There is another new wrinkle in home mortgages getting a lot of press. The
option style mortgage (with marketing names such as
Power Option or
Cash-Flow mortgage) has been around fairly quietly since at least 2002
but has been gathering interest as house prices have increased and buyers and
mortgage providers alike strive to keep payments affordable. It is, as most new
mortgage products are, a modification of older products that have been around
forever. Option mortgages appear to be a modification of, well of almost
everything, including the 30 and 15-year fixed rate mortgage, ARMs, and
interest only loan payments and with a sprinkle of
negative amortization.
The
option mortgage is
well named. Borrowers have four separate alternatives that they can invoke, not
when they take out the mortgage, but every single month. There are probably a
number of variations on the option mortgage theme, but here are some of the
common denominators we found.
The option product is an adjustable rate mortgage; a caffeine stoked ARM. One
of the biggest selling points is an incredibly low initial interest rate, some
as low as 1 percent. Notice the words "initial rate." "Teaser rate" is probably
more appropriate and borrowers should enjoy it while they can. The
option arm mortgage adjusts frequently, every few months or
even every month, based on an index such as the London Interbank Offered
Rate (LIBOR) plus a margin set by the lender. Therefore, as with a
traditional mortgage, if the LIBOR index or other index goes
up, the mortgage rate rises with it, only much more frequently. Nothing we have
read indicates whether these loans have a rate cap that controls the speed of
rate increases or the lifetime maximum interest, but given the low initial rates
that first step is bound to be a doozie. Many do seem to have a period during
which the initial "teaser" rate is fixed. One lender advertises "for up to 60
months." But "up to" are among the world's best weasel words.
The option part of this loan however comes in the many alternative payments
that the borrower can make. Most of the option loans allow the borrower to make
a decision, each and every month, as to the payment they will make.
A payment based on a 30 year amortization table which, if made every
month, will pay off the mortgage, in 30 years of course.
A payment based on a 15 year amortization table.
An interest only payment. The principal balance will remain
unchanged after the payment is applied for that month. The programs we looked at
did not seem to put a limit, at least in their marketing materials, on the
number of months this option could be utilized.
A partial interest payment in which part of the interest is deferred
and added to the principal balance (where one would assume it also accrues
interest.)
One company illustrates these four mortgage payments with the following
examples based on a $400,000 mortgage, a LIBOR of 1.318 percent (today the
3 month current LIBOR rate is 3.5045), and a margin of 2.55
percent. The initial start rate for the minimum payment (the teaser rate) is
1.95 percent.
The minimum amount due would be $1,468.50
The interest only amounts would
be $1,679.59
The 30-year amortization payment would be $1,879.35
The
15-year amortization payment would be $2,932.36
Promoters of these products make a number of points about their advantages.
For example:
- The borrower can tailor loan payments to achieve short and long term
financial goals.
- Borrowers can budget so to adjust to seasonal variations in income or
irregular expenses such as home heating costs or tuition payments.
- Borrowers have greater flexibility in managing tax deductions.
- Borrowers can use the money saved by making interest only or less than full
interest payments to invest, consolidate debt, or add to college or retirement
funds.
The above will pass without editorial comment, but here are some questions
you should ask if you are contemplating such a loan product.
- How long is the initial rate fixed and how often after that will the
interest rate adjust?
- Is there a cap that limits any single increase or the lifetime increase?
- Is interest charged on the interest that is added to the principal?
(Probably a dumb question, but you need to know and factor it in to
decision-making.)
- What is the underlying index of the loan (then check to make sure it is one
you can easily monitor to keep the lender honest) and the margin (most seem to
be in the 2.25-2.55 range).
- If you frequently utilize the less than full interest payment option, is
there a point at which your loan to value ratio will trigger a penalty? For
example, if you have 80 percent LTV at loan inception and accrued interest
drives that up to 85 percent; will the need for some type of mortgage insurance
kick in? Might the interest rate carry a penalty kicker under that scenario?
Might you now be required to make a fully amortizing payment (perhaps at a
financially inopportune time.)
The availability of option loans and the increasingly
popular interest only loans have triggered some anxiety among banking
regulators. Realty Times has published a report that federal regulators were
taking a look at both of these mortgage types and that they "could be reined
in." The report, based on an interview with Barbara Grunkemeyer, Deputy
Comptroller of the Currency, said that the current examination is likely to
result in new guidance for banks and other regulated lenders vis-?vis their
underwriting and credit standards for these loans but that this would not
necessarily restrict their availability.
Federal regulators have little control anyway over mortgage companies which
are largely state licensed and regulated.
For the reasons used by lenders to promote their products as stated above,
these are intriguing loans. But, as can be clearly seen there are a lot of
hazards - interest rates that could take off and drag payments along behind them
with a higher rate of acceleration than regular adjustable rate mortgage loans;
the possibility that the principal balance will be higher in years two, three,
or four than at inception. The latter coupled with any decline in housing values
could leave a borrower in a fine mess indeed should he need to sell the
home.