NEW YORK -- The biggest home mortgage lenders in the country are in hot competition to take thousands of American home buyers and refinancers -- possibly including you -- for a balloon ride in June.
The Federal Home Loan Mortgage Corp.'s rollout here last week of a new short-term, discount-rate mortgage signaled an intensification of the great balloon war of 1990. Freddie Mac's new loan goes by the ungainly trade name "30-due-in-5." But stripped to its essentials it is a balloon mortgage designed to do battle with the bulging arsenal of balloon and balloon-like mortgages held by its arch-rival, the Federal National Mortgage Association (Fannie Mae).
Fannie Mae and Freddie Mac respectively are the largest and second largest sources of money for home loans. Both operate by purchasing billions of dollars of mortgages per year that have been originated by local banks, S&Ls and other lenders.
A balloon in the mortgage field is a loan with a relatively short payback term -- anywhere from three to 10 years from the date of origination. In the 1920s and early 1930s, balloons were the predominant form of housing finance. Lenders would extend credit for five years, collect interest-only payments during the term, and then demand repayment of the full principal at the end of 60 months. Borrowers who couldn't come up with the money lost their houses via foreclosure.
The 1990 versions of the balloon are much kinder and gentler. Fannie Mae's highly popular seven-year balloon, for example, comes with a parachute on board. Borrowers who continue to qualify can retain the loan for another 23 years after the seven-year expiration date, at a fixed rate carrying a one-half-percentage-point premium over Fannie Mae's regular 30-year fixed-rate quotes.
An even more popular variant of the seven-year balloon is Fannie Mae's so-called "two-step" mortgage. Introduced in March, the two-step has produced $1.5 billion in commitments in its first 90 days, and is one of Fannie's hottest new products in its history. Technically an adjustable-rate mortgage (ARM), the two-step nonetheless has a key similarity to a balloon: The rate after the seven-year period tends to run above competing fixed or adjustable rates in the marketplace.
Therefore many rate-conscious borrowers view the loan as a seven-year maximum term mortgage. They don't plan to stay in their house longer than that, nor do they plan to extend the loan at an above-market rate.
Fannie's two-step, for instance, carries a three-eighths of 1 percent discount rate below conventional 30-year fixed rates. Lenders were quoting 9.75 to 9.85 percent last week. That's the hook. But the rate after the seven-year deadline would jump to as high as 11.1 percent, if a borrower were converting in today's market. That's the boot -- the reason many borrowers would make sure they bail out before the seven-year deadline.
Fannie Mae's great success with its short-term, balloon-like loans this spring hasn't been lost on its top competitor. Freddie Mac last week struck back by unveiling its own battle balloon -- a shorter-term, more deeply discounted mortgage aimed at the same borrowers.
Freddie Mac's balloon carries a five-year term and a starting rate one-half percentage point or more below the prevailing conventional 30-year fixed-rate alternatives. In last week's market, that put Freddie Mac's five-year into the 9.6 to 9.7 percent range.
The actual starting rates, a Freddie Mac official emphasized, still are being set through negotiations with the local lenders who will be offering the loans to consumers. Freddie Mac's loan also comes with other competitive features, including a rate-conversion formula after five years that would produce a lower fixed-rate than Fannie Mae's two-step.
Given the emerging national competition for rate-discounted, shorter-term mortgages, should you consider signing up for one? Should you go for a balloon ride, whatever name the lender happens to give it?
The answer depends heavily upon your own prospects for remaining in your home, and your view of the competing adjustable-rate alternatives. True balloon loans, like Freddie Mac's five-year and Fannie Mae's seven-year loans, carry the risk that you may have to pay off your loan. Freddie Mac's loan documents make clear that if you were delinquent on your loan during the prior 12 months, or if the house has been encumbered with a second mortgage, or you no longer occupy the property yourself, your loan will be "callable" -- fully due, cash on the barrel head -- at the 60-month mark.
The attractions of a half-percentage point discount might begin to pale, in other words, if you had to hand over your house.
Before signing up for any balloon, check the one-year and three-year alternatives in the adjustable market. The average one-year ARM last week among 2,000 lenders nationwide carried a start-rate of 8.5 percent, according to mortgage analyst Paul Havemann of HSH Associates Inc. Fully indexed by the third year, however, that ARM probably would be above 11 percent in today's type of market.
So a five-year or seven-year balloon ride at less than 10 percent might prove to be a sensible trip.