Refinancing a Home When it Seems Hopeless

When a marriage ends in Texas, whether by divorce or annulment, the judge is required to divide all property owned by either spouse between the spouses.1Tex. Family Code § 7.001. For some couples, the marital residence is a critical piece of property, the division of which raises multiple issues that must be resolved.

Marital Residence Issues

Several issues must be resolved in determining who, if anyone, will keep the marital residence once the marriage is dissolved. If these issues cannot be resolved to both parties' satisfaction, the marital residence will have to be sold as part of the divorce proceedings.

(Related: Property Division)

1. Financial Interest in the Home

First, you have to determine the couple's financial interest in the home. Some people refer to that as equity. A quick way of estimating the financial interest in the home is to start with the current market value of the home and subtract all the debts secured by liens on the property, like this:

Current Market Value            $400,000
LESS: Payoff of Mortgage Loan  -$250,000
                               ---------
Financial Interest to divide    $150,000

Even this simple valuation formula raises some issues:

  1. Market Value: How do you come up with market value? It's glib to say that the property is worth whatever someone will pay for it on a given day, but you won't know that number until it after it's sold. So that's not helpful. There are three ways to estimate the value of the property and depending on where you are in the process, any of them can be appropriate. First, you can use an owner's estimate of value, which can be based on gut feeling (bad), tax appraisal (tends to be low), or a web site like Zillow (tends to be high). Second, you can order a formal appraisal, which will cost $400 - $800, will give you a spot-in-time valuation, but will not take into consideration the conditions of the interiors of the properties selected as comps. Third, you can ask a real estate agent to create a Comparative Market Analysis (CMA). A good agent will not only look at comparable sales in the relevant market area but will also, to the extent possible, compare conditions of the interiors of the properties. A CMA is free.
  2. Debts to Subtract: You need the most recent statement for each loan against the property. Some people have a single loan against their home while others have a first and second mortgage while still others may have workman's liens, tax liens, or municipal liens due to maintenance that the city had to do on the house, such as mow the grass or remove junk. The same real estate agent who performed a CMA for you can ask a title company for a list of all debt secured against the home.
  3. Cost to Bring the House into Marketable Condition: All houses need to have some work done on them before they are listed for sale. Sometimes it's as simple as removing excess clutter to make the rooms look larger or may require significant repairs as the result of deferred maintenance such as carpet, roofing, landscaping, gutters, and water damage mitigation. The real estate agent who prepares the CMA can give you a list of suggested repairs and a good real estate agent can provide you an estimate of how much a given repair or upgrade will improve the sellability of your home as well as how much it will enhance the sales price.
  4. Phantom Equity: The person who keeps the marital residence will have to sell it one day. That day might be 20 years from now, but it's a day that will come. When the house is eventually sold, there will be costs associated with that sale and those costs will reduce the net proceeds of the sale. Moreover, the Texas Constitution limits the amount an owner can borrow against residential property to either 80%2Tex. Constitution Art. 16 § 50(a)(6). or 95%3Tex. Constitution Art. 16 § 50(f)(2).,4If the debt on the home falls under 50(a)(6), it may have to be converted into 50(f)(2) debt in order to make the transaction work. If that's the case, the parties and their attorneys need to know this BEFORE THE PETITION IS FILED. If the parties are going to need the more generous loan-to-value limitations of 50(f)(2) (95%), the underwriters are going to look askance at a financing transaction that begins after the petition is filed because that raises an unlimited number of issues as to which party will be burdened with financial obligations such as child support, spousal support, and other debts from the marriage. If one party wants to keep the marital residence and there are other assets in the marital estate with equivalent value to the parties' interest in the home AND the party wishing to keep the house is not a very high wage earner, the parties should quickly prepare an inventory of debts and assets and consult with a divorce lending specialist BEFORE THE PETITION IS FILED. Homeowners: There is a very, very good chance that neither of your attorneys is going to know or understand this so it's going to be on you to raise the issue so that it can be addressed BEFORE THE PETITION IS FILED. That means that 5% - 20% of the "equity" in the property is not available to the owner through cash-out or home equity line of credit transactions. I call this phantom equity because it is a portion of the owner's financial interest in the home that the owner will never, ever receive.
  5. Refinancing Costs: Any debt that is in both parties' names will have to be extinguished or paid off eventually and relatively quickly. That is the subject of another article, but the cost of doing that will have to be taken into consideration in determining the parties' real financial interest in the property.

