By Kirstin Downey
Washington Post Staff Writer
Sunday, January 14, 2007
At 64, and looking toward his retirement next year, Willie Lee Howard agreed to refinance his duplex in Northeast Washington, thinking that a fixed-rate loan would help stabilize his finances.
What Howard got instead was a mortgage he did not understand. Baffled by the loan documents he was mailed after the closing, he consulted an AARP lawyer and learned that he now had an interest-only loan, a new and controversial kind of mortgage. Howard was told that under its terms, his mortgage balance will rise instead of fall and that he will need to refinance in 10 years, when he may be too old to work.
"This is a bunch of junk they done to me," said Howard, a construction worker.
Howard's chagrin at his mortgage's complex provisions illustrates the confusion felt by many borrowers struggling to adapt to a radically transformed home lending market. Consumer advocates say most people learned about mortgages from their parents and grandparents, who typically put down 20 percent on a 30-year fixed loan on which they always knew what their payments would be.
Those long-standing assumptions have been challenged in recent years by the rapid proliferation of new loan products with looser credit requirements and fluctuating payment plans. Although the newer mortgage products allow almost anyone to buy or refinance a house, consumer groups say the loans often contain land mines hidden in the fine print.
Consumer advocates say the loosened standards are putting more people at risk as loans originally designed for sophisticated individuals are being marketed to far-less-savvy borrowers.
"Consumers haven't caught up with the dynamics of the market," said Allen Fishbein, director of housing and credit policy at the Consumer Federation of America. "They are still thinking of how it use to be, but it isn't like that anymore."Product Comparison
Alternative mortgage loans were first developed for a handful of people with promising long-term earnings potential: young lawyers destined to make partner, doctors finishing medical school or stock brokers who get large commission checks several times a year.
But as housing prices have surged, outstripping wages in the most expensive markets, alternative financing has become a popular path to homeownership.
These new loans come in many forms. "Nontraditional" mortgages allow borrowers to pay only the interest on the loan or even only a portion of the interest each month, without being required to pay down the principal. Nationwide, more than a third of borrowers who got loans in the first nine months of 2006 got nontraditional loans, up from about 2 percent in 2000, according to First American LoanPerformance, a real estate information firm.
"Piggyback" loans allow people to borrow for a down payment, sparing buyers the trouble of saving for years and letting them avoid paying mortgage insurance, which is usually required on loans with down payments of less than 20 percent. In 2005, about 22 percent of people buying homes took out piggyback mortgages, according to the Federal Reserve.
"Subprime" loans are available to people who have bad credit, though they charge interest rates 2 to 3 percent higher than the rates charged to borrowers with good credit. About a fifth of the loans originated in 2006 now fall into that category, up from about 5 percent in 1999, according to the Federal Reserve.
Jim Sugarman, supervisory attorney at AARP's financial-abuse unit, says these alternative loans offer new opportunities but also carry added risks. About 59 percent of subprime loans have adjustable rates, according to the Mortgage Bankers Association, and any sudden spike in interest rates would push payments higher.
In a rising real estate market like that of the past few years, borrowers who fall behind on their mortgages could sell before going into default. For that reason, lenders haven't been too worried about repayment. But now, with home prices flat or falling, many homeowners may not be able to sell their homes for enough to cover their mortgage balances.
Alternative loan products are giving many people access to homeownership, counters Steve Calem, vice president with American Bank in Bethesda. "Interest-only loans help people get into their first house," he said. "Interest-only loans minimize their payments, when people know their income is going to be going up. It gives them flexibility."
Most consumers have only themselves to blame because they are not doing enough research on the mortgage market as it has grown increasingly complex, said Christopher Cruise, who trains mortgage brokers at major lending companies.
"The American consumer's ignorance of mortgage procedures in the past hurt them a little," he said. "What's different now is that it'll hurt them a lot. The stakes are a lot higher."Persistent Phone Calls
Howard said he was persuaded to refinance his house by a "very friendly" loan officer who called once a week for a year, telling him the time was right to stabilize his finances.
After deciding to take out the loan, he said he told the lender he would need help reading the paperwork at the closing. He said he still doesn't understand exactly what kind of mortgage he signed.
