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The Nation's Housing

Low-Payment Mortgages Can Take Off Quickly

By Kenneth R. Harney
Saturday, January 15, 2005; Page F01

Are low monthly payments on a home mortgage always good?

Are you kidding? Of course they are, you might answer.

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But a new report issued by a Wall Street firm suggests that some of today's low-payment loans could be highly toxic to borrowers who don't really understand the risks.

The report is from Dominion Bond Rating Service, which evaluates the risk of mortgage securities bought by deep-pocket investors. Those bond investors provide most of the money lent to U.S. home buyers, and they view defaults and foreclosures as dread diseases.

Dominion's study focused investors' attention on two widely used loan features that reduce buyers' monthly payments or allow them to fudge their incomes: interest-only loans and no-documentation "stated-income" mortgages.

"Some of the new mortgages we see are very scary," said Susan M. Kulakowski, a Dominion vice president and co-author of the report. "They allow people to qualify solely on the basis of a low initial payment," rather than what they can afford to buy at current interest rates. Then the mortgages turn into money-gobbling monsters that can push consumers into payment shock, default and foreclosure.

Kulakowski is especially concerned by a bumper crop of short-term hybrid interest-only loans flooding the market, aimed at home buyers with marginal credit or income. Interest-only mortgages require no paydown of principal -- no reduction of your actual debt -- for a set period at a low fixed rate of interest. Payments during the initial period typically are well below what a borrower would pay on a conventional 30-year fixed-rate loan.

At the end of the initial period, which may be as short as two years, the loans convert to fully amortizing adjustable rate mortgages at prevailing market rates. Principal reduction then kicks in, but because of the compression of the payback period -- 25 to 28 years, rather than 30 -- and the addition of principal to the payment mix, the monthly cost can balloon 50 percent to 70 percent.

Marginally qualified home buyers jolted with such payment increases within 24 to 36 months of their purchase are "very likely" to be pushed beyond their ability to repay the loan, Kulakowski said. Their only alternative may be to refinance, but because they still may not be able to afford market-rate payments, they could be stuck over their heads in house debt.

As an example of the problem, Dominion's report tracked a popular "3/1" interest-only hybrid closed last September through a projected payment scenario over the next 10 years. The original loan was for $350,000, at an enticing 4 percent rate for the initial fixed period of 36 months. (The "3/1" designation refers to the initial three-year period of fixed payments on interest only, followed by conversion to a market-rate adjustable whose rate changes once a year for the remaining 27-year term.) The buyers' initial-period payment, which they used to qualify to purchase the house on their then-current income, came to just $1,167 a month. That is $773 a month lower than they would have had to pay on a competing 30-year amortizing fixed-rate mortgage of $350,000 at September's lowest-available 5.28 percent rate.

What happens to the buyers' loan after the 36th month? Their payment in the 37th month rockets to $2,184 -- an overnight increase of $917 that would put a severe strain on most new homeowners' budgets. In a faster-rising rate environment, the shock would be even worse. By year 10, according to Dominion's projections, the owners would be paying close to $2,700 a month.

Kulakowski is concerned by other default-prone mortgage products that she sees pouring into the marketplace. Potentially worst of all are "stated-income" loans made to borrowers with marginal credit scores. Stated-income or no-documentation loans allow borrowers to dispense with the usual proof of income -- W-2s from their employers, for instance -- and proof of assets such as bank deposits.

Dominion says that no-documentation mortgages "were originally intended for self-employed borrowers" who own businesses or have substantial income or assets they did not wish to list as part of a loan application. Recently, however, the no-documentation concept "has been expanded to include salaried borrowers who cannot or will not show proof of income."

Why don't people with W-2 documented salaries want to show them? You guessed it: Many of them are buying houses at prices they can't really afford. And if the economy falters or their incomes drop, they will be the first into foreclosure.

Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.


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