For years, we heard little about assumptions because market rates were so low. Now that rates are above their lows, and may rise further, we can expect that assumptions will receive increasing attention.

The value of an assumption depends on the difference in rate, the balance and period remaining on the old loan, the term of the new loan, on how long the buyer expects to have the mortgage, and on the "investment rate" – the rate the buyer could earn on her savings. Assuming that the 5.5 percent loan has a $100,000 balance with 200 months remaining while the 7 percent loan would be for 30 years, and that the buyer expects to be in the house for five years and can earn 4 percent on investments, the value is about $7,000. A spreadsheet that makes this calculation is available on www.mtgprofessor.com.

The $7,000 of savings does not include the settlement costs on a new loan. On the other hand, the savings would be reduced if the buyer has to supplement the existing loan balance with a new second mortgage at a higher rate. This could well be the case if the existing loan balance has been paid down appreciably, and/or the house has appreciated since that mortgage was taken out. The buyers who do best on assumptions are those who have the cash to pay the difference between the sale price and the balance of the old loan.

However, buyers should not expect to receive the full value of an assumption. The seller must benefit as well; typically, the parties share the savings. The seller's share will be in the form of a higher price for the house. Indeed, some economists believe that the full value of the assumption should be reflected in the price of the house, but this is as implausible as the opposite view, that only the buyer benefits.

The benefit to buyer and seller from assuming an old loan comes at the expense of the lender. Instead of having the 5.5 percent loan repaid, which would allow the lender to convert it into a new 7 percent loan, the 5.5 percent loan stays on the books. Back in the '70s and '80s, lenders couldn't do anything about this. Mortgage notes at that time did not prohibit assumptions, and the courts ruled that lenders could not prevent them.

Following that experience, however, lenders have inserted due-on-sale clauses in their notes. (An exception is FHA and VA mortgages, which do not contain these clauses, as discussed next week). These stipulate that if the property is sold, the loan must be repaid. Even with a due-on-sale clause, the lender may allow an assumption – keeping the loan on the books avoids the cost of making a new loan – but the interest rate will be raised to the current market rate. 

Raising the interest rate to market removes most of the benefit of the assumption to the buyer and seller. In some cases, they attempt to retain the benefit by agreeing to a sale using a wrap-around mortgage, without the knowledge of the lender. The seller takes a mortgage from the buyer, which may be for a larger amount than the balance of the old loan, and continues to pay the old mortgage out of the proceeds of the new one. The new mortgage "wraps" the old one. 

This is a dangerous business, particularly to the seller, who has given up ownership of the house but retained liability for the mortgage. The seller is in deep trouble if the buyer fails to pay, or if the lender discovers the sale and demands immediate repayment of the original loan. I wouldn't do it, even if I were selling the house to my mother.