It is likely that the owners will argue about which of these items (2-5) should be subtracted from the market value to arrive at the parties' financial interest in the home. For example, if one party wants to keep the home, the other party is going to resist subtracting any costs to bring the house into marketable condition. Even if some of these expenses must be incurred to make the house livable, the party giving up their interest in the home will argue (correctly) that the party keeping the house will enjoy 100% of the benefit of those repairs and upgrades so the party yielding their interest should not be taxed for them. That is a valid argument but sometimes has to be tempered by other realities imposed by the parties' desire to resolve their disputes out of court.

For our purposes, let's say that a CMA suggests that the house will eventually sell for $420,000, that the title company found a first mortgage having a payoff of $252,000, and that a mortgage lender estimates that the cost of refinancing the debt on the home will be $5,000. That would suggest that the parties' financial interest in their home is:

Current Market Value            $420,000
LESS: Payoff of Mortgage Loan  -$252,000
LESS: Refinance Costs          -$  5,000
                               ---------
Financial Interest to divide    $163,000

Keep in mind that this first step--calculating the financial interest to be divided--is going to involve some negotiation. There is no binding legal principle that dictates how financial interest is to be calculated.

2. The Ability of One Spouse to Maintain the Home

The next issue to consider is whether the party who wants to keep the house can make the payments on a long-term basis. If the party who wants to keep the house makes $200,000 a year and has no other debt, then it's probably safe to assume they can continue to make payments equal to what the parties have been making, say $2,500 a month. However, if the party who wants to keep the house cannot afford the payments, you'll have to see if there is a way to move assets around and refinance the debt on the home so that they can make the payments going forward.

Although there is some variation in debt to income limits imposed by law, a good figure to use is 43%.5Hizmo, Aurel, and Shane Sherlund (2018). "The Effects of the Ability-to-Repay / Qualified Mortgage Rule on Mortgage Lending," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, November 16, 2018, https://doi.org/10.17016/2380-7172.2296. To estimate the amount of debt that can be undertaken by the party keeping the marital residence, you would do a calculation like this:

Gross income from all sources        $52,000 / year
Dodd-Frank DTI Ratio                x     43%
                                    ---------------
Maximum debt payments per year       $22,360 / year

Maximum debt payments per month      $ 1,863 / month

For this article, we'll assume that the party keeping the house will have no debt other than the debt associated with the home they are keeping. That is not always a realistic assumption.

If the current monthly payment is $2,500, including escrows for property taxes, homeowner's insurance, and HOA dues, you can see that we already have a problem. The spouse who wants to keep the house can't afford it. This is where most people give up and, if the marital residence is the only asset of any significant value, this is where you have to stop. However, let's assume the couple has additional assets, such as 401(K), IRA, cash, and stocks and keep going.

If the spouse who is keeping the house can make $1,863 per month in payments, how much mortgage debt can they afford? This is easy to estimate if you have the latest statement from your mortgage loan. That statement will include a section that breaks the loan payment into categories for principal, interest, and escrows (and perhaps others if there are late fees or other amounts being paid each month). Find the line for escrows and subtract that amount from the Maximum debt payments per month that you calculated using the above formula. Say the escrows are $910 per month:

Maximum debt payments per month      $1,863
LESS: Escrows                       -$  910
                                    -------
Income available to pay mortgage     $  953

Why do you subtract the escrows? Because they don't change. No matter who owns the house, the taxes and HOA fees will be the same, and the homeowner's insurance premiums are not likely to change much, so these are fixed costs that reduce a person's ability to make debt payments.

Finally, we estimate how much of a mortgage this spouse can be approved for. With current interest rates, you can estimate that for every $10,000 in debt, the payment will be $50. This yields a factor of 200 ($10,000 / $50 = $200).

Income available to pay mortgage   $    953
TIMES: Debt factor                x     200
                                   --------
                                   $190,600
LESS: Refinancing cost            -$  5,000
                                   --------
Maximum mortgage debt              $185,600

3. Size, Nature, and Character of the Remainder of the Marital Estate

From our examples, we have a $252,000 loan against the property, and the spouse who wants to keep the house can only afford a mortgage with a maximum principal amount of $185,000. We've also established that the parties have an approximate financial interest in the home of $163,000. If you assume a 50:50 property division, the question you have to satisfy is how can the assets of the marital estate be rejiggered so that the amount to be refinanced by the house spouse is no more than $185,600, and the other spouse receives other assets that recognize half of the $163,000 financial interest in the home?

