportion to their ownership share. This means the customer will always receive a percent of the proceeds.
For example, let’s say Mariam owns a $100,000 home, and she has 20% equity. Her home is destroyed beyond repair by a tornado, and the insurance company sends a check for $80,000.
In a conventional mortgage, the bank is paid first. The $80,000 pays off her loan, and she is left with nothing.
If her home were financed through Guidance Residential, she would receive 20% of the proceeds and Guidance receives 80%. Guidance cannot pursue Mariam for the amount remaining on the contract; plus she receives $20,000 in accordance with her ownership share.
In Summary …
Financing a home with Guidance Residential looks similar on the surface to a traditional mortgage loan — when circumstances are normal. When anything happens that is out of the ordinary, that is when the differences between a traditional loan and co-ownership arrangement become apparent. And the differences are nearly always in the favor of the co-ownership customer compared with the mortgage loan borrower. In essence, profits are yours alone, while risks and losses are shared. It’s a win-win for you as a home buyer with Guidance.
Your Guidance Residential Account Executive is here to help with any questions. Looking to refinance or purchase? Rates have dropped to historic lows! Have a friend or family member who is looking for a home? Call 1.866.Guidance, or start an application today!