Nontraditional loans can carry big risks

Record numbers of people have taken out nontraditional mortgages, loans with lower initial payments or other options designed to help buyers with limited resources overcome skyrocketing home prices. But these loans — which in some cases are considered predatory by consumer advocates — come with higher risks. Not only are these risks to the individual buyer, these alternative loans have not been tested in a time of economic hardship, so their larger effect on the economy is unknown.

Comprising less than 1 percent of the loan market in 2000, some estimate that as many as a third of all mortgages currently are nontraditional loans, Allen J. Fishbein, director of housing and credit policy for the Consumer Federation of America, testified before the Senate Banking, Housing, and Urban Affairs subcommittee on economic policy in September.

Additionally, although industry experts say there is likely a correlation between high-risk mortgages and foreclosures, “statistics on how many homes foreclose because of high-risk mortgages is hard to track,” says Fannie Mae Foundation Director of Public Affairs Albert King.

Mr. Fishbein told the Senate subcommittee that 2006 delinquencies on adjustable rate mortgage loans increased 141 percent over delinquencies in 2005. Some estimate that subprime borrowers are 25 percent more likely to default on their mortgage, he says.

Still, lenders are filling what they perceive as a need in the marketplace.

“Three out of five of my clients will be interested in a more ‘risky’ type mortgage,” says John Womeldorf, Realtor with Liz Moore & Associates in Williamsburg.

Mr. Womeldorf says it’s usually the first-time home buyers who look for the loan that allows them the least out-of-pocket cash and the lowest possible monthly payment.

Home buyers have several costs involved in their mortgages. A mortgage payment includes principal and interest and also includes taxes and insurance. It is sometimes referred to as the PITI. For our purposes, we’ll be discussing the principal — the amount borrowed — and the interest, the amount the lender charges for the loan.

How a homeowner repays the loan with interest is what determines the true cost of a home.

Home buyers have many creative ways to finance a home, rather than the so-called traditional 30-year mortgage. Here are four options, from the “safest” to the “riskiest.”

m A 40-year, fixed-rate mortgage reduces the monthly payment by about $100. The trade-off is that it is slower to earn equity.

• Another choice is an interest-only loan, where consumers can pay nothing toward principal for a period of time. Typically, these loans work like an adjustable rate mortgage (ARM) with a three- to 10-year term that ends with a balloon payment.

For example, when the 10-year interest-only feature ends on the 30-year loan, the entire principal has to be paid over the final 20 years. This can cause the monthly payment to jump by as much as 50 percent.

m A low-documentation loan available for self-employed home buyers relies only on the word of the consumer as to annual income. The home buyer is asked to sign an income declaration form and complete a loan application.

m Finally, there is a loan that economists consider to be the riskiest, the option-ARM, a loan where the buyer has the option to pay only a portion of the interest monthly. The balance of the monthly interest charge is rolled back into the loan, increasing the principal.

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