Exotic mortgages are "time bombs" for moderate-income homebuyers

Don DeBat

With mortgage interest rates on the rise, it’s becoming more of a financial struggle for cash-strapped Americans to step across the threshold of a new home.
As a result, lenders increasingly are pushing the use of interest-only adjustable-rate loans and optional-payment mortgages. The burden of these riskier products is falling on middle-income and moderate-income borrowers with less than stellar credit scores, according to a new study released by the Consumer Federation of America.The study, “Exotic or Toxic? An Examination of the Non-Traditional Mortgage Market for Consumers and Lenders,” analyzed borrower and loan characteristics of more than 100,000 mortgages originated between January and October 2005.
The analysis showed that African Americans and Latinos were more likely to receive payment-option mortgages than whites and that African Americans were more likely to receive interest-only mortgages.
“While the lending industry has characterized non-traditional borrowers as financially sophisticated and savvy consumers, the truth is that many are far from affluent and could be betting the house on their mortgages,” said Allen Fishbein, CFA’s director of credit and housing policy.
“Because homeownership is so critically important to financial security, these Americans are unwittingly putting their entire financial livelihood at risk,” Fishbein warned. Borrowers are increasingly relying upon non-traditional mortgages as a means to buy homes they could not otherwise afford in a rapidly escalating housing market, he said.

Exotic mortgage products typically offer lower monthly payments than traditional fixed-rate loans early on. But when these loan terms adjust, usually after two to five years, consumers are vulnerable to payment shocks. For example, on a $200,000 home, the monthly payment could rise by 54 percent on an interest-only adjustable-rate mortgage and by 123 percent on a payment-option mortgage if the interest rate rose to 6.5 percent from 5 percent.
“Non-traditional mortgages are more complex than your parents’ home loan,” said CFA senior researcher Patrick Woodall. “Some highly leveraged or unsophisticated consumers could end up learning that the mortgage that helped them buy their home was a ticking time bomb that destroyed their finances for years.”
The CFA study found evidence that these loans are not being marketed exclusively to the wealthy, sophisticated consumers most able to risk that payment shock.
For example, most non-traditional mortgage borrowers earn less than $70,000 annually, less than the median income in the high-cost housing markets where these loans are most prevalent.
Among interest-only borrowers, more than a third earned under $70,000, and about one in six who earned under $48,000 annually. Similar percentages of payment-option borrowers earned less than $70,000 (35 percent) and less than $48,000 (12.1 percent).
Latinos are nearly twice as likely as non-Latinos to receive payment-option mortgages, while African Americans were 30.4 percent more likely than non-African Americans to receive payment-option mortgages. African Americans were also 11.7 percent more likely than non-African Americans to receive interest-only mortgages.
Many non-traditional borrowers have credit scores that are average or weaker. More than half (53.8 percent) of payment option borrowers and nearly two-fifths (38 percent) of interest-only borrowers have credit scores below 700. More than a fifth (21.4 percent) and about one in eight (12.1 percent) of interest-only borrowers had credit scores below 600.
“Non-traditional mortgage products may benefit certain consumers but pose more risks than benefits for many others,” Fishbein said.
Furthermore, there are indications that many borrowers do not fully understand that these mortgages expose borrowers to potentially sharp increases in borrowing costs, he said. As a result, federal regulators recently urged lenders to provide more comprehensive information to borrowers.
“Given the array and complexity of many of the new mortgage products being offered, improved disclosures may not be enough,” Fishbein warned. “The plain fact is that deferred-payment mortgages simply may not be appropriate for all borrowers who receive them and therefore could pose a threat to home ownership stability.”
The report’s findings recently were presented at public forums held by both the Federal Trade Commission and the Federal Reserve Board.
Meanwhile, an adjustable-rate mortgage that drastically limits borrowers’ interest-rate risk while still allowing them to enjoy the benefits of falling rates has been introduced by New York Mortgage Company, LLC.
Known as the Homeowner Protection ARM, the new 30-year loan product has an introductory interest rate pegged at 6.5 percent for three months, and a cap of 6.99 percent for the first 10 years. If interest rates fall during that decade, the floor on the rate is 4 percent.
Interest rate adjustments on the loan are pegged to the London Interbank Offered Rate (LIBOR). The rate is adjusted monthly and has a low margin of 1.5 percent over LIBOR, which gives it a fully indexed rate of only 6.75 percent currently.

Real estate columnist and media consultant Don DeBat has written about Chicago-area housing and mortgage markets since 1968. He is chief executive officer of DeBat Media, Inc., www.DonDeBat.net.

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