Alternative Mortgage Products
Katherine Worthman Attorney Federal Trade Commission
3 June 2008
The views expressed are those of the speaker and not necessarily those of the FTC or any other person.
Hypothetical
Umit and Karli decide to purchase a home. They are expecting their first child. They have a steady income, that will likely increase by 510% each year. They plan to have two more children and will likely stay in this home for 5-10 years. They initially thought they wanted a fixed rate mortgage but the 30 year fixed rate payments are too high if they purchase a three bedroom house. They want to learn more about adjustable rate mortgages and more complex mortgages. They are also considering purchasing a smaller home. After looking at different loan options, we will discuss what type of loan will work best for them.
Traditional Mortgages
In the United States, the traditional mortgage is a 30 year fixed interest rate mortgage which means the interest rate does not change during the entire term of the loan. The monthly payment includes interest on the money borrowed plus repayment of some principal. The monthly payment stays the same throughout the term of the mortgage.
Alternative Mortgages
Adjustable rate mortgage (ARM) – an ARM is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indexes. Hybrid Loan – a mortgage that offers a fixed rate for an initial period, typically three to ten years, and then adjusts every six months, annually, or at another specified period, for the remainder of the term. 2/28 and 3/27 mortgage – example of hybrid ARMs
Alternative Mortgages
Two more complex loan products are interest-only and payment option mortgages Interest only mortgages allow you to pay only interest for a limited time, and avoid paying back principal for a few months or years. The result in the early years of your mortgage: you have interest-only payments that are often a low amount. How does an interest-only loan work?
Interest-Only Loans
• Pay only interest and no principal in the loan’s early years for low payments at first. • Higher monthly payments kick in after the early period because they now include both interest and principal • The loan now must be amortized – or paid off – over a shorter time • Payments will increase even if market interest rates remain stable and your ARM rate and payments would not otherwise change • Interest-only payment periods are often three, five, seven, or 10 years.
Interest-Only Loans
How prevalent have they become? – In 2001, they constituted less than 2% of the market – By 2005, they were 23% of loans originated in the United States and 30% of subprime loans – Most prevalent in high-cost markets – 61% in California and 54% in the District of Columbia
Sources: George McBride, Bankrate.com, Mortgage Bankers Association, LoanPerformance
Who May Want an Interest-Only Loan?
Households with variable income (salespeople, small business owners) that have the discipline to pay down principal when income permits Homeowners or investors looking to maximize cash flow Consumers who expect their incomes to increase significantly However, borrowers may use an interest-only loan when they do not have the income necessary for a more traditional mortgage
Why Do Some Borrowers Prefer Interest-Only Loans?
Comparing Monthly Payments
Scenario: $350,000 loan 30-year fixed rate mortgage at 6.5% carries a payment of $2,212 But a 5-year interest-only loan at 6% has a monthly payment of $1,750
$2,500
$2,000
$1,500
$1,000
30-year fixed
5-year interest only loan
But What Happens to the Monthly Payments?
Here is what happens after five years: – Even if the rate remains at 6%, the payment jumps to $2,255…an increase of more than $500 per month – If the rate jumps to 8% instead, the payment jumps to $2,701…a jump of $951 per month
Interest-Only Payments
$3,000 $2,500 $2,000 $1,500 $1,000 $500 $0
Initial interestonly payment
Rate remains 6%
Rate jumps to 8%
Considerations for Interest-Only Loans
Pros Lower monthly payments at first Consumer may plan on refinancing the mortgage before the interest-only period ends and securing a lower interest rate Consumer may plan on selling the home before the interestonly period ends
Considerations for Interest-Only Loans
Cons When the interest-only term is up, payments could suddenly increase so much that consumer may not be able to afford the loan. If the loan has payment caps to control the amount of the payment changes, the consumer’s overall debt (your principal balance) may be increasing (i.e. negative amortization). Consumer does not build any equity.
Option ARMs
During the initial loan period, the consumer chooses from several payment options each month: Principal and interest for 30 years Principal and interest for 15 years Interest-only Minimum payment that does not cover the interest On a $350,000 loan with a loan rate of 6.5% and a pay rate of 1.5%: – 30-year amortization ($2,212) – 15-year amortization ($3,049) – Interest-only ($1,896) – Minimum ($1,208)
Risks of Option ARMs
How do options ARMs work? Paying the standard principal and interest will reduce the overall amount you owe Paying only the interest will not increase the amount you owe, but it will not decrease it either. Paying only the minimum will result in an increase in overall debt The interest rate on a payment option ARM is adjusted from time to time, based on the contract. If the rate increases, the payments can further jump due to this feature.
Risks of Option ARMs
For example, the minimum payment rate at that time might be as low as 1%, and the payment amount might be allowed to rise by only 7.5 % every six months or a year for a few years Important exceptions: Payment may be “recast” and the amount of the required monthly payments may be recalculated so that they will fully amortize the outstanding balance over the remaining loan term. Loan balance usually cannot exceed a rising debt amount of 110% - 125% of the original loan balance. If the increasing balance hits this high then payment is immediately raised.
Consider This Scenario
Here is what happens after five years of minimum payments: – If the loan rate remains at 6.5%, the payments jumps to $2,611 – If the loan rate rises to 8%, the payment jumps to $2,984
Option ARM Payments
$3,000 $2,500 $2,000 $1,500 $1,000 $500 $0
Initial minimum If loan rate monthly pmt remains at 6.5%
If loan rate jumps to 8%
Considerations for Option ARMs
Pros Consumer will have smaller payments at first Consumer may be able to refinance with more favorable terms or sell his house If a consumer knows his income will increase, an option ARM may be a good choice
Considerations for Option ARMs
Cons If a consumer makes minimum payments, the rest of that month’s interest is tacked onto the loan balance The consumer could end up owing more than the home is worth and be unable to refinance or sell Consumer could face dramatically increased payments in the future
New Products in the Marketplace
Fixed rate interest-only mortgages – Removes any interest rate uncertainty but future payment shock still possible – Example: $350,000 loan at 6.75% – Interest-only payment = $1,969 – Principal and interest payment after 10 years is $2,661
New Products in the Marketplace
40-year fixed rate mortgages – Advantage: predictable payment for buyers concerned with affordability – Disadvantage: modest difference in payments and the loan balance declines at a snail’s pace – On a $350,000 loan, the difference in monthly payments is just $100 by stretching out to 40 years
Miscellaneous Products in the Marketplace
“Piggyback” loans “Balloon” loans Loans with “conversion” ARMs with high “floors”
Hypothetical
What do you think? Umit and Karli should take out which mortgage product?
Alternative Mortgages
Katherine Worthman kworthman@ftc.gov 202-326-2764