Optional mortgage payments can be iffy

Nation's Housing

June 10, 2006|By KENNETH HARNEY

They are the new breed of "affordability" mortgages, and homebuyers in high-cost real estate markets can't get enough of them: interest-only and "payment option" plans that cut monthly payments sharply in the early years of a loan.

Lenders have marketed both types of mortgages aggressively - often to people who need to stretch their incomes to afford a home purchase - but have insisted that their borrowers have solid credit histories, excellent credit scores and fully understand the possible payment-shock risks once payments reset in a few years.

In some parts of the country, the numbers of interest-only and payment-option loans have soared from single-digit market shares two years ago to more than 50 percent in 2005.

But federal regulators worry that all is not well: Too few borrowers, they say, really comprehend the potential risks involved and have a solid grasp of how the loans work.

Within weeks, a team of regulators led by the Federal Reserve and the Comptroller of the Currency is expected to issue new guidelines for mortgage lenders that could have the effect of reducing the number of interest-only and payment-option loans being offered.

Now a new statistical study is challenging some of the mortgage industry's claims about borrowers' sterling credit qualities.

The Consumer Federation of America examined the case files of more than 100,000 mortgages closed between January and October 2005. The files contained detailed information on household income, credit scores, down payment amounts and racial and ethnic characteristics.

Among the findings: Homebuyers who take out payment-option loans tend to have below-average credit scores.

Nearly 54 percent of payment-option users in the sample had FICO scores below 700. Fair Isaac Corp., developer of the FICO scoring system widely used to gauge credit risk by the home mortgage industry, says the median FICO score is 723.

Sub-par FICOs "are not what you really want to see" in connection with payment-option mortgages, said Patrick Woodall, senior researcher for the Consumer Federation and co-author of the study.

Most payment-option mortgages permit borrowers to choose what they want to pay per month for a preset period - ranging from a fully amortizing standard payment to an interest-only payment to a rock-bottom minimum payment even lower than the interest-only option.

Some mortgage securities industry experts estimate that upward of 70 percent of payment-option borrowers elect to go with the minimum payment. That, in turn, causes them to increase their principal debt through a process known as "negative amortization."

Borrowers often are allowed to increase their original loan balance by 10 percent to 25 percent before they must begin paying down the principal - i.e., actually reducing their debt through significantly higher monthly payments.

If home price appreciation stagnates, some of these consumers could find themselves facing rising debt burdens and minimal - even negative - equities.

Such a circumstance would be tough enough for borrowers with excellent credit histories and debt management skills. But it would be disastrous for borrowers with below-average scores and higher-than-average predispositions to miss payments.

The CFA study also examined the household incomes of interest-only and payment-option borrowers.

More than three out of five payment-option plan borrowers and 47 percent of interest-only borrowers had annual household earnings of $72,000 - seemingly a good sign. But Woodall noted in an interview that many of these households still had incomes well below the median for their metropolitan areas, which often are high-income, high-cost markets such as Washington, San Diego, Los Angeles and San Francisco.

Finances stretched

More troubling, he said, was the finding that substantial numbers of borrowers using interest-only and payment-option loans have modest incomes and could already be stretched financially. One out of eight payment-option borrowers and one out of six interest-only borrowers earned less than $48,000.

Woodall said that "all sorts of events could trigger problems for these people" that could lead to defaults, foreclosures and loss of houses - unexpected medical bills, a loss of income by one earner, divorce - along with the 30 percent to 80 percent monthly payment jumps built into the loans themselves as they mature.

Minority groups

The CFA study also found that minority groups appear to be disproportionately targeted for certain of the high-risk loans: Latinos "are nearly twice as likely as non-Latinos to receive payment-option mortgages." African-Americans are 30 percent more likely than non-African-Americans to have payment-option plans.

Bottom line: Though the jury is out on the risks of payment-option and interest-only mortgages, the CFA findings suggest that lenders are hardly reserving them for high-income, high-credit-score applicants.

In an economic squeeze, some of these loans could prove highly toxic - a prospect almost certain to weigh heavily in the financial regulators' forthcoming new guidelines.

kenharney@earthlink.net

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