Use caution with 2 types of attractive mortgages

By Al Heavens, Philadelphia Inquirer Columnist 6/26/06<br /><br />There’s growing worry in official Washington, as well as in the frothier real estate markets of Florida and California, about a couple of potentially problematic mortgage products.<br />I’m talking about mortgages that offer interest-only options and something called an option adjustable-rate mortgage.<br /><br />Both are attractive to prospective buyers who are looking to buy more house with little money. Their popularity reflects the phenomenal growth of the subprime loan market, which caters to borrowers with blemished or limited credit histories.<br /><br />Subprime loans carry higher rates of interest than prime loans, to compensate for increased credit risk. On June 3, Federal Reserve Board governor Edward Gramlich said the subprime market had been growing about 27 percent a year, based on preliminary data he had seen.<br />That translates to $530 billion, or 19 percent of the mortgage-loan market in 2004, versus about $35 billion and 5 percent of the market in 1994, Gramlich said.<br />That preliminary data indicated that African Americans and Latinos were more likely to be in the subprime market.<br /><br />According to the U.S. Department of Housing and Urban Development, studies show that even in upper-income African American neighborhoods, a homeowner is 11/2 times as likely to have a subprime loan than a homeowner in a low-income white neighborhood.<br /><br />In neighborhoods where Hispanics make up at least 80 percent of the population, they are 11/2 times as likely than borrowers as a whole to have subprime mortgage loans.<br />Concerns about subprime lending aren’t new. Gramlich, anticipating Fed chairman Alan Greenspan’s comment to Congress June 9 that “the apparent froth in housing markets may have spilled over into mortgage markets,” suggested on June 3 that the government may need to look into loan products that could be “problematic.”<br /><br />Since he didn’t identify which products he considered potentially problematic, I can only assume Gramlich was alluding to loans with interest-only options. I think I can safely add option ARMs to that category.<br /><br />Interest-only loan options, which National Association of Realtors chief economist David Lereah has dubbed “renting from a bank,” mean that you don’t pay on the principal for a set number of years.<br /><br />It’s not that interest-only options are evil. They have, for example, helped legitimate investors (who buy properties and rent them) stay in the market after rising home prices made such investments unprofitable.<br /><br />Home equity loans can be interest-only, too, and they’ve been around forever.<br />Interest-only options are good for a buyer who wants more house but isn’t planning to stay in it for more than a few years. Because they involve more risk for lenders, the fixed-rate options tend to be one-eighth to one-quarter point above conventional. In the last few months, the rate spreads on adjustable-rate options have narrowed considerably.<br /><br />These options also benefit people who buy a new house before closing on their previous house. Say you’ve taken out a five-year, $500,000, 3.875 percent adjustable-rate mortgage with an interest-only option on the new house and are paying about $1,600 a month. You sell the old house, take the $250,000 or $300,000 you made on the sale, and reduce the principal by that amount.<br /><br />With a conventional mortgage, you’d have to refinance, which you should do anyway before the five years are up. By then, the interest rate could double and so could your monthly payment.<br />Interest-only is a good short-term option for people who know what they’re doing.<br /><br />Then there are the option ARMs, which <a href=””>Fred Glick, president of U.S. Loans Mortgage of Philadelphia</a>, calls evil incarnate: “I won’t even do an option ARM unless the person applying for one knows as much or more about them than I do.”<br /><br />Option ARMs can have teaser rates as low as 1 percent. Borrowers are given four different choices of how much to pay every month. The minimum-payment option is so low it might not cover the interest due.<br /><br />Whatever is not paid is added to the principal, known as “negative amortization.” It means you lose the equity on the money added to the principal.<br /><br />Freddie Mac and Fannie Mae buy loans with interest-only options. Only Fannie Mae buys option ARMs.<br /><br />Though Glick handles a lot of interest-only products in other parts of the country – in Maryland, they account for 80 percent of the market – the numbers here are much smaller.<br />”We tend to be conservative here,” he said. “But if home prices continue to rise, that could change.”

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