Interest-only loans may start cheap, `reset' scary

Nation's Housing


Call it the reset jitters.

Lenders, mortgage investors and financial regulators across the country are concerned about the ability of millions of homeowners to handle the potentially painful payment spikes coming due on loans they took out during the height of the housing boom.

Though estimates vary, some industry experts say that at least a half a trillion dollars worth of loans with reduced initial payment terms are scheduled to reset during the coming year.

Some of these mortgages are "payment-option loans" that allow borrowers to make minimal payments for the first several years and carry "negative amortization" features that permit borrowers to pile on additional debt beyond their original balance.

Once the initial period is over, however, payments could shoot up 100 percent or more as the loan resets.

Other programs allow interest-only payments with no reduction in the original loan balance until the reset point. Then payments can increase 50 percent or more to amortize the debt balance over a compressed number of years.

Federal and state financial regulators are expected to issue mildly restrictive guidelines for lenders making new loans this fall, but tightened rules won't help homeowners who are heading for payment resets in the coming year, but may be blissfully unaware of the financial shocks they face.

John G. Walsh, a senior official at the federal Comptroller of the Currency, recently described his agency's concerns about poorly informed borrowers who don't realize that their artificially low monthly payments won't continue indefinitely.

"We've had consumers tell us they didn't know that after making 60 minimum payments on a [payment-option loan], they would owe more than they did when the loan was brand-new. They should certainly understand the basic bargain: The price of a low payment now is a much higher payment later.

"I think it goes without saying," added Walsh, "that someone, at some point, should have explained this" to borrowers with these loans.

Lenders active in nontraditional mortgages carrying negative-amortization and interest-only features say they have taken care to ensure that their customers comprehend the inner mechanisms of their reduced-payment loans.

They also insist that they've reserved these high-risk programs for borrowers with solid credit scores, large down payments and excellent employment histories.

Wall Street view

Wall Street analysts have questioned those confident assurances, however.

Standard & Poor's, the mortgage bond-rating agency, warned last year that it was observing disturbing numbers of minimum-payment loans being extended to borrowers with sub-par credit profiles.

Other Wall Street firms noted that given the option to make minimum payments, more than 7 out of 10 borrowers did so. In the process, those borrowers are racking up heavy additional debt balances and could be heading for payment shocks - or worse - without always understanding the consequences.

To head off potential problems, the largest mortgage originator in the United States, Countrywide Home Loans, quietly has begun sending out letters to thousands of borrowers who have been making only the minimum payments on the company's popular "PayOption" adjustable-rate mortgages.

The letters explain that "this is an early message to alert you that, based on your current payment trends and potential future interest rate changes, the monthly payment you will be required to pay may increase significantly."

A model letter provided to me by Countrywide includes this hypothetical example of what could be ahead for a California homeowner currently making only minimum payments monthly on a $402,000 loan.

The current full interest rate on the loan is 7.6 percent, but the borrower has been paying just $1,348.47, far less than what's needed to fully amortize the mortgage over its 30-year term.

If the loan reset at today's rates, the letter explains, the full payment required would be $2,887.50 - more than double what the homeowner has gotten used to paying. Future reset rates could be even steeper, making the potential payment crunch much worse.

Countrywide advice

Countrywide's helpful advice to its customers who want to prepare for their resets:

Switch their payment option out of the minimum if they can and move to either a 15-year or 30-year standard amortization plan.

Switch to an interest-only option if full payments are not feasible at the moment. At least interest-only payments will not result in still-higher principal debt balances to pay off later.

Explore alternative refinancing options sooner, rather than later.

That's good advice for just about anybody facing big resets in the coming year. Maybe other major lenders will see the benefits of proactively reaching out to their most vulnerable customers before they get smacked with payment shocks they never knew were coming.

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