RealEstateJournal.com
Exotic Mortgages Remain Popular Despite Their Increasing Risks Jun 07, 2006, 9:00 pm PDT
Exotic Mortgages Remain Popular Despite Their Increasing RisksBy Rachel Koning Beals
Call it the triumph of the exotic mortgages.
Such loan innovations allow home buyers to put little money down and make low monthly payments. They've also poured fuel on one of the hottest and longest housing booms in the nation's history.
But in the wake of the Federal Reserve's push to take away easy money, low interest rates and red-hot home prices have faded away. With them went the main conditions that made interest-only and other flexible mortgages worth their risks. So the consumer's love affair with such loans is drawing to a close now, right?
Wrong.
Far from just another financing fad, exotic mortgages have become such a fixture on the U.S. housing landscape that they've proven to be a key lever for many borrowers even as they have become a greater danger at the same time.
"In our changing market, from unprecedented low rates to a steady rising of interest rates, these varieties of loan programs have become much more popular," says Bill Callanan, a partner with Mortgage Management Systems, a San Francisco mortgage broker. "But if you're scraping nickels together, they're not for you."
While traditional long-term, fixed-rate mortgages remain the loan of choice for the majority of home buyers, more borrowers are also shopping for interest-only loans, pay-option ARMs and hybrid fixed-ARM loans.
That's particularly true in high-cost housing markets, where taking one of those loans may be the only way to afford a house.
It worked well when double-digit home-price gains built equity while leaving more cash in homeowners' pockets. Low interest rates muted the potential sting of upward rate adjustments.
But neither of those conditions exist today: Interest rates are well above year-ago levels and home-price gains have cooled or, in some of the hottest markets, already started to erode.
One big problem, says Callanan, is that household incomes haven't been rising as fast as interest rates, creating greater affordability hurdles for home buyers. Borrowers who use these loans now are challenged more than ever to gauge the health of home prices in their area and measure their ability to stay on top of payments, and to know when to refinance.
Paying off
For some, the gamble still pays off. Regardless of the health of the housing market, say mortgage experts, increasingly savvy consumers want more control over their own finances, including being able to invest money that would otherwise be tied up in a mortgage.
They say the mortgage market should never be viewed as one-size-fits-all process, particularly because few homeowners keep the same loan for more than a few years -- they either move or refinance.
"There's a risk-taking attitude," says Anthony Hsieh, president of Lending Tree.com, an online brokerage. "People aren't as motivated to pay off their home. Most people aren't in their home for more than five to seven years, anyway."
That penchant for added risk, including some mortgages that allow borrowers to vary their payments or skip a payment, has drawn several warnings from regulators and from consumer watchdog groups, who anticipate a shock to monthly budgets once the impact of higher interest rates is fully felt. For many, that time is coming soon.
Since the Fed's two-year campaign to tighten monetary policy, there has been a pronounced effect on mortgage rates. The 1-year, Treasury-indexed adjustable-rate loan, for instance, has jumped to a national average rate of 5.68%, according to Freddie Mac, up from 4.26% a year ago and from a low of 3.39% in March of 2004.
Mortgage bankers concede that demand for alternative loans that reduce payments isn't as brisk as 12 months ago, in part due to the warnings. But marketing remains aggressive and mortgage lenders continue to compound the options: qualifying buyers now face an often confusing buffet of loans with terms of anywhere from 1 to even 50 years. Some of them can result in negative amortization -- an increasing monthly principal balance.
The complexity of these options can leave less-sophisticated borrowers at the mercy of lenders, who consumer groups charge are all too willing to entice home buyers with looser financing so that they may go after properties well out of their conventional reach.
"While the lending industry has characterized nontraditional borrowers as financially sophisticated and savvy consumers, the truth is that many are far from affluent and could be betting the house on their mortgage," says Allen Fishbein, director of credit and housing policy at the Consumer Federation of America. "Because homeownership is so critically important in financial security, these Americans are unwittingly putting their entire financial livelihood at risk."
The federation analyzed certain borrower and loan characteristics of more than 100,000 mortgages originated between January 2005 and October 2005. Their findings show that more than one-third of interest-only borrowers earned below $70,000 annually; about 1 in 6 earned less than $48,000. Some 35% of borrowers with the option to make a payment or not earned under $70,000; 1 in 8 earned less than $48,000.
Cash flow
"Truth is, an option ARM is appropriate for a very small part of the population," says Steve Habetz, president of Threshold Mortgage in Westport, Conn. "Think of a doctor just out of medical school, maybe with kids, and who wants a home in a desired school district and so is maybe going after more house. Negative amortization is worth it in this case because ultimately, that doctor's income will pick up and he's cut out transaction costs of moving up in house soon after that income kicks in."
