“The U.S. mortgage giant Freddie Mac said it would no longer buy those high-risk home mortgages that it deems to be the most vulnerable to foreclosure. The surprise move came amid a deteriorating market for subprime loans affected by slumping home prices and rising interest rates.” (See: Freddie Mac tightens home mortgage standards, The International Herald Tribune, Feb. 28, 2007)

But the fact is that home prices are not slumping in some local markets and interest rates are plainly at the low end of historic norms. Such factors are simply not the root cause of today’s mortgage instability.

Instead, problems in the subprime mortgage market — and a growing sense of problems in other parts of the mortgage universe — are the result of dicey loan concepts that turned out to be exactly what any lucid person would expect: risky beyond reason.

Who could have known such things? Anyone with common sense, including readers of this column.

Let’s begin with interest-only loans. These are mortgages where borrowers do nothing to reduce the principal for the first several years of the loan. Once the interest-only “start period” ends then the loan must be repaid at the fully indexed and fully amortizing rate. Given that most interest-only loans are adjustable, and given that fewer years remain after the end of the start period, it follows that such financing will inevitably require higher monthly payments.

“There’s no doubt,” it said here in 2004, “that the newest trend in real estate financing is the interest-only loan, a trend which needs to be examined with care by anyone who prefers to avoid poverty.”

Moreover, said the column, “with an interest-only loan your initial monthly cash payments each month will be — and be sure to read the rest of this paragraph — lower than with a self-amortizing loan of the same size and with the same rate and terms. However, the interest-only borrower has more debt for a longer period and thus higher total costs. And if rates rise, monthly costs and overall interest costs could be substantially larger than with fixed-rate financing.” (See: The Beauty Of Interest-Only Loans — And The Beast, November 30, 2004.)

The reality is that buying homes with little down has always been risky, something that should neither shock nor surprise anyone. Just look at what the New York Times wrote — in April, 2000.

But what happens if housing values or the economy head south — particularly if a homeowner has a huge mortgage and no appreciable equity? Experts like Peter G. Miller, author of ”The Common Sense Mortgage” (Contemporary Books), warn that buyers who suddenly need to sell will face brokerage fees and related costs that they will have to pay out of pocket. ”Where do you get the cash?” he asked. (See: PERSONAL BUSINESS; Zero Down, And Maybe Something To Gain, The Sunday New York Times Business section, April 2, 2000)

Home prices have risen substantially since 2001 and thank goodness. While those in real estate prospered the stock market largely took a snooze during the same period. The catch, as noted in 2005, was that “the only way we’re supporting high real estate prices is by fudging traditional rules. We allow people to buy at levels that would have been unaffordable under past lending standards.”

“Playing mortgage roulette is fine as long as everyone realizes there are massive opportunities to lose.” (See: Are We Facing A Recession? September 13, 2005)

Is anyone “surprised” that a number of lenders are now in trouble — and that their backers are also taking losses? Why? Some of the risk represented by “non-traditional loans” can be offset by rising home values. But two years ago it was pointed out that if home values do not rise — and they plainly have not in many areas during the past year — then “lenders may be using ARMs to offset future rate risk, but what about future asset values? Is it worth originating loans today which may sink lenders tomorrow? A large number of foreclosures won’t look good on anyone’s books, reason enough to tighten ARM loan standards.” (See: Wrong-Way Borrowing Threatens Borrowers, Lenders, June 7, 2005)

One of the most widespread of the new financing concepts seen during the past few years has been the use of “stated-income” loan applications.

In the summer of 2004 it was explained that “stated-income loans represent too much risk for lenders — and too much temptation for borrowers. Perhaps a little rigidity in the lending process is not so bad. After all, how hard is it to produce tax returns and pay stubs? (See: Should Lenders Dump No-Tell Loans? July 27, 2004)

“What’s obviously best is to get the numbers right when making a loan application,” it said here in November 2004. “It’s equally obvious that ’stated income’ mortgages open the vault to temptation. Such no-tell loans ask borrowers what they earn and the borrower then puts down a number. Unlike a typical mortgage application, the lender usually does not verify the figure with tax returns, pay stubs or calls to employers.”

Of course, if it happens that those self-estimates of income are off a touch then lenders will have problems.

