Toxic Loans & The Art of Denial
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There’s an idea which has been voiced with more and more frequency and it generally goes like this:
I have a toxic loan but why worry? After four years or so — just before the monthly cost of this loan doubles — I’ll just go out and get another interest-only or option ARM, begin the start rate all over again and then have low monthly payments for another four or five years. Since this is so easy, why be concerned?
“The idea of refinancing one toxic loan with another — superficially at least — offers a certain element of logic and reason,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the largest marketplace for foreclosure properties.
“But when you look at the potential liabilities it becomes clear that a strategy of repeated toxic-loan replacement will be a formula for disappointment if not disaster for many borrowers.”
With a typical interest-only mortgage the borrower can elect to make interest-only payments for the first five years. With a $300,000 loan at 6.25 percent the monthly cost for principal and interest during the first five years would be $1,562. At the end of five years — having paid interest worth $93,750 — the loan balance remains $300,000.
After five years the loan must be amortized; that is, monthly payments must be sufficient to pay down the loan over the remain loan period — 25 years in this example. Assuming the interest rate does not change — a wildly implausible assumption if the loan is adjustable — the new monthly payment for principal and interest will be $1,979.
Of course, if the interest rate rises then the numbers begin to change radically: The monthly cost would reach $2,120 at 7 percent and $2,315 at 8 percent.
The situation with an option ARM could be substantially worse. With such financing borrowers during the first five years can make monthly payments sufficient to repay the loan in 30 years or 15 years. They can also make interest-only payments or they can make low payments which produce “negative amortization” — an expression which means the monthly payment is insufficient to cover even the cost of interest, so what’s not covered is added to the loan balance.
If we have a $300,000 option loan with a 6.25 interest rate and a 1.25 percent start rate, the initial payments for the first five years would be $1,000 per month. Of course, this payment would mean that $563 in interest was not being paid, an amount added to the loan balance.
After 60 payments the loan amount would be nearly $325,000, the loan would be re-set and the minimum monthly payment for principal and interest would be $2,126 — assuming (foolishly) that interest rates never rise.
Okay, so here we have two loans which both feature wondrously-low monthly payments during the first five years. If an owner doesn’t sell during the past five years, why worry about higher monthly payments when such loans can be refinanced with new mortgages that again offer low monthly payments?
Here are eight reasons why refinancing “nontraditional” loans with a new round of similar mortgages may be destined to fail.
First, someone who qualified for financing five years ago might not qualify today. A job may have been lost, credit may have been damaged or income may have declined.
Second, the house may not support a full refinancing, especially if the loan’s principal amount has increased. Real estate values do not always rise and they do not always rise in all places. There’s no guarantee that a home will have sufficient value in five years to justify the loans available today. If a home cannot be refinanced in full, an owner would need cash to pay off any part of the old loan which cannot be refinanced. Of course, if an owner does not have that cash then the first loan cannot be refinanced.
Third, income qualification standards may change. It may be that today’s income and debts will be sufficient to qualify for our model $300,000 loan, but if loan standards tighten then even if incomes remain stable or increase it’s possible that a borrower will not be able to fully refinance an existing debt.
Fourth, equity requirements may evolve. Today it’s fairly easy to buy with 5 percent down — or less. But there’s no assurance that more won’t be required. For instance, if lenders in five years require 10 percent equity, then someone seeking to refinance a $300,000 loan would need a home that appraises for at least $333,333.
Fifth, interest-only and option ARM financing may not be widely available in five years. As lenders get more experience with “nontraditional” loans they may limit such financing to borrowers with exceptional credit and resources — and some may stop offering such loans entirely.
Sixth, interest rates could rise. We’re currently in a period where interest rates are low by the standards of the past fifty years, but it’s entirely possible that rates could rise sharply in the future. Even a minor increase. say from 6.25 percent to 7 percent or 7.5 percent, would strain many budgets — and bankrupt others.
Seventh, owners may need to move for a new job or another reason — even if the value of the home after marketing costs is less than the mortgage. In such a situation an owner might be required to bring cash to closing or could be forced to accept a loan from the lender for the missing money. In one case you would have less cash to purchase a replacement property while in the other you would have less credit to secure another mortgage.
Eighth — and perhaps most importantly — “the financial purpose of owning real estate is not to create perpetual debt,” says RealtyTrac’s Saccacio. “Instead, the path to wealth for most people has been to have a home which appreciates in value, debt that’s reduced over time and monthly housing costs that eventually decline relative to income. This is the formula which has been used by households nationwide to provide for college educations, retirements, better living and inter-generational inheritances.”
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Published originally by RealtyTrac.com during December 2006 and posted with permission.
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