Sunday, April 10, 2005

Low-payment loans could turn out to be scary

The Miami Herald


Some new loan features begin with low monthly payments that suddenly balloon after an initial period.

Are low monthly payments on a home mortgage always good?

Are you kidding me? Of course they are, you might answer.

But a new report issued by a Wall Street firm suggests that some low-payment loans in today's hot housing market could prove to be highly toxic to borrowers who don't understand the risks they entail.

The report is from Dominion Bond Rating Service, a company that evaluates the risk characteristics of mortgage securities purchased by deep-pocket investors. Those bond investors now provide most of the funds loaned to American home buyers, and they view defaults and foreclosures as dread diseases to be avoided.

Dominion's study focused investors' attention on two widely used loan features that reduce buyers' monthly payments or allow them to fudge their incomes: interest-only loans and no-documentation ''stated-income'' mortgages.

SCARY MORTGAGES

''Some of the new mortgages we see are very scary,'' said Susan Kulakowski, a Dominion vice president and co-author of the report. ''They allow people to qualify solely on the basis of a low initial payment,'' rather than what they can truly afford to buy at current interest rates. Then the mortgages morph into money-gobbling monsters that can push consumers into payment shock, default and foreclosure almost overnight.

Kulakowski is especially concerned by a bumper crop of short-term ''hybrid'' interest-only loans now flooding the market to help consumers with marginal credit or incomes buy houses. Interest-only mortgages require no paydown of principal -- no reduction of your actual debt -- for a set period of time at a low fixed rate of interest. Payments during the initial period typically are set well below what a borrower would pay on a conventional 30-year fixed-rate loan.

At the end of the initial period, which may be as short as two or three years, the loans convert to fully amortizing adjustable rate mortgages at prevailing market rates. Principal reduction now kicks in, but because of the compression of the payback period -- 25 to 28 years -- and the addition of principal to the payment mix, the total costs can suddenly balloon by anywhere from 50 percent to 70 percent.

Marginally qualified home buyers jolted with such payment increases within 24 to 36 months of their purchase ''are very likely,'' according to Kulakowski, to be pushed beyond their ability to pay the loan. Their only alternative may be to refinance, but since they may still not be able to afford market-rate payments, they could be stuck over their heads in house debt.

As an example of the problem, Dominion's report tracked a popular ''3/1'' interest-only hybrid closed last September through a projected payment scenario over the next 10 years. The original loan was for $350,000, at an enticing 4 percent payment rate for the initial fixed period of 36 months. (The ''3/1'' designation refers to the initial three-year period of fixed payments on interest only, followed by conversion to a market-rate adjustable whose rate changes once a year for the remaining 27-year term.)

The buyers' initial-period payment, which they used to qualify to purchase the house on their then-current income, came to just $1,167 a month. That is $773 a month lower than they would have to pay on a competing 30-year fixed-rate mortgage of $350,000 at September's lowest-available 5.28 percent rate.

What happens to the buyers' loan after the 36th month? Their payment in the 37th month rockets to $2,184 -- an overnight increase of $917 that would put a severe strain on most new homeowners. In a faster-rising rate environment, the shock would be even worse. By year 10, according to Dominion's projections, the owners would be paying close to $2,700 a month.

Kulakowski is concerned by other default-prone mortgage products that she sees pouring into the marketplace. Potentially worst of all are ''stated-income'' loans made to borrowers with marginal credit scores.

STATED INCOME

Stated-income or no-documentation loans allow borrowers to dispense with the usual proof of income -- W-2s from their employers, for instance -- and proof of assets such as bank deposits.

Dominion says that no-documentation mortgages ''were originally intended for self-employed borrowers'' who own businesses or have substantial income or assets they did not wish to list as part of a loan application. Recently, however, the no-doc concept ``has been expanded to include salaried borrowers who cannot or will not show proof of income.''

Why don't people with W-2 documented salaries want to show them? You guessed it: Many of them are buying houses with price tags they can't really afford. And if the economy falters or their incomes drop, they will be the first into foreclosure.

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