Exotic loans carry big risks

Interest hikes hit mortgages

A recently purchased house in San Francisco is up for sale. Regulators are warning borrowers and lenders to be careful of nonfixed-rate mortgages because interest rates have been going up. (Justin Sullivan/Getty Images)

HACKENSACK, N.J. -- David Moro and his wife stretched their budget to the limit when they bought their center-hall C olonial in 2003. They took out an interest-only loan, which keeps the payments low for the first 10 years, but will bump up monthly payments in the future.

Moro dreads that day.

"What's getting me a little squirrelly is seeing interest rates go up," said Moro, who works in the music licensing industry in Lyndhurst, N.J. "The reality is when I went into this mortgage, I didn't fully understand it. . . . I'm not going to be able to make the payments."

Like Moro, many homeowners who took interest-only and other exotic mortgages in the past few years are starting to have second thoughts.

In the face of higher payments -- now or in the future -- many are looking for a way to protect their home investments.

And regulators are warning both borrowers and lenders to handle these loans with care.

For many home buyers, including the Moros, these mortgages were the only way to afford a house in recent years, as prices skyrocketed from 2000 to 2005.

Most of these loans have adjustable rates that start out artificially low but rise later.

The unconventional loans include no-down-payment loans and no-documentation loans, in which the borrower doesn't have to prove how much he makes. Interest-only mortgages allow the buyer to start out by paying only the interest on the loan.

In addition, option adjustable-rate mortgages let buyers vary their monthly payments -- in some cases, paying so little that the mortgage actually grows, rather than being nibbled away over time by monthly payments. These are called negative amortization loans.

"That's a scary product," said Mary Johnson, head of education at the Consumer Credit Counseling Service of New Jersey. "You can be losing equity on the home while you're making your monthly mortgage payment."

Sooner or later, of course, the principal and interest must be paid -- possibly at a much higher interest rate. At that point, the homeowner can face a painful "payment shock," with monthly payments jumping $500 or $1,000. Johnson said her group is seeing many more people falling behind on their mortgage payments, in part because they took risky loans. In addition, the Mortgage Bankers Association of America reports that more homeowners are falling behind on monthly payments on adjustable-rate loans this year, compared with last year.

"They come to us when they're two, three, four, six months behind in mortgage payments," Johnson said. Many of these homeowners borrowed more than they can really afford; others have seen their monthly payments readjust to unaffordable levels. Some are paying half of their income for shelter -- well above the one-third maximum recommended by most personal finance experts.

"We don't have an easy solution for people in this situation," Johnson said. Some people are so determined to keep their homes they take on second jobs, she said.

To protect their investments in their home, many people who started out with interest-only loans or negative amortization loans are now refinancing into fixed-rate loans, which remain inexpensive by historic standards. Moro would like to refinance to a fixed-rate loan -- but can't find one with monthly payments he can afford.

New homebuyers are also turning away from exotic loans, opting for the security of a fixed-rate mortgage.

Federal regulators have tightened lending requirements for interest-only and option loans. On Sept. 29, the Federal Reserve and other federal regulators issued new guidelines requiring lenders to better explain the risks of unconventional loans.

The new guidelines also require lenders to be more cautious about making these mortgages and carefully evaluate whether a borrower will be able to repay the loan, even if the monthly payments reach their worst-case maximum. Lenders who ignore these rules may be subject to penalties, the regulators said.

Much of the fallout from the boom in exotic mortgages hasn't hit yet. Many people took out these loans in 2004 and 2005, locking in the low rates for three to five years, or longer.

But looking ahead, mortgage professionals, borrowers, and regulators are worried.

Alex Giassa, a mortgage consultant with First Interstate Financial in Shrewsbury, N.J., said he has a client who chose an option ARM but can't pay all the interest every month. So it is being added to the body of the loan.

"Her mortgage balance has increased by almost $20,000," Giassa said.

Worse yet, many of these home buyers have seen the value of their properties decline as the housing market has slumped over the past year. They may now be underwater on the loan -- owing more than the house is worth.

"It seems un-American to say this, but not every person should own a home," said Thomas Laird, senior vice president for lending at Hudson City Savings Bank in Paramus, N.J., which avoids unconventional loans. "You don't want to get someone into a house if they can barely qualify for a loan " because those are the people in danger of losing their homes when their payments inevitably rise.

Another example: People finishing up law, medical or graduate degrees. They have low current incomes but good prospects. The loans also could work for people who are planning to move in a short period, who can take advantage of the lower rates and get out before the higher payments hit.

Michael Olin and his wife, Dana Defonte, fell into those two categories. When they bought their Hoboken, N.J., condo in 2004, Olin was still in graduate school.

He has now finished his degree and is working as a college administrator. The couple also recently had their first child.

"We chose the interest-only mortgage because I was still completing my doctoral degree at the time of our purchase, and we wanted to keep our monthly payments as low as possible," Olin said. Taking the interest-only loan cut their monthly payments by about $150, although it also meant they built up no equity through mortgage payments. The only equity they gained was derived from a rise in housing values, which increased in 2004 and 2005 but have flattened this year.

Olin and Defonte plan to move within the next year or two because they need more space.

"Taking the interest-only loan has definitely helped with our finances over the past two years," Olin said. "It was a bit of a gamble taking this loan, but I think it has served its purpose for us, and should continue to do so until we move in the next year or so."