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Payment-option mortgages: Do you know all the facts?
An important debate is raging inside the home-mortgage market, though well beyond the earshot of most consumers.
The issue: Wildly popular "payment-option," interest-only and piggyback loans and the financial risks they pose to homebuyers and lenders alike.
On one hand, federal financial regulators say the risks are too significant to ignore, so lenders need to take special care in evaluating and approving customers who apply for these mortgages. Regulators want to impose new creditworthiness restrictions and disclosure requirements to make sure lenders are certain that borrowers understand the potential dangers. Banks and mortgage companies, on the other hand, aren't happy about regulators' plans. They say new restrictions are unnecessary intrusions and could stifle free-market innovations that have expanded consumers' ability to afford today's high housing prices.
Between January and the end of March, lenders bombarded federal banking regulators with demands to back off or soften the proposed new rules.
Regulators at the Federal Reserve Board, FDIC and three other agencies are studying the lenders' comments and are expected to announce final plans within the next couple of months.
Why all the fuss? And what might it mean for you as a homebuyer or refinancer? The fuss derives from the fact that payment-option, piggyback, interest-only and other creative loan concepts can be costly for applicants who really don't understand them.
The question is whether most lenders are taking pains to educate borrowers about how the loans work or whether they have been mass-marketing dangerous mortgages to people with borderline credit profiles, low down payments and minimal knowledge.
Here's a quick overview:
Payment-option mortgages have soared in popularity in the past three years, especially in areas of the country where real-estate prices and appreciation rates have been high. Payment-option plans typically allow borrowers to choose among one of four payments each month:
• A minimum payment based on an artificially low start rate and negative amortization (buildup of principal debt);
• Traditional amortizing payments based on 15- or 30-year schedules.
Negative amortization options can add 12 to 15 percent onto a homebuyer's debt in the early years of the loan and lead to monthly payment increases of 100 percent or more after the loan resets to market rates and a fully amortizing payment schedule.
The payment shock could be far worse — more than 150 percent a month after the reset — if interest rates in the economy rise steadily during the early years of the mortgage.
If borrowers encounter income problems or property values flatten, they may face intolerably high monthly payments, defaults and major losses on forced sales or foreclosures — possibly on property then worth less than the amount owed on it.
Interest-only loans cut monthly payments for anywhere from three to 10 years by deferring principal payments. At the end of the interest-only period, the original mortgage balance on the house remains to be paid. Monthly payments can then jump substantially — by 30 percent or more — because the principal debt has to be paid over a shortened period.
So-called piggyback loans targeted by regulators allow buyers to combine a standard first mortgage equal to 80 percent of the property value with a home-equity credit line or second mortgage of 10 to 20 percent of the home value.
These loans are popular because they allow buyers to avoid paying private mortgage-insurance premiums, require little or no down payment, and often qualify borrowers of "jumbo" loans to pay lower interest rates on the primary mortgage.
Banks and mortgage companies say they already carefully select customers and avoid undue risks for these loans. In a letter to regulators March 29, the Mortgage Bankers Association said its research indicates that members restrict payment-option and interest-only loans to borrowers with higher credit scores and larger down payments.
Other lenders argue that payment-option and interest-only loans only go to relatively sophisticated people who plan to use their monthly-payment savings for investment purposes.
Nick Nickerson, a mortgage consultant with Nations Home Funding in Durham, N.C., says 100 percent of his clients "invest their savings ... and end up financially ahead."
"I insist that each client have a financial planner involved and the mortgage-payment savings are direct-deposited to their investment account," Nickerson said.
Lenders don't want borrowers to default, Nickerson says.
"Negative amortization is simply a way of taking equity out of your home slowly over time rather than all at once," he said.
Bottom line for you? If you understand all the working parts of a payment-option loan, have sterling credit, make a big down payment and are using your savings like Nickerson's clients, you probably don't need the financial regulators' intervention.
But if you don't fit these criteria, you probably do.
Kenneth R. Harney: firstname.lastname@example.org
Copyright © 2006 The Seattle Times Company