Exotic Mortgages 101
Smartmoney.com has a basic facts article detailing some of today's exotic mortgage products, their pros and cons, as well as who make up the ideal customers for each loan.
They acknowledge that with skyrocketing home prices fewer people were able to afford to buy a home. Therefore the mortgage lending industry has become quite creative and now offers a whole host of lending options marketed under the guise of "affordability products."
Smartmoney does make mention that while lower payment options may make over-priced homes affordable, these loans also present risk. While they take a rather simplistic and neutral approach to explaining these products, they don't discuss that the real risk isn't just the terms of the loans, but the reality of the riskiest loans being in the hands of those who can least afford them.
I heard a story recently about a retired grandmother with only modest retirement income being offered a negative amortization loan to buy a million dollar house. This apparenly was not a lady with a large stash of cash in the bank, under a mattress, or due to her from some maturing annuity. There was no second income, and she wasn't much away from being fixed income. This was someone's grandmother who clearly is not sitting on cash reserves.
I think the real risk not covered in Smartmoney's article is that not only are some of these loans in less than ideal hands, but that they were put there by people who are supposed to be professionals presenting appropriate products for the customer. Somehow I doubt that a grandmother with a small retirement income is the ideal candidate for a negative amortization loan for a million dollar McMansion. If one mortgage broker can make such a recommendation knowing full well the circumstances of the potential borrower, how many more brokers are doing the same thing, and have done the same thing?
(Smartmoney's list of mortgage products)
1. The 40-Year Mortgage
These products are similar to 30-year fixed-rate mortgages, except that borrowers stretch the payments out for an extra 10 years. Lenders, however, charge a slightly higher interest rate, up to half a percentage point, according to Bankrate.com's Greg McBride.
Pros: A 40-year mortgage offers lower monthly payments than a 30-year loan, while locking in today's attractive interest rate. On a $300,000 mortgage at today's prevailing interest rates (6% for a 30-year and 6.25% for a 40-year), a home buyer could save nearly $95 each month.
Cons: By extending the length of the mortgage, the borrower increases the amount of interest paid over the life of the loan. On that same $300,000 mortgage, a home buyer would spend an additional $170,030.42 using a 40-year mortgage.
Good For: Experts recommend this product only for first-time home buyers who don't plan on staying in the house for more than a few years, and who can't afford the higher monthly payment associated with a 30-year mortgage.
2. The Portable Mortgage
In 2003, E*Trade launched a program called Mortgage on the Move. It allows home buyers to lock in today's low interest rates and take the loan with them should they move into a new house a few years down the line. A second mortgage can be used if the buyer needs to borrow more money for the next home.
Pros: With current mortgage rates low — and by most estimates likely to rise — locking in today's rate for the next 30 years is attractive.
Cons: Interest rates for portable and second mortgages come at slightly higher interest rates than do standard loans. A portable mortgage is priced at 3/8 to 1/2 a percentage point higher, and a second mortgage is often 3/4 of a percentage point higher than a typical 30-year fixed-rate product, says Robert Snow, vice president of retail lending at E*Trade Bank.
Good For: People who know they will be moving in a reasonable amount of time and want to lock in today's historically low rates.
3. The Interest-Only Mortgage
With an interest-only loan, lenders allow borrowers to pay just the interest portion of their mortgage during the first, say, 10 years of their commitment. After that, the loan essentially becomes a new mortgage with new interest and principal payments stretched out over just 20 years.
Pros: In addition to smaller monthly payments during the interest-only repayment period, all of the money a borrower puts toward the mortgage during this time period is tax deductible.
Cons: Should home prices stagnate, homeowners would build up no equity during the interest-only years. Also, monthly payments jump significantly once the principal-payment period begins. Most of these loans also carry variable interest rates, further increasing a borrower's risk for higher monthly obligations.
Good For: Young lawyers, doctors, MBAs and others who know (and remember, there are no guarantees in life) that their incomes will rise significantly over the next few years. Interest-only loans can also be a good option for professionals who receive bonus payments as part of their compensation. This product allows them to make minimum payments during most of the year when cash is tight and then put down several thousand dollars toward principal when they get their bonus checks.
4. The Negative Amortization Mortgage
This interest-only product allows buyers to pay less than the full amount of interest necessary to cover the costs of the mortgage. The difference between a full interest payment and the amount actually paid each month is added to the balance of the loan.
Pro: An even smaller monthly payment than an interest-only mortgage, during the first few years of the loan.
Con: This is the riskiest mortgage lenders offer. Should housing prices stagnate or fall, buyers would find themselves "upside down" or in "negative equity," meaning they would owe money to the lender if they sold their homes.
Good For: Sophisticated borrowers with large cash reserves who want the flexibility of lower payments during certain parts of the year but plan to pay off their loans in large chunks during other parts the year.
