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.