There are many, many ways to achieve this and how you do it is specific to the needs of the parties and the resources within the marital estate. Here's one example. Suppose the marital estate looks like this:

Asset Value To Husband To Wife
Financial interest in marital residence $163,000
401(K) $200,000
Currently marketable equity securities (stock) $160,000
TOTAL MARITAL ESTATE $523,000

For this example, we will assume that the spouse giving up an interest in the marital residence does NOT have an immediate need for significant cash and we'll ignore brokerage fees and capital gains taxes incurred in selling the parties' stock. We'll further assume that Husband wants to keep the home and earns $52,000 a year while Wife is content to give up her financial interest in the house in favor of other assets and, because of her high income, has no immediate need for cash.

If the house were to be sold and the proceeds distributed to the parties, one way to divide the estate would be like this:

Asset Value To Husband To Wife
Financial interest in marital residence $163,000 $81,500 $81,500
401(K) $200,000 $100,000 $100,000
Currently marketable equity securities (stock) $160,000 $80,000 $80,000
TOTAL MARITAL ESTATE $523,000 $261,500 $261,500

Solving the Problem

We don't want to sell the house. Instead, we could do this:

  1. Contact a divorce lending specialist to verify our numbers and qualify the husband for a loan.
  2. Sell $80,000 worth of stock and use it to pay down part of the outstanding debt on the marital residence.
  3. Rebalance the assets.
Current payoff of mortgage loan            $252,000
LESS: Amount paid down by selling stock   -$ 80,000
                                          ---------
Resulting payoff of mortgage loan          $172,000
PLUS: Refinancing cost                     $  5,000
                                          ---------
Husband's new mortgage                     $177,000

We already established that husband can afford a mortgage of $185,600 so this mortgage of $177,000 falls below that maximum and therefore is probably workable.

Husband's monthly payment would be (approximately):

Husband's new mortgage                     $177,000.00
Divided by debt factor ($50/$10,000)      x        .005
                                          -------------
Monthly payment, principal & interest      $    885.00
PLUS: Escrows                              $    910.00
                                          -------------
Total Monthly Payment                      $  1,795.00

Above, we showed that husband can afford up to $1,863 per month in house payments so this payment of $1,795 falls below that maximum and thus satisfies the debt to income (DTI) ratios and ability to repay (ATR) requirements of federal legislation62010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank
Act)
. Now that we've figured out how to keep husband in the house, let's redo the property division balance sheet:

Asset Value To Husband To Wife
Financial interest in marital residence $163,000 $163,000 $0
401(K) $200,000 $18,500 $181,500
Currently marketable equity securities (stock) $160,000 $80,000 $80,000
TOTAL MARITAL ESTATE $523,000 $261,500 $261,500

Summary

We intelligently worked through this problem with other professionals and subject matter experts:

  • Real estate agent: To estimate the couple's financial interest in the house and, though not necessary here, estimate the cost and value of bringing the property into marketable condition.
  • Mortgage lending specialist: To preemptively convert 50(a)(6) debt to 50(f)(2) debt, if necessary, and structure a refinancing transaction.
  • Attorneys who understand financial transactions: To see past the barriers to success and structure a division of marital property that has the dual benefits of achieving both parties' goals and keeping the dispute out of court.

A word of caution: This deal cannot be reached at mediation unless everyone has clearly articulated their objectives and done their homework before mediation. When parties show up and only then announce their dream of keeping a house they can't obviously afford, it's practically impossible to structure a settlement like this. Mediation is an essential tool in resolving disputes and works to everyone's general satisfaction ONLY when they do their homework in advance.

We Help People Achieve their Objectives

Too often, people give up on their objectives because they do not understand how to achieve them. Many attorney's brag that they went to law school because they can't do the math. When you face complicated property division issues, you need an attorney who understands complex financial transactions--and can do math.

Next Steps

Creative solutions can lead to better outcomes for everyone. We're here to help. Give us a call: 972-985-4448.

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