Adds Habetz: "But that's not who [this loan] is being sold to. It's sold as this great cash-flow thing, eating up equity."
Interest-only mortgages carry their own risks, but Habetz says they typically make sense for a wider range of borrowers, offering the benefit of more control over monthly cash flow and providing a tax deduction on the interest payment.
While interest-only loans push back payments on principal to a set date (there's typically no penalty for paying toward principal early), an option ARM allows home buyers to vary their monthly payment. But as with many nontraditional loans, payments early on won't reduce the size of the loan, limiting the equity buildup and increasing the risk of default should home prices falter.
"We're socialized to think we ought to be paying down debt, but you can use debt to create wealth," Callanan says of the rationale behind taking out such loans.
Despite their prominence in the news, exotic mortgages do not, in fact, entice all that many Americans. The good old 30-year fixed-rate mortgage is still used by 72% of U.S. homeowners, although that loan type is less popular in the West, where home prices have been highest.
"Fixed rates are a great deal right now," says Greg Eckert, vice president of Centennial Mortgage in Kingston, N.Y. "Historically, rates under 7% are low and that is what we have at this time. This payment offers stability and predictability."
Even those wooed by adjustable rates are moving out on the spectrum. Five to 10-year ARMs are in much greater demand these days than 1-to-3-year plans, says D.C. Aiken, a North Carolina-based lender with Homebanc.
But that presents another personal-finance dilemma: Many of those holding 30-year mortgages are paying for security they don't need.
Rates on longer-term fixed loans are higher to compensate lenders for the interest-rate risk. With an adjustable-rate loan, homeowners share that risk with the lender and so get a break on rates, at least initially. Since homeowners move, on average, every seven years or so, it makes little sense for them to hold a 30-year loan.
That's why lenders like Hsieh believe demand will remain strong for alternative mortgage products. He says more borrowers will tailor their loan to their predicted stay in a house.
"But plans do change," he says. And then consumers need to be prepared to refinance, and at the mercy of current market rates.
Here's a short list of some of the loans being marketed today, their advantages and their risks:
30-year, fixed-rate, interest-only mortgages
These relatively new mortgages allow the borrower to make interest-only payments for the first 10 years. The principal balance is repaid over the final 20 years.
Advantages: Rate doesn't fluctuate; lower initial payments
Disadvantages: Fixed rates are generally higher than adjustable-rate mortgages; borrower doesn't build equity in the first 10 years (unless the home is appreciating); payments increase dramatically starting in the 11th year (however, lenders assume that the borrower's income has grown substantially over the first 10 years).
Adjustable rate, interest-only loans
The program is best suited for borrowers who have a proven track record for managing their finances well and understand the product's pros and cons.
Advantages: Rate can go down; initial payments are lower; borrower can pay down principal balance at any time and it resets the next month's payment.
Disadvantages: Risk of payment shock as rate can go up; risk of payment shock when amortization period begins; borrower not building equity during the interest-only period; these loans can have a balloon payment at the end of the interest-only period; also, at the end of the initial fixed-rate term the rate can adjust as often as every month.
40-year fixed-rate loans
This loan offers a payment nearly halfway between interest-only and 30-year fixed. The 40-year fixed works for buyers focused on the long-term value of their property and who want to build equity each month.
Advantages: Stability of a fixed rate and predictable payments; lower payments than traditional 30-year fixed rate loan.
Disadvantages: Rate slightly higher than 30-year fixed; longer term to pay off loan (slower equity build); balloon payment after 30 years.
Option ARM
Advantages: A popular product over the past few years because it allows consumers the option of making their payments in one of four different ways: Interest only, fully amortizing over 30 years, fully amortizing over 15 years or a minimum payment for 12 months.
Disadvantages: This loan shouldn't be used to qualify someone who wouldn't normally qualify for a regular fixed-rate loan. Sees gradually increasing minimum payments for the first five years, resulting in a higher loan balance and a significant payment shock in year six, when the loan is recast and fully amortizing payments are required.
'Piggyback' with home-equity loan
A primary mortgage can be combined with a home-equity loan or line of credit.
Advantage: Tends to eliminate the requirement to pay private-mortgage insurance.
Disadvantage: Sees payment shock of 48% over five years, beginning in the second year when the floating rate on the home-equity line of credit begins to adjust and increasing in year four when the fixed period on the first loan expires.