Older home owners in modest neighborhoods are especially likely to find people going door-to-door with refinance offers. Why? Because older folks are more likely to have accumulated a lot of home equity, and those in less affluent areas are more likely to have loans for people with credit problems. That makes them and others with home equity and bad credit prime targets for a scam called equity stripping.

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No, your home doesn't take its clothes off.

Equity stripping involves selling people very expensive loans and using the home's equity to pay for them. So the actual cost of the mortgage is hidden from the borrower.

How do equity strippers hide the cost of a bad credit refinance?

First of all, these folks are not associated with reputable mortgage financing institutions. So you may not get a legal Truth-in-Lending disclosure or Good Faith Estimate. Or they may give you one but fast talk you through it so that you don't understand what you're getting into. But the main reason equity strippers get away with what they do is that little or no money changes hands when you refinance a mortgage with them.

Here's how it works.

Say you are paying nine percent on your bad credit mortgage, your original loan amount was $200,000, and today your home is worth $250,000 and you owe $150,000 on your home. Your payment is $1,609. Now, if someone offered to refinance your mortgage for a cost of five points at the same nine percent rate, would you take it? Of course you wouldn't! But what if you were offered a payment reduction to $1,267 at no out of pocket cost, what would you say? A lot of people would say yes. Even though they'd be paying five points, for, yes, the same nine percent rate.

The lender would be taking that five points or $7,500 right from your equity. Your new mortgage would be $157,500. And because you'd be restarting your mortgage payoff to a new 30-year term, your payment would be lower. Even though your interest rate was not. That's equity stripping. The lender probably gets paid by the wholesale lender too and ends earning $15,000 on a $150,000 loan, which is ten points and criminally high.

New laws make it harder to strip equity, but not impossible.

Mortgage reform legislation has made it harder for semi-legitimate brokers and lenders to strip equity because they are not allowed to earn extra commissions based on the terms of the mortgages. For example, they can charge a borrower this way:

  • Two points to get a rate of 4.5
  • One point to get a 5% interest rate
  • Zero points to get 5.5%
  • Minus one point (cash to the borrower) with a rate of 6%

The lender profit is the same regardless of which rate the borrower chooses. But lenders cannot charge a different borrower zero points and give her a rate of 6% and pocket the extra one point of profit. Mortgages are no longer like buying used cars where borrowers who are less skilled negotiators pay more. So a lender that might have been legally able to charge five points for a mortgage by sucking them unnoticed out of the borrower's home equity in the past can't do it in the future.

What you need to do to avoid ending up naked:

1. Shop with reputable and licensed mortgage lenders. Like the ones on this site. These lenders are all licensed in their states and are required to adhere to the Real Estate Settlement Procedures Act (RESPA) andthe Truth In Lending Act (TILA).

2. Get several mortgage quotes. So you know a fair offer when you see one. When it comes to shopping for a mortgage, knowledge is power.

3. Read and understand your disclosures. If you don't understand them, don't sign them. HUD has free or low-cost mortgage counselors who can explain these documents.

4. Make sure your final documents contain the same mortgage terms as your offer. The costs should be similar, the rate should be the one you locked, and there should be no surprises like prepayment penalties or negative amortization that were not discussed and agreed to.

The government can help you choose a good mortgage, but it can't force you to turn down a bad one.