When Alan Greenspan, Federal Reserve chairman, testified to Congress last month, he warned that he was concerned about "the dramatic increase in the prevalence of interest-only loans as well as the introduction of other exotic forms of adjustable-rate mortgages…"
It's a safe bet that he wasn't talking about the good old-fashioned 30-year fixed-rate mortgage.
What he was referring to is the surging use of a new form of adjustable rate mortgage that allows borrowers to pay less than the interest owed, which can result in the borrower's mortgage debt actually increasing over time.
A Rise in Interest-Only ARMS
A lot has been said lately about the concern over a potential real estate price bubble. In many regions, housing prices have increased so much in such a short period of time that buyers who want in on the American Dream are forced to stretch to buy a home.
According to Loan Performance, a mortgage industry expert, just four years ago, interest-only mortgages made up less than 2 percent of all new mortgages. But in 2004, more than 30 percent of new mortgages were adjustable rate, interest-only mortgages, where borrowers were allowed to make payments for only the interest owed each month. In the second half of 2004, adjustable rate and interest-only loans made up more than 63 percent of all new mortgages.
Interest-only loans come with payments that are hundreds or even thousands of dollars less initially than a fixed-rate mortgage, because they start off with an artificially low interest rate and require no principal payments initially. It seems that suddenly homebuyers have discovered that they want the small initial monthly payments that result from paying nothing but the interest on their home loans and, increasingly, that is not even low enough.
The risk, of course, is that some borrowers, if not prepared, could experience payment shock. Down the road, when the low introductory interest rate expires, and higher rates and principal payments are required to kick in, their monthly mortgage payment can jump 40 to 60 percent from where it initially started. Buyers who stretch to buy a home based on these low initial payments are in for a shock that can strain their cash flow, or worse.
The New Thing in Mortgages: Option ARMs
Another of the "exotic mortgages" that is causing concern among industry watchers is called the option ARM and is touted as the newest fashion in adjustable rate mortgages.
It seems that option ARMS are the hot new mortgage of choice in 2005: according to UBS in New York, during the first quarter of 2005, 40 percent of new mortgages over $360,000 were option ARMS. These new mortgages were hardly (if ever) mentioned or used just two years ago. The concern is that these new mortgages are becoming popular at a time when low interest rates and surging home prices are the only reality many people have known.
Like the name implies, option ARMS allow borrowers to choose from four payment options each time they write a check for the monthly payment. These payment options range from a payment at a fixed dollar amount that is less than the interest owed each month, to larger payments that include principal and interest.
One might take the view that all this flexibility in the hands of homeowners would be a good thing. After all, as long as option ARM borrowers made good financial decisions, such as making a few minimum payments on an option ARM and using the cash flow savings to pay down other high-rate credit card debt, how harmful can this be?
Unfortunately, the data on the use of option ARMS suggests otherwise. According to UBS, in the first quarter of 2005, 70 percent of option ARM borrowers made minimum payments, which means that they added more debt back to their loans. And according to Economy.com, a fast-growing segment of buyers taking out these aggressive loans is made of lower income families living in areas where home prices are expensive. Paying only the minimum payment is similar to making minimum payments on credit card debt: something all consumers are taught is a financial no-no.
The big risk to borrowers who make only minimum payments under option ARMs is the risk is that the mortgage will always increase. The minimum payment can also increase, or be "recast" when the mortgage increases to 115 to 125 percent of the original loan amount.
To sum it up, if a borrower makes only minimum payments, their mortgage loan and their payments can rise. If the mortgage increases faster than the home grows in value, and the borrower has to sell it, it's not a pretty picture.
But the growing popularity of option ARMs, driven by consumer demand especially on the West and East Coasts, has caught the attention a number of large mortgage lenders and buyers. Freddie Mac, who buys and repackages large quantities of mortgages for resale to institutional investors, is considering buying option ARMs later this year. When they do, this will increase the number of lenders who offer option ARMs.
To be fair, having the option to pay the minimum payment may be a good idea if it frees up cash flow to pay off other high-rate debt.
Also, having the option to make larger payments is valuable to people whose income fluctuates because of commissions or bonus income that's paid infrequently.
The problem is that mortgage brokers are selling option ARMS as a tool to maximize the home-buying power of first-time home buyers – the very people who are least experienced and least likely to make a payment that is more than the minimum due.
Mortgage brokers report that these mortgages sell themselves based on the lowest payment mentality of borrowers, and often pay an additional commission of .125 to .25 percent to the mortgage broker. There will be a day of reckoning for many option ARM borrowers who get shocked with higher payments or growing mortgage debt…or both.
Option ARMs are a viable choice for people who are experienced (or are a quick study) with all aspects of homeownership and mortgages, and who expect, with reasonable certainty, to have big increases in income.
But first-time buyers, or people whose incomes that are not likely to rise as rapidly as necessary to avoid unpaid interest on an option ARM (such as municipal employees, retirees, etc.) should use caution when considering an option ARM.