Monday, April 11, 2005

More homeowners on borrowed time

Los Angeles Times
April 11. 2005 9:32AM

Buyers are seduced by "interest only" loans, but what happens when the principal finally comes due?

achael Herron's new condo will assure her financial salvation - unless it provokes her ruin.

Herron, who lives in Oakland, Calif., put no money down for her tidy one-bedroom, borrowing the entire purchase price of $211,000. To keep her monthly payments as low as possible, she got an adjustable-rate mortgage that won't require her to pay any principal for three years.

Thanks to her "interest-only"loan, the 911 police dispatcher was able to afford, barely, her first home. She now has a stake in California's sizzling real estate market. As her home increases in value, she plans to use some of that equity to pay down her credit cards.

But Herron is also setting herself up for a day of reckoning: Nov. 1, 2007.

That's when she has to start paying off her loan principal. If interest rates are higher than when she bought her home last fall - something many economists consider probable if not inevitable - her monthly payment will increase by as much as a third.

"I don't know what I'll do,"said Herron, 32. "I'm already working overtime to pay my bills."

Confronted with soaring home prices, Californians are adopting a "buy now, pay later" strategy on a massive scale. The boom in interest-only loans - nearly half the state's home buyers used them last year, up from virtually none in 2001 - is the fuel behind California's surging home prices.

Mortgage companies have started advertising interest-only loans and refinancing deals in New Hampshire and the rest of the country as well.

But all that borrowed money might be living on borrowed time. If higher bills start coming due, Herron and hundreds of thousands of other homeowners will have to find ways to cope - or will have to sell.

In the most dire scenario, if they owe more on the home than it's worth, they'll walk away. Abundant foreclosures could spark a downturn in the entire housing market, leading to the long-feared bursting of what some call a housing bubble.

Interest-only loans, and other forms of so-called creative financing that are far riskier than the traditional 30-year fixed-rate mortgages, have allowed more people to afford homes even as prices skyrocketed.

When the price of houses in California soared 17 percent in 2003 and 22 percent in 2004, a curious thing happened: Instead of home ownership decreasing because fewer people could afford houses, it rose to record levels.

During the last two years, according to U.S. Census Bureau data, home ownership in the state rose to 59.7 percent from 57.7 percent. The previous record was 58.4 percent, measured during the 1960 Census.

While home ownership in California traditionally lags behind the rest of the nation, the 2-point increase during the last two years was greater than in all but a dozen states.

Rather than closing the door, lenders have apparently been opening it wider, inviting in people like Herron who would not have qualified for a mortgage under the more rigorous standards of an earlier generation. "If you can fog a mirror, you can get a home loan," said mortgage analyst Ralph DeFranco.

An interest-only loan offers the ability to defer for three, five or seven years any payment for the house itself. That allows a potential buyer to stretch to afford a place that would be otherwise out of reach.

Of course, everyone else using an interest-only loan can stretch too. The result is that prices keep rising. That encourages still more people to use interest-only mortgages, which fuels still more appreciation.

In 2001, as the current housing boom got under way, fewer than 2 percent of California homes were bought with interest-only loans, according to an analysis done for the Los Angeles Times by LoanPerformance, a San Francisco mortgage research firm.

By last year, the level had risen to 48 percent. Nationally, interest-only loans were used in about a third of all purchases.

What's propelled the market upward in California, some experts worry, could just as easily speed its descent.

"In the last few years, rates went down and values went up. It's like you were paid to live in California,"said analyst DeFranco, who works for LoanPerformance. "People got so used to refinancing. They'd think, 'No problem. My house will be worth twice what I paid, and I'll refinance my way out of trouble.' That's not going to be a good approach going forward."

Here's how he thinks a collapse could occur: Rising interest rates put a brake on price appreciation and refinancings. People realize their interest-only period is ending, raising their monthly payments substantially. Since they have no equity in the house, they choose to default.

Federal Reserve Chairman Alan Greenspan has a different point of view. "I do believe it is conceivable we will get some reduction in prices, as we've had in the past," he said in February. But he added this wouldn't be a problem because housing prices have gone up so much, providing homeowners with "a fairly large buffer."

