- The Washington Times - Wednesday, November 15, 2006

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.

Interest rates on option-ARMs generally start between 9 percent and 10 percent. If homeowners cannot refinance before the introductory rate expires, they could find themselves paying up to 15 percent interest.

“I consider the payment-option ARMs to be the riskiest loans available,” Mr. Womeldorf says. “If the loan is not used properly, the buyer may accrue negative amortization over time, which will eventually chew up a lot of equity in the home.”

Mr. Womeldorf says he believes that many home buyers lack an understanding of how the loan works.

“If a home buyer has an option-ARM loan and sees their interest rate go up two points within two years, they could see their mortgage payment up by 30 percent,” he says.

Gary Herman, president of Consolidated Credit Counseling Services.com, counsels people who fall victim to overwhelming debt because of risky mortgages.

“The initial rate these mortgage lenders quote is almost always a teaser,” Mr. Herman says. “It’s never spelled out for the borrower what the final payment ‘could’ be if the interest rate keeps rising.”

Mr. Herman says many people don’t know what it will cost them over the life of the loan.

The majority of Mr. Herman’s clients have credit card debt and a second mortgage.

“A client asked me to talk to a financial service for them about what their final payment could be and what they would actually pay for the loan,” Mr. Herman says. “I called them up and asked them for the bottom line and to fax me the paperwork. The guy laughed at me and said that if they knew that they wouldn’t take the loan.”

The upside? ARMs give consumers with credit problems and no savings a way to finance housing.

But there are other choices.

Mr. King says Fannie Mae offers a 40-year fixed mortgage.

“A 40-year fixed mortgage helps consumers avoid some of that term-interest payment,” Mr. King says. “It helps make the monthly payments more affordable.”

Gary and Linda Baines took out a 40-year mortgage on their $350,000 home in Greenbelt earlier this year.

“The 40-year mortgage will help us pay down our debts and still have enough to pay the mortgage,” Mr. Baines says.

“We have two small children, and there are always unexpected expenses. This gives us room to breathe,” Mrs. Baines says.

Only about 5 percent of prime bank lenders offer risky mortgages. About 65 percent of so-called subprime financial services offer high-risk mortgages.

Financial industry insiders say consumers often are unaware of the difference. Prime lender interest rates are regulated by the federal government and subprime financial services interest rates are not.

The 109th Congress, currently in its lame-duck session, has considered, but has not passed, several measures to combat so-called predatory lending practices, including H.R. 1182, the Miller-Watt-Frank bill; H.R. 1295, the Ney-Kanjorski bill; and H.R. 4471, the Uniform National Mortgage Lending Standards Act introduced by U.S. Rep. William Lacy Clay, a Missouri Democrat.

Critics of the latter two measures say they would weaken state laws already in place regulating such loans. Industry groups, such as the Mortgage Bankers Association, the National Home Equity Mortgage Association and the National Association of Mortgage Brokers have announced they favor the Ney-Kanjorski proposal.

For details, consult the National Low Income Housing Coalition’s summary (www. nlihc.org/advocates/predatory lending.htm).

Meanwhile, federal regulators, including the Office of the Comptroller of the Currency, the Federal Reserve Board, Federal Deposit Insurance Corp. and others, last summer issued a 27-page “Interagency Guidance on Nontraditional Mortgage Product Risks” (www.federalreserve.gov/ boarddocs/press/bcreg/2006/20060929/attachment1.pdf ).

The concern for economists is that these alternative loans have not been tested in an economic downturn, so they not only pose a risk for individual consumers, but potentially could have deeper ramifications.

Mr. Fishbein told the Senate subcommittee that consumers had relied upon what he called the “superheated housing market” to increase housing prices — and their equity in the investment — in order to refinance their way out of subprime loans into more traditional financing, avoiding large balloon payments. But as the market cools, this will no longer be possible, he testified.

The new financing is complicated not only for consumers, but also for real estate agents.

“We have meetings at least once a week where our preferred lenders update us on mortgage information,” Mr. Womeldorf says. “We make sure our clients are educated and aware of all the options available to them and the risks associated with each.”

Dave and Ellen Parker of Fredericksburg understand what it is to be “surprised” by a jump in their monthly mortgage payments.

“When we bought our home six years ago for $400,000, we never planned to stay more than five years,” Mr. Parker says.

“Our payments were $1,050 a month,” he says. “Then the ARM ended and our payment shot up to over $1,500. Now we are facing foreclosure.”

Mrs. Parker says she can’t believe what’s happened.

“Our dreams of owning our own home weren’t supposed to end like this,” she says. “They never told us how high our mortgage payments could get. Now we are in credit counseling and are trying to hold on to our dream.”

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