Homeowners place faith in 'exotic' mortgages

Bob Sullivan Technology correspondent • Profile • E-mail

It’s called the Stress Free Mortgage.  The interest rate is advertised as a rock-bottom 0.99 percent. Better still, initial monthly payments are almost a dream, nearly half what a traditional mortgage holder would pay. With the Stress Free Mortgage, offered by Great Financial Mortgage in Fullerton, Calif., a buyer looking at a $310,000 loan would pay only about $995 a month. For the first year.

The stress could come later. 

Minimum payments rise each year, so in five years the minimum is $1,330 a month.  Even at that, borrowers have not even begun paying for the house. In fact, they haven’t even paid all the interest they owe the bank. After five years of rising payments, the mortgage balance is actually higher, closer to $329,000. 

At that point, the real stress begins. When the loan payment is reset, because of the rising outstanding balance, the new minimum payment is $2,015 — more than double the initial payment.  And that assumes interest rates are flat.  Were interest rates to rise slowly – say from the current 5.5 percent to 6.4 percent — the new minimum monthly payment would be a knee-buckling $2,243.

Welcome to the high-stakes world of the negative-amortization loan. With skyrocketing home prices in America’s hottest markets, lenders have become increasingly creative in their efforts to stretch consumers into pricier homes.

Interest-only loans, nearly unheard of three years ago, have jumped in popularity.  “IO” mortgages, which come in many shapes and sizes, can shave 20 to 30 percent off monthly payments because they temporarily relieve borrowers of the need to pay any principal.  But after that temporary reprieve, mortgage payments jump sharply. Fully one-third of mortgages opened last year were interest-only loans, causing a stir of concern among economists including Federal Reserve Chairman Alan Greenspan.

But interest-only loans seem conservative compared to the latest lending rage, the negative-amortization loan.  Consumers who sign up don’t even have to pay the full interest owed the bank each month. Instead, they borrow more money as time goes by, making minimum payments in a way that echoes the world of revolving credit card debt.  In a housing market that goes suddenly flat, such a loan guarantees the buyer will be “upside down” after a few years — meaning their home will be worth less than the mortgage on it. 

Offered 'alongside Viagra ads'
Few financial experts or even mortgage brokers see these loans as a sound borrowing technique for most consumers. Yet according to UBS analyst David Liu, 40 percent of mortgages over $360,000 that have closed so far this year are “neg-am” loans.  And the Internet is crawling with all manner of come-ons, offering products with names like “Name Your Payment” loans.

“I always remind people that those things are offered on the Internet alongside Viagra ads and deals with shady folks from Nigeria,” said UCLA economics professor Edward Leamer.  He believes the rise in riskier mortgages is a sure signal that America is indeed in a housing bubble, and he worries consumers who are anxious to buy high-priced homes are getting in over their heads.  “I can't say everybody doesn’t know what they are doing, but this is a direction that is very worrisome.”

There is still plenty of debate about the size and scope of a possible housing bubble.  But there is little debate that soaring prices are stretching home budgets like never before.  Harvard University's Joint Center for Housing Studies recently found that nearly one in three American households spends more than 30 percent of income on housing, and more than one in eight spend close to 50 percent.

There is also growing consensus that the rising popularity of creative home loans could spell trouble. The gyrations of lenders alone should give consumers pause. 

Interest-only loans haven’t been this popular since the late 1920s; negative-amortization loans since the early 1980s California housing boom. Both those trends ended badly. But today, there are entire families of adjustable-rate, interest-only loans.

Consumers who choose negative-amortization loans — also called option ARMs — are not locked into additional borrowing each month.  Loan holders can choose one of four options — a minimum payment that results in “deferred interest,” increasing the mortgage balance; an interest-only payment; a payment that represents a traditional 30-year mortgage rate; and a larger payment that  represents an accelerated 15-year mortgage payment.  But a UBS  study recently suggested that 70 percent of neg-am mortgage holders make just the minimum payment.

'That's the risk you take'
Such monthly borrowing from your house spells real trouble, financial experts say.

“The only way you can assume that kind of risk is you are saying the house is going to appreciate substantially, you are assuming your income will increase significantly, or you are assuming interest rates will fall or remain the same,” said Robert Manning, author of "Credit Card Nation" and a personal finance expert. “If interest rates rise, property values fall or your income stays the same, you are absolutely screwed.”

Richard and Jamie Henriquez just refinanced their home in Granada Hills, Calif., with Great Financial Mortgage and chose a negative-amortization loan with low initial payments.

“We looked at 30-year fixed,five-year fixed, three-year fixed, and we chose that one because with the payment, you can’t go wrong. It’s flexible,” Henriquez said.  Asked if she was worried about what might happen in three or four years, she said, “I'm really not. I could sit here and worry about that right now, but I don't know what's going to happen three or four years down the road. I know if interest rates skyrocket that’s going to put us in a bad position, but that’s the risk you take.”

In Congressional testimony last month, Greenspan called such loans “exotic” and said their popularity was a development of “particular concern.” Federal banking regulators have made noises about additional scrutiny on banks that make such loans. And credit rating firms Fitch and Standard & Poors have announced they are mulling a re-examination of investments tied to such loans.

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