People who buy at the peak, however, aren't going to have that buffer - or, if they have an interest-only loan, much room to maneuver.

Lenders seem reluctant to turn away any potential borrowers, no matter how few their qualifications. At the moment, at least, this is a profitable venture, although by their own admission it is becoming a riskier one too.

The Federal Reserve regularly queries banks whether they're tightening or loosening credit standards for home mortgages. In four of the last five quarters, standards were loosened. The combined drop was the biggest in more than a decade.

Meanwhile, the range of home mortgage products keeps expanding. Some lenders offer mortgages that are spread over four decades rather than three. Others extend the interest-only period to 10 or 15 years.

"A few years ago, you would have had to go to an infomercial to get the kind of deals we're offering now,"Wells Fargo home mortgage consultant Jimmy Kang recently told a group of new real estate agents.

In late March, the Fed raised short-term interest rates, which caused adjustable rates to spike. But that only increased their popularity. The Mortgage Bankers Association said adjustables rose the following week to a record high of 36.6 percent of all mortgages nationwide, exceeding earlier peaks in 1995 and 2000.

In California, the traditional fixed-rate loan is in danger of becoming extinct. According to recent LoanPerformance data, the percentage of new loans that are adjustable in Santa Rosa was 85 percent; in Oakland, 84 percent; in San Diego and Santa Cruz, 83 percent; in Los Angeles, 74 percent.

About two-thirds of these loans are also interest-only, compounding borrowers' risk of "payment shock."

Proponents of interest-only loans like to note that Californians tend to move every couple of years, and therefore many will escape payment shock. On the other hand, many people move to get into a better house, something that will be less attractive if interest rates keep going up.

Amy Matz and her fiance, Chris, a restaurant manager, are closing this month on their first house, a three-bedroom in Palm Springs that cost $495,000. They're borrowing $60,000 from their parents for a down payment, and financing the rest with an adjustable-rate loan that is interest-only for the first three years.

"We will be extremely nervous if we decide to stay longer than three years in that house and interest rates skyrocket," Matz said. "We are just banking on the hope that the home will gain enough equity by the time we sell."

It's not just first-time buyers who are at risk of payment shock. Miseon and T.G. Kang just sold their town house in San Jose for $625,000 and bought a new home for $1.21 million.

"We paid a premium. We wanted this house. Without an interest-only loan, we couldn't have afforded it,"said Miseon Kang, a pharmacist. "For five years, our payments will be okay. But after that, they'll be a problem. My husband and I are concerned."

Rachael Herron is concerned too, but mostly she's just exultant to have a home of her very own. It's only about 540 square feet, but it has a claw foot bathtub, space to store a voluminous amount of yarn (her passion is knitting) and a porch where Herron likes to watch the cars on the freeway, which is about 10 feet away.

Even better, she pays a few dollars less each month than she did for her last rental.

It's good to be a homeowner. Herron knew that three years ago, when she saw a place she liked for $169,000. She could have gotten a mortgage, but this was before interest-only loans were widely available, and she didn't think she could swing the payments. "I was being fiscally responsible," she said.

She kept an eye on that condoand says it's now worth $250,000. Something that seemed incredibly risky would have made her solvent.

Last fall, Herron decided to take the plunge. With the first four places she found, she was outbid. Then a bottom unit in a fourplex became available, and she got it. She's still amazed.

"I have $40,000 in student loans from my master's degree," Herron said. "I have high credit card debt. I'm a typical American. And yet they wanted to give me more debt to buy a house."

She wonders if she'll end up in foreclosure, if the bank will take her home away from her when she can no longer pay her bills. Maybe it was a mistake to give her this money, maybe it was a mistake for her to take it.

"If you're like me, you're so incredulous that anyone would give you any money whatsoever, you just close your eyes and sign the papers," Herron said. "I would have signed anything."


At 4:22 PM, Anonymous Safe said...

Too bad that most of these people have already lost their homes.


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