By Kenneth R. Harney
Saturday, June 10, 2006
They are the new breed of mortgages, and home buyers in high-cost real estate markets can't get enough of them: interest-only and payment-option plans that cut monthly payments sharply in the early years of a loan.
Lenders have marketed both types of mortgages aggressively -- often to people who need to stretch their incomes to afford homes -- but have said often that their borrowers have solid credit histories and excellent credit scores and that they fully understand the risks once payments reset in a few years. In some parts of the country, the share of buyers using interest-only and payment-option loans has soared from the single digits two years ago to more than 50 percent in 2005.
But federal regulators worry that all is not well. Too few borrowers, they say, really understand the risks involved and have a solid grasp of how the loans work. Within weeks, a team of regulators led by the Federal Reserve and the comptroller of the currency is expected to issue new guidelines for mortgage lenders that could reduce the number of interest-only and payment-option loans being offered.
A new statistical study challenges some of the mortgage industry's claims about borrowers' sterling credit qualities. The Consumer Federation of America examined the case files of more than 100,000 mortgages closed from January to October 2005. The files contained detailed information on household income, credit scores, down-payment amounts, and racial and ethnic characteristics.
Among the findings: Home buyers who take out payment-option loans tend to have below-average credit scores. Nearly 54 percent of payment-option users in the sample had FICO scores below 700. Fair Isaac Corp., developer of the FICO scoring system widely used to gauge credit risk by the home mortgage industry, says the median FICO score is 723. That means that half of people have scores above 723 and half below.
Sub-par FICOs "are not what you really want to see" in connection with payment-option mortgages, said Patrick Woodall, senior researcher for the Consumer Federation and co-author of the study.
Most payment-option mortgages permit borrowers to choose what they want to pay per month for a preset period, ranging from a fully amortizing standard payment to an interest-only payment to a rock-bottom minimum payment even lower than the interest-only option.
Some mortgage securities industry experts estimate that up to 70 percent of payment-option borrowers go with the minimum payment. That, in turn, causes them to increase their principal debt through a process known as negative amortization. Borrowers often are allowed to increase their original loan balance by 10 percent to 25 percent before they must begin paying down the principal with significantly higher monthly payments.
If home price appreciation stagnates, some of those buyers could face rising debt burdens and minimal -- or even negative -- equity. Such a scenario would be tough enough for borrowers with excellent credit histories and debt-management skills. But it would be disastrous for borrowers with below-average scores and higher-than-average predispositions to miss payments.
The Consumer Federation study also examined the household incomes of interest-only and payment-option borrowers. More than three in five payment-option plan borrowers and 47 percent of interest-only borrowers had annual household earnings of at least $72,000, seemingly a good sign. But Woodall noted in an interview that many of those households still had incomes well below the median for their metropolitan areas, which often are high-income, high-cost markets such as Washington, San Diego, Los Angeles and San Francisco.
More troubling, he said, was the finding that many borrowers using interest-only and payment-option loans have modest incomes and could already be stretched financially. One in eight payment-option borrowers and one in six interest-only borrowers earned less than $48,000.
Woodall said that "all sorts of events could trigger problems for these people" that could lead to defaults, foreclosures and loss of houses -- unexpected medical bills, a loss of income by one earner, divorce -- along with the 30 percent to 80 percent monthly payment increases built into the loans as they mature.
The study also found that minority groups appear to be disproportionately targeted for certain of the loans. Latinos "are nearly twice as likely as non-Latinos to receive payment-option mortgages." African Americans are 30 percent more likely than non-African Americans to have payment-option plans.
Though the jury is still out on the risks of payment-option and interest-only mortgages, the Consumer Federation's findings suggest that lenders are hardly reserving them for high-income, high-credit-score applicants. In an economic squeeze, some of the loans could prove highly toxic -- a prospect almost certain to weigh heavily in the financial regulators' forthcoming new guidelines.
Kenneth R. Harney's e-mail address isKenHarney@earthlink.net.