Howard's mortgage contains several of these new features, said Sugarman, who has reviewed the documents. It is an interest-only loan, which is one of the nontraditional mortgages designed to help wealthy people manage their cash flow, and for people whose incomes are likely to rise -- not for those whose incomes, such as Howard's, are likely to fall as they retire on Social Security. The rate is fixed, but only for 10 years. Sugarman said Howard appears to have qualified for it with a "NINA" loan, a "no-income, no assets" loan that required minimal income documentation.
"It's a very exotic mortgage, and he had no idea he was getting that," Sugarman said. "He thought he was doing something smart."
Sugarman said that in the past, lenders didn't make these kinds of loans because they put financial institutions at risk. Bad real estate loans marked the beginning of the Great Depression, and subsequent banking reforms required lenders to consider the soundness of their lending practices. That made loans safer for borrowers and lenders alike.
What has changed is the booming market for real estate securities. Major financial institutions now put thousands of loans together and sell them in slices to investors. That means lenders seldom get caught holding the loans. If an individual loan goes bad, the effect is dissipated among many investors.
The new mortgage products have fueled record profits for the lending industry in recent years. Brokers can generate tens of thousands of dollars in additional fees, beyond what they earn on traditional mortgages, by placing borrowers in these loans, Cruise said.
The question is whether some consumers can adequately protect themselves in the complex financial transactions of the new mortgage marketplace.A Tough Price to Pay
Willie Webb Jr. of Lauderdale Lakes, Fla., was pleased for his daughter at first when she told him she had refinanced the home she had inherited from her grandparents, reducing her interest rate and allowing her to pay off some bills. He assumed she had gotten a fixed-rate mortgage, the kind of loan with which he is most familiar. A few months later, she called him in a panic. It turned out that she had an adjustable-rate mortgage in which the payments starting rising almost immediately, and when Webb investigated further, he learned that she can't get out of the loan without paying a $6,000 prepayment penalty.
Webb is angry that his daughter, Keisha Smith, a single mother with four children, agreed to take a loan she did not understand. He has made the payments for her some months because otherwise she would risk losing her home.
Many newer mortgage products make it difficult and costly for borrowers like Smith to extricate themselves. The mortgage bankers group recently reported that more than 50 percent of some kinds of adjustable-rate loans contain prepayment penalties, which require borrowers to shell out big bucks to break free. A prepayment penalty of about 3 percent of the mortgage loan -- about $9,000 on a $300,000 mortgage -- is not unusual, according to the Federal Reserve.
A study by the Center for Responsible Lending, a consumer-advocacy group, said last year that about two-thirds of Virginians with high-interest, subprime loans also have prepayment penalties. In Maryland, where prepayment penalties are restricted by law, about a quarter of subprime borrowers have them. (Comparable figures were not available for the District.)
The biggest risk lurking behind all these loans is the threat of foreclosure. Last month, the Mortgage Bankers Association reported that mortgage delinquencies were on the rise, particularly for costly subprime loans. Likewise, the Center for Responsible Lending said in a recent report that more than 19 percent of subprime loans made in 2005 and 2006 are at risk of foreclosure.
Federal and state banking regulators have instructed lenders to make sure before issuing a loan that borrowers can keep up if payments are adjusted upward. Consumer advocates and some members of Congress have asked that the guidance also include what is called a 2-28 mortgage, under which borrowers have low, teaser rates during the first two years, after which payments increase.
Consumer groups also say they would like to see a "suitability" standard imposed on mortgages whereby lenders would be required to show that people got loans appropriate for them. Sugarman, for example, thinks putting Howard into an interest-only loan left the man with a "horrible situation." But banking trade groups oppose these proposals, saying they could curtail lending to some people who would otherwise have trouble getting loans they need.
Additional government regulation "could impede the ability of the market" to change to meet demand, said Doug Duncan, the chief economist at the Mortgage Bankers Association.
But Fishbein, the consumer activist, said legislators, regulators and lenders need to do more to protect consumers.
"We're not confident buyers are getting all the information they need," he said. "They don't understand the toxic environment."