Lenders told by U.S. what to avoid in cheap loans

Nation's Housing

October 06, 2006|By Kenneth Harney

You may have seen reports about tough new federal rules aimed at curbing the availability of popular payment-option and interest-only mortgages - both of which feature low monthly payments in the early years, followed by big payment increases later on.

Those cutbacks, in turn, could make it more difficult for many buyers in high-cost markets to stretch their budgets to afford the houses they want.

That's all true - to a point. The "guidance" jointly released Sept. 29 by the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration did not ban or attack payment-option and interest-only loans per se.

To the contrary: The regulators acknowledged that both types of mortgages are legitimate, innovative ways to finance a home.

Payment-option plans allow borrowers to choose among several payment levels each month - a bedrock "minimum" amount so low the loan balance increases; interest-only payments, which do not reduce the principal balance owed, or fully amortizing payments that include both interest and principal.

At a specific "reset" point, the borrower's monthly payments increase sharply to cover all the deferred interest and principal contributions and shift to a "fully indexed" rate.

Interest-only loans cut homeowners' payments for anywhere from the first three to 10 years by sidestepping principal reduction; at the end of that period borrowers have the same principal balance they started with, but their payments jump significantly to begin reducing their principal debt over a new, shorter period.

Marketed to financially qualified borrowers who understand what they're getting into, and who understand the prospect of big monthly jumps in costs in later years, payment-option and interest-only loans are fine, said the regulators.

But when lenders begin to mass market them and add on a grab bag of other features, payment-option and interest-only mortgages can verge on toxic.

Risk features

Among the risk features the federal government wants lenders to avoid piling on top of each other:

Borrowers with incomes that can't support the full costs looming down the road. Extending a mortgage to homebuyers at a 1 percent or 2 percent effective payment rate in a 6 1/2 percent to 7 percent market is OK if the applicants can actually afford to pay the full rate.

After all, some consumers choose to make minimum payments because they have more profitable uses for their cash.

But if homebuyers don't have the current income to afford the house and the mortgage, extending a payment-option mortgage becomes a crapshoot.

Once the low payments of the introductory period are over, will they have gotten raises or won the lottery and have the cash to handle monthly payments double or more than they've gotten used to?

Minimal or no documentation of applicants' incomes and assets. Popular among self-employed earners and professionals, so-called "stated income" underwriting can push the risks of payment-option and interest-only loans off the charts.

If banks don't verify that the incomes applicants are claiming are for real - by checking in with the IRS or demanding W-2s - they should generally avoid extending payment-option and interest-only mortgages.

"Piggyback" plans that allow minimal or zero down payments through the use of simultaneously closed first and second mortgages. For example, a borrower who applies for a payment-option first mortgage equal to 80 percent of the price of the house might also ask for an interest-only credit line equal to 20 percent of the property value.

In effect, the borrower is buying the house with nothing down, paying nothing per month to reduce the principal debt, and is highly likely to face huge payment-shock increases in the not-too-distant future. Avoid such time bombs at all costs, the federal regulators urged the banks.

Sub-par credit scores. No need for explanation: Poor credit histories don't mix well with mortgage programs with built-in payment shocks.

Non-owner occupancy. When a buyer doesn't plan to live in the house but instead to rent it out or flip it, that automatically raises the statistical likelihood of default and foreclosure. The risks soar even higher when lenders allow investors to buy properties they really can't afford using payment-option plans.

Making sure

The new guidance requires lenders to make certain that all loan applicants for payment-option and interest-only mortgages truly understand the mechanics - especially the lurking dangers of payment shocks.

The agencies' new rules cover all federally chartered banks, mortgage banking subsidiaries and credit unions. State-regulated mortgage brokers and independent mortgage companies aren't yet required to follow the guidelines, but they will in the near future when state regulators issue parallel restrictions against risk-layering.

Bottom line: Payment-option and interest-only loans aren't going away. You'll still be able to shop for them. But don't expect they'll come with all the risky razzle-dazzle add-ons they used to.


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