5. The Flex-ARM Mortgage
This is a cross between a hybrid ARM, which offers a lower fixed rate during the first five or seven years and then adjusts annually, and a negative amortization loan. Each month the lender sends the borrower a payment coupon that calculates four possible payment options: a negative amortization, an interest-only, a 30-year fixed and 20-year fixed. The homeowner then decides how much he wants to pay. (Some mortgages offer only an interest-only and a 30-year fixed option.)
Pro: The bank does all the thinking. Each month it recalculates the balance and tells the borrower how much he or she would owe under different scenarios, giving the homeowner significant flexibility.
Con: Borrowers could end up owing more money on their mortgage than they can fetch for their homes.
Good For: People who like options and have large cash reserves for when the mortgage payments increase during the later portion of the loan. Like interest-only loans, Flex-ARMs are good tools for those who derive much of their income from bonuses, says David Herpers, director of consumer affairs for online lender Amerisave.
6. The Piggy-Back Mortgage
This product is actually two mortgages. The first covers 80% of the property's value. The second, which comes at a slightly higher rate, covers the remaining balance.
Pro: In most cases, homeowners save money by taking out a piggy-back loan (also known as a combo loan) since it allows them to avoid paying costly private mortgage insurance when buying a home with less than a 20% down payment. Plus, the money that would have gone toward PMI is now tax deductible, since it's going toward an interest payment.
Con: As we mentioned, borrowers pay a higher interest rate on the second mortgage. And rates can vary greatly depending on credit score. Also, since the borrower has little equity in the home, should it fall in value when it's time to sell, the borrower would need to pay the difference in cash, warns Mark Prather, president of Mark 1 Mortgage, a Cerritos, Calif.-based mortgage lender.
Good For: Young professionals with relatively high salaries but little savings.
7. 103s and 107s
Who needs a down payment? Nowadays, people can even borrow 3% to 7% more than the house is worth.
Pro: There's no up-front cost to move into a home. The buyer can borrow the money needed for closing costs and have some left over for home repairs. Closing costs are typically 1% to 3% of a home's total value.
Con: Interest rates for these products tend to be high. Pete Bonniker, a senior vice president at E-Loan, says borrowers would be better off in a combo loan. And like piggy-back loans, borrowers run the risk of negative equity if the house loses value.
Good For: People with large cash reserves who prefer to invest in, say, the stock market rather than tying up their assets in real estate.
8. Home Equity Line of Credit
They aren't only for existing homeowners anymore. Known in the industry as HELOCs, these products let buyers finance original home purchases using a credit line rather than a traditional mortgage. HELOCs are variable-rate loans tied to the prime rate, which now sits at 4%. If a HELOC is used as a first-position loan, all of the interest is tax deductible, says Amerisave's Herpers.
Here's how it works: The buyer makes a down payment, and the credit line covers the rest. HELOCs typically cover up to 90% of the appraised value of the home. Lenders also offer up to 100%, at significantly higher interest rates.
Pro: In this environment, HELOCs offer much more attractive interest rates. A 30-year fixed-rate mortgage now carries a 6% interest rate, according to HSH Associates, a mortgage-information firm based in Pompton Plains, N.J. Borrowers can also take out additional funds against the equity in their homes without hassle or additional cost.
Con: Most HELOCs are structured for just 10 or 20 years, rather than the customary 30. And since the interest rate is variable, payments can be volatile, and can rise substantially higher alongside the prime rate.
Good For: People who plan on paying off their home quickly but want the flexibility of access to more cash at a moment's notice.
9. Loan Modification Mortgage
With this loan, the borrower can subsequently change the terms just by making a phone call, with a capped closing cost each time of just $1,000 for every million dollars borrowed. Moreover, the mortgage's duration isn't changed each time the rate is modified.
Pro: No paperwork is necessary, and closing costs are kept to a bare minimum.
Con: The added flexibility comes with a price tag of roughly 3/8th of a percentage point on every type of loan.
Good For: People who like to follow interest rates. But borrowers should make sure to factor in the $1,000 fee every time they consider modifying their loan. Ron Chicaferro, president of Thornberg Mortgage, says most of his customers have financial planners who manage their mortgages for them.
10. Short-Term Hybrids
Like traditional hybrid adjustable-rate mortgages, these short-term ARMs offer fixed-rate periods and then the interest rate floats with the index they're tied to. But since the fixed portion is for a very limited time — say, six months or one year — lenders offer very competitive rates.
Pro: Very low interest rates during the fixed portion of the loan. The initial monthly payments are relatively small.
Con: Six months or a year can pass by in the blink of an eye — and rates can change dramatically during that span. Back in July 2003, for example, Charles Schwab offered a six-month ARM with an interest rate of 2.995%. Today, that same product sits at 3.75%. On a $250,000 loan, that would mean an increase of $125, says Richard Musci, chief marketing officer for Charles Schwab Bank.
Good For: People who plan on moving in a very short period of time.