The Nation's Housing
Should Risks Beget Rules?
An important debate is raging inside the home mortgage market, though well beyond the earshot of most consumers.
The issue: Popular "payment-option," interest-only and piggyback loans -- and the financial risks they pose to home buyers and lenders alike. On the one hand, federal financial regulators say the risks are too significant to ignore, so lenders need to take special care in evaluating and approving customers who apply for these mortgages. The regulators want to impose new creditworthiness restrictions and disclosure requirements that would force lenders to be certain that borrowers understand the potential dangers.
Banks and mortgage companies, on the other hand, aren't happy about the regulators' plans. They say new restrictions are unnecessary intrusions and could stifle free-market innovations that have expanded consumers' ability to afford today's high housing prices. Between January and the end of March, lenders bombarded federal banking regulators with demands to back off or soften the proposed new rules. Regulators at the Federal Reserve Board, Federal Deposit Insurance Corp. and three other agencies are studying the lenders' comments and are expected to announce final plans within the next couple of months.
Why all the fuss? And what might it mean for you as a home buyer or refinancer? The fuss derives from the fact that payment-option, piggyback, interest-only and other creative loans types can prove toxic for applicants who don't understand them. The question is whether most lenders are taking pains to educate borrowers about how the loans work or whether they have been mass-marketing dangerous mortgages to people with borderline credit profiles, low down payments and minimal knowledge.
Here's a quick overview:
Payment-option mortgages have soared in popularity in the past three years, especially in areas of the country where real estate prices and appreciation rates have been high. Payment-option plans typically allow borrowers to choose among one of four payments each month: a "minimum" payment based on an artificially low start rate and negative amortization (buildup of principal debt); an interest-only payment involving no principal reduction; or traditional "amortizing" payments based on 15-year or 30-year schedules.
Negative amortization options can add as much as 12 to 15 percent onto a home buyer's debt in the early years of the loan and lead to monthly payment increases of 100 percent or more after the loan "resets" to market rates and a fully amortizing loan payment schedule. The payment shock could be far worse -- well over 150 percent per month after the reset -- if interest rates rise steadily during the early years of the mortgage. If borrowers encounter income problems or property values flatten, they may face intolerably high monthly payments, defaults and major losses on forced sales or foreclosures.
Interest-only loans cut monthly payments for periods anywhere from three to 10 years by deferring principal reductions. At the end of the interest-only period, the original mortgage balance on the house remains to be paid. Monthly payments can then jump substantially -- by 30 percent or more -- because the principal debt must now be paid over a shortened time period.
So-called piggyback loans, also targeted by the financial institution regulators, allow buyers to combine a standard first mortgage equal to 80 percent of the property value with a home equity credit line or second mortgage equal to 10 percent to 20 percent of the home value. The arrangement is popular because it allows buyers to avoid monthly private mortgage insurance premiums, requires little or no down payment, and often qualifies "jumbo" loan borrowers to pay lower conventional market interest rates on the primary mortgage.
Banks and mortgage companies say they already carefully select customers and avoid undue risks for all these loan types. In a letter to regulators March 29, the Mortgage Bankers Association said its research indicates that its members restrict payment-option and interest-only loans to borrowers with higher credit scores and larger down payments.
Other lenders argue that payment-option and interest-only loans go only to relatively sophisticated people who plan to use their monthly payment savings for investment purposes.
Nick Nickerson, a mortgage consultant with Nations Home Funding Inc. in Durham, N.C., said "100 percent" of his clients "invest their savings . . . and end up financially ahead. I insist that each client have a financial planner involved and the mortgage payment savings are direct-deposited to their investment account."
Lenders "don't want borrowers to default," said Nickerson. "Negative amortization is simply a way of taking equity out of your home slowly over time rather than all at once."
Bottom line here for you? If you understand all the working parts of a payment-option loan, have sterling credit, make a big down payment and are using your savings the way Nickerson says his clients do, you probably don't need the financial regulators' intervention. But if you don't fit these criteria, probably you do.
Kenneth R. Harney's e-mail address isKenHarney@earthlink.net.