Balloon Loans, Lease-Options Prove Riskier in Today's Market

By Jack Guttentag
Saturday, September 20, 2008

The home mortgage market is devilishly difficult to navigate in normal times. During a time when home prices are declining, the difficulties are compounded.

Problems I had never thought about before now pop up regularly in my mailbox. Here are a few:

· Constructing a home has become more hazardous. Building a home to one's own specifications is enormously appealing to many people. It is also time-consuming, with many pitfalls that can cause delay, extra costs or both.

One reader, John, agreed with the lender on a combination loan -- a construction loan that would convert into a permanent mortgage upon completion of construction, with a 5 percent down payment. The construction cost was $1 million, making the down payment $50,000. Construction took a year, at the end of which the lender had the house appraised and found it was worth only $800,000. This reduced the loan amount to $760,000 and forced the borrower to come up with $240,000 rather than the anticipated $50,000.

John does not have the added $190,000 to put down, and the house could go to foreclosure without ever being occupied. More likely, the deal will be modified with the lender sharing the loss.

I have always advised against constructing a home from scratch unless the borrower owns the land outright and has money in reserve. In today's market, such caution is even more important.

· Balloon loans are dangerous. Tom wrote that he took a five-year balloon loan 4 1/2 years ago because the rate was a little lower than that on a 5/1 adjustable-rate mortgage. On both instruments, the rate is fixed for five years, but on the balloon the balance is payable after five years whereas on the ARM it is not. The ARM rate is adjusted after five years (and every year thereafter), but the lender cannot demand repayment.

In a normal market, the borrower with the balloon could easily refinance, provided that his credit remained strong. He would pay the current market rate, which might be higher or lower than the rate he had been paying, but his ability to borrow would not be an issue.

Tom's house, however, is in a neighborhood devastated by foreclosures, and its current value is 20 percent less than it was five years ago. As a result, he cannot refinance without putting up additional cash, which he does not have. Foreclosure is on the horizon.

· Lease-to-own deals can unravel. Two years ago, Mary wrote, she did a lease-to-own deal under which she paid a home seller 2 percent of an agreed-upon price for an option to purchase the house at that price within three years. Mary also pays rent for the right to live in the house for up to three years.

Recently, she was informed that the current owner was not making mortgage payments, possibly because of a sharp decline in the property value. The option to buy the house no longer has any value because the option price is above current market value. Mary is concerned about her right to live there for the rest of the term if the lender forecloses. The lawyers I have consulted on this case indicate that a foreclosure would wipe out Mary's tenancy right.

There is nothing that Mary can do at this point to protect herself. Those contemplating a lease-to-own deal would do well to avoid deals where the seller's mortgage is more than 90 percent of current market value. They should also bear in mind that an option to purchase a house at a price 10 percent below current market value is not worth much in a market in which values are declining.

· Loan approvals aren't conclusive until the loan closes. During a period of declining home prices and rising defaults, underwriting requirements -- the conditions that must be satisfied before a loan can be approved -- become more restrictive. Down-payment requirements in particular are likely to be raised as an offset to declining values.

If mortgage transactions were initiated and closed within the day, borrowers would immediately know whether or not they were approved. In actuality, the process takes time, especially when it involves a home purchase. This creates a danger that the rules may change when the borrower is in mid-stream.

This happened to Lucy, who wrote that she kept getting a message from the loan officer that her loan "would probably be approved," but in the end it was denied. She lost the house she hoped to buy, along with fees she had paid for an appraisal and other services.

Most reputable lenders will warn that an underwriting change is coming and that the old rules will apply only to loans locked and submitted before some specified date. But information about rule changes is distributed to brokers and loan officers who, in their anxiety to get deals done, may leave borrowers exposed, as one did with Lucy. Borrowers whose acceptance is borderline are in the greatest danger from such rule changes.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2008, Jack Guttentag

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