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.