Pamphlet Spells Out Risks of 'Exotic' Loans

By Kirstin Downey
Washington Post Staff Writer
Saturday, October 21, 2006

Federal banking regulators last month issued a strongly worded warning to lenders about the dangers of nontraditional, or "exotic," mortgages, telling them they feared that borrowers did not understand the implications of the loans.

Now regulators have issued a similar warning directly to consumers in a pamphlet that explains how these loans work, including a glossary of terms that represent a new vocabulary for borrowers accustomed to traditional lending.

Nontraditional loans include those where borrowers need pay only the interest on the amount borrowed, known as an interest-only loan, as well as loans where people can pay an amount even less than the interest owed, often called an "option" loan.

The pamphlet has been published because use of these loans has increased so quickly. In 2000, fewer than 2 percent of people in the Washington area had them. In the past two years, more than 40 percent of people buying or refinancing homes here used them. These loans make good sense for some borrowers, but may be dangerous for others.

The brochure starts with two particular terms. The first is "payment shock," which it defines as "payments may go up a lot -- as much as double or triple -- after the interest-only period or when the payments adjust."

The second is "negative amortization." That's what happens when the payments made do not cover the interest owed, which means that the unpaid balance is added to the mortgage balance. Borrowers who make only minimum payments on these loans can end up owing more than when they started, even after years of making payments.

The pamphlet, "Interest-Only Mortgage Payments and Payment-Option ARMs -- Are They For You?" is available on the Web sites of the Federal Deposit Insurance Corp., which regulates banks and insures deposits placed in banks; the Office of the Comptroller of the Currency, which oversees national banking regulation; the National Credit Union Administration, which charters and regulates credit unions; and the Office of Thrift Supervision, which regulates savings and loan institutions.

But banking regulators have stressed that people getting loans outside these sources should be made aware of the implications, too. About 60 percent of such loans are being made by lenders who are outside of federal banking oversight, the federal regulators have said. Last month, John C. Dugan, comptroller of the currency, warned that the "most abusive practices" are found among those kinds of lenders.

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