Posted on 07/25/2005 10:43:25 AM PDT by hripka
I have tried to devise the absolute worst mortgage loan that I can imagine. Fortunately, this loan is nothing more than a figment of my imagination -- at least, as far as I know. But take a cynical guy like me with a looming deadline and this is what you get.
This fictional loan would contain many of the elements that appeal to borrowers hemmed in by affordability. Like today's option, adjustable-rate mortgages, borrowers would be able to choose an interest-only payment or even a minimum-payment option. While the borrower is lured by the minimum payment, what results is a loan balance that grows through the initial years of the loan. This is known as negative amortization.
What is worse than making a payment so low that it doesn't cover the interest? Not making a payment at all. The option to skip a payment or two each year makes the eyes of prospective borrowers light up.
There is a trade-off many borrowers are unaware of: The lower the initial rate, the quicker the rate begins to adjust upward. How many people are in this boat? According to the Mortgage Bankers Association, more than half of ARMs originated in the second half of 2004 face the first rate adjustment within three years. So accordingly, the rate on this mythical loan would adjust monthly and would be pegged to an index such as the three-month LIBOR, so that rising interest rates impact the borrower immediately.
The day of reckoning does ultimately arrive as repayment of the loan balance must begin, at least in some modest measure. To limit the payment shock on this loan, the loan balance will be amortized over 40 years, 10 years longer than the old standard. While the future payment shock is reduced, so is the accumulation of equity.
OK, so I have devised a way to shield the prospective borrower as much as possible from the burden of mortgage payments, at least for the first few years. But how should I address the lack of available funds for a down payment and be marketable to borrowers that don't have a steady paycheck or have launched their own businesses? These contingencies are covered through the no-down-payment, no-documentation feature. By making 100 percent financing available on this product, no down payment is necessary. Neither is the need to prove your income. We'll take your word for it.
This loan would also have two features that are profitable to lenders -- a prepayment penalty and balloon payment. According to a survey by the University of North Carolina, the presence of a prepayment penalty increases the risk of foreclosure by 20 percent, and the presence of a balloon payment increases the foreclosure risk by 46 percent.
The presence of both on the same loan would indeed be rare, but we're talking worst-case scenario, so why not? The borrower would have limited flexibility if either provision were present and would be effectively handcuffed in the case of both. A balloon payment mandates a future refinancing on the lender's timetable and a prepayment penalty limits the ability to refinance on something less than the lender's timetable.
As I noted previously, such a loan doesn't actually exist. Or does it? Each of the components that make it so dreadful exists on other loans currently being offered. The continual evolution of mortgage products is justified with the lip service of "appealing to borrowers with unique cash needs." But the frothier the housing market gets, the riskier new mortgage products become. And unfortunately, borrowers are lapping these up as quickly as the products come to market.
With a loan like this, a borrower with unverifiable income, poor credit, no savings and a tight budget could buy a ridiculously expensive home and be perfectly positioned for the rocket ship of future home price appreciation that will surely continue forever. After all, this is the American dream, right?
On second thought, the idealistic scenario could give way to the reality of a budget-busting financial commitment that leads the borrower into a downward financial spiral. Instead of counting on the best-case scenario of low rates, rock-bottom payments, sizzling home price appreciation and maximum household earnings, it does pay to consider a less favorable, and perhaps inevitable, scenario. Household emergencies do arise and income can drop due to a variety of reasons from illness to job loss or reduction of overtime. That home-based business may not get off the ground as originally envisioned.
Rising interest rates spell higher payments in the future and continued price appreciation is hardly assured. Mix together one too many of these conditions with a loan designed to address affordability only on closing day, and the safe haven of the home could be something far different to household finances.
Naaah. The housing bubble will never pop...
People make negative amoritization payments for two years (give or take a few months) and then due to re-location, job-loss, transfer, divorce, etc. are forced to sell their home when they have no equity.
Then what?
It should pop for someone who chooses an interest only-adjustable-balloon payment loan. Foolish money practices.
"California real housing prices have increased 80% since 1997, which is a greater gap than anywhere but Washington, D.C. According to Christopher Thornberg, senior economist and speaker at the 54th UCLA Anderson Forecast held June 21 in Westwood, Californians are “spending like it’s a full recovery.” And it is not.
A housing cooldown with a soft landing, as well as an economy that will grow only incrementally, is what is in store, according to Thornberg. “The housing market has to start cooling, and when it does, it’s going to have an influence on people’s spending behaviors and that’s going to be a big drag on the state’s economy.” A recession may be in the works, though probably not until 2007. However, for those living for home appreciation, here is his prediction: “In 2011, your house will likely be worth what it is today.”
Thornberg says California is overpriced, particularly for a growing group of residents. “A lot of the population growth in California is low-skilled immigrants who are not making a lot of money and can’t even afford a normal apartment. What we have a shortage of here in California is low-income apartments and we’re not building those now and we’re not going to build them when this thing cools down.”
He asks, “Should you buy a house right now? As long as you’re comfortable with the fact that it’s a low-return investment, then by all means, feel free.”
I bought a car on a variable rate loan in the 1980's and got bitten by that. My 9% loan? Hah, it's 14% after 3 months. I looked at the papers and checked the WSJ for the index they based it on and it would have been 14% from the beginning except they had a cheap rate until the first rate adjustment date. 17 years later and I'm still bitter about it.
One of the new trends in the EU are ZERO percent interest loans. They are done with an eye towards forclosing on the land rather than just making money from loans.
If you throw in the reapair costs up front
( like the old 203b loans...house is worth 100k but 200k if fixed up...FHA/HUD used to finance the 200k from the get go, plus roll all closing costs into the loan)
then I'll take it ! :)
They're already here. Quicken Financial is offering such a program (I think they call it "Smart Choice"). It may actually be a fine program for a speculator, but for someone who plans on staying in their home it's anything but "smart."
Nobody in California thinks that equity is accumulated by making payments. Payments are just the nuisance fee (to be kept as low as possible) you pay to own something that always goes up 30% a year, with no exceptions. ;)
"What we have a shortage of here in California is low-income apartments and we’re not building those now and we’re not going to build them when this thing cools down.”
Low-skilled immigrants are very good at creating their own low-income apartments - all they have to do is choose a moderate-income complex, and move in in large numbers.
Been there. OOPS! .... AM there!
Interest ony loans in Maryland have been running about 25% of all new loans issued.
I figure I will be in a position to buy my first home in about 4 years. Hopefully the real estate bubble will have popped hard and I can snatch up properties for a song.
/Evil Laugh and rubbing hands together
I am thoroughly convinced that 95 plus % of the American people have no more financial knowledge than they did when they were children. What is amazing is that a good many of them run their own businesses or help manage corporations. If they are getting suckered in their private lives, than what about their own business decisions. It's not like mortgages and compound interest are rocket science - these are the basics! Scary man - so many people don't even have the basics. Maybe I'll get into the foreclosure recovery business now, and be situated for all the business that is one the way in that field!
Since MOST people do not stay in their homes longer than 3 years, it actually does not make financial sense to get a fixed rate loan.
That said, most of the McMansions here run $800,000 and up and the majority are interest only loans. As you drive by you look in and see most rooms are bare of furniture. That's REALLY living on the edge.
Then what?
They have a lot more money in their pocket because they had a lower rate than they would of had under a fixed rate loan....
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