Betting the Farm

In past articles I have warned about the dangers awaiting consumers who got suckered into low payment mortgages. The signs have not gotten any better. In fact, they seem to have gotten even worse.

Americans seem to be suckers for things that are cheap. We buy cheap clothes that wear out, we buy cheap tools that break, and so forth. When it comes to financing our purchases, we love low payment options, whether it's for a car loan, credit card, or a mortgage. Marketers of loans have noticed this too. As a consequence, marketing of mortgages usually panders to consumers' desire for a low payment.

Several years ago lenders started offering interest-only mortgages as an alternative to standard fully-amortized loans where a portion of each payment pays of some of the principal. You might ask why that makes much of a difference because only a small percentage of the payment is applied to the principal. Not so now. That was true when interest rates were at double digit rates in the 1980's. On a 10% loan, only 5 percent of the monthly payment goes to principal. At 8% it rises to 9 percent. On a 5% loan a whopping 22% of the payment goes to principal. That can make a big difference.

The payment on a $250,000 5% interest-only loan is $1,041.67 compared with a payment of $1324.05 on a fully amortized loan. If a lender were to qualify a borrower based upon the lower payment, he could qualify for a much larger loan. He could also bite off more than he can chew.

The good news is that many people who could not have bought a home with standard loans have been able to do so. That is one reason why the real estate industry has been the brightest spot in the American economy for the past few years. It is also a reason why we might be in more trouble.

We have been doing Interim Fixed Rate loans, ones that are fixed for the first 3, 5, 7, or 10 years for over 15 years now. As rates have steadily fallen during this period, holders of these mortgages have found their payments falling after the end of the fixed periods. But no longer.

If a borrower's a 5% interest-only loan were to switch to 1-year T-Bill Index, now 3.33%, plus a standard 2.75% margin, the payment goes to $1,516.60, a 46 percent increase. If those borrowers couldn't qualify for a $1,324 payment, how are they going to handle $1,516? It gets worse.

According to a Deutche Bank survey, only about $80 billion of such ARM's are coming off of their fixed rate periods this year, only about 1 percent of all mortgages. But in 2007, the number rises to over $1 trillion. That means that 12 percent of American borrowers will be in that situation. Let's make the not unreasonable assumption that rates are 1% higher in 2007. That means the payment goes up to $1,934.24, an 86 percent increase! Whoa! If you think that's bad, it gets even worse!

Perhaps the most popular loan today is the one with - get ready to guess – the lowest payment, the so-called option ARM. It has an initial payment based upon an interest rate of only 1%. The payment on that loan is only $804.10 per month. So if you made the assumption that someone really ought to be paying the fully-amortized rate, $1,934, that's a whopping 141 percent increase.

One industry executive said that these loans "haven't been tested in a rising interest rate environment." Well, our industry is about to get its chance.

Now I don't think that there will be blood in the streets. Lenders do not want to take the houses back, and I'm sure that maybe they'll be out there doing new interest-only loan refinances to keep people out of the fire. What I really worry about is the borrowers themselves. Owning your own home is and ought to be part of the American Dream, but when you look at statistics like these, it looks as if it's going to be a nightmare for some people.

If you are planning on buying or refinancing a home now, I would strongly urge you to avoid the temptation posed by these low payment loan products. It's just not prudent and I don't want to see you hurt. You'd do your friends a favor by spreading this article around and save them some grief too.

Be careful out there!