“With a growing number of stated income loans on the books, financing with exaggerated numbers could quickly become a lender concern if home values dip, the economy slows and monthly payments don’t show up. That’s the point at which stated income loans will come home to roost.” (See: How Much Is Too Much? November 16, 2004)

It’s hard to look at the tough times now facing the mortgage industry without mentioning the worst of the worst, the option ARM combined with little or nothing down plus a stated-income loan application.

Here’s a loan concept which gleefully allows borrowers to make payment after payment that will not even cover interest costs. Obviously — no “surprise” here — the loan must be repaid at some point which means that monthly costs must rise if the loan is held past the start period.

As stated here in 2005:

“In the next two to four years we’ll see elective payments end for many option loans. Then we’ll find out who should not have bought and who should not have loaned. Don’t be surprised if a lot of cheap real estate floods the market — and don’t be shocked if the value of your home is impacted as a result. As to lender share prices and dividends, how attractive will such companies appear when huge numbers of loans are unpaid, especially if in many cases the size of the debt exceeds the value of the underlying properties?

“Alternatively, if we restrict option loans now by regulation or lender choice, the pool of buyers will shrink and home prices will be under far less pressure to go up. We will see less appreciation and even price declines in some local markets. Acting now we may face moderate and tolerable declines in market activity, an opportunity which should not be ignored in the face of the financial calamity which looms ahead.” (See: The Case Against Too Many Options, June 28, 2005)

The growing number of loan failures has produced a rising volume of foreclosures. RealtyTrac.com reports that foreclosure actions rose from 885,468 in 2005 to 1,259,118 in 2006 — a 42 percent increase.

The huge number of foreclosure means that we have a growing supply of distressed properties, properties which are often available at discount. Even a small number of foreclosures can drag down local real estate prices.

“To believe that an increasing number of foreclosures will not have a marketplace impact is neither logical nor believable. Just ask the people in the subdivisions and condo projects where developers have recently cut prices on just a few units. (See: Foreclosures — No Worries, No Vision, May 5, 2006)

At this writing we have evidence that home values have fallen in about half of all major metro areas. The problem, of course, is that we really do not know the extent of value declines and thus cannot project future loan failures and foreclosure levels.

“While unit sales are easy to track, data regarding recorded prices is less certain. If you have a strong sellers market you can bet that sale prices are indeed what people paid because sellers have no need to offer discounts and buyers will not pay any more than required. But if you have a market that’s losing steam, the same assurance is not plausible.

“The problem with slowing markets is that sale prices may not tell the whole story. Sale prices may be discounted, and the extent of those discounts cannot be reliably estimated.” (See: A Time For Yellow Flags, November 28, 2006)

A major part of the problem has been the untenable view that home prices only rise. Does anyone believe that? Apparently a lot of people did, which is unfortunate:

The prevailing theory seems to be that higher monthly costs are not a problem because one can just sell the underlying property. But such thinking assumes that property values will rise — and that is not guaranteed. If property values merely stay the same large numbers of people in the next few years will be both unable to make monthly payments and unable to sell for enough to pay off growing mortgage debt. (See: Exit Strategy: What If There Is No Way Out? November 1, 2005)

The news today is concentrated on the subprime market, but guess what? This is not a problem that can be contained to poor and marginal borrowers. A lot of well-funded entrepreneurial people bought with toxic loans and they too will be facing tough times as required payments rise and in too many cases property values fall.

“We now have a large percentage of loans that involve negative amortization and potentially huge payment increases. It’s impossible to believe that some portion of these loans — and perhaps a large portion — will not result in financial disaster.” (See: Toxic Loans Threaten Home Values, February 14, 2006)

In fact, it’s not just borrowers and lenders who suffer when loans fail, it’s also neighbors and communities who suffer. How? Just think about what will happen to the value of your home if a neighbor is foreclosed. As I said in a 2006 speech to the Association of Real Estate License Law Officials (ARELLO):

A growing number of recent property owners will find that they have homes and investments which cannot be sold at a profit — as well as homes and investments which cost too much to carry. The fruits of this impossible dilemma will be more properties for sale, more supply, more pressure to moderate if not lower prices, more foreclosures and more bankruptcies. Even those without a mortgage may find that the value of their home will drop as neighbors who financed imprudently rush to dump their properties on the market.

If “nontraditional” mortgages are so great, how come loan buyers and regulators are now demanding a return to long-time lending standards? More importantly, why did they accept such risky concepts in the first place? Surely no one will be “surprised” if lawmakers start asking pointed questions as foreclosure rates rise and increasing numbers of lenders fail.

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Published originally by Realty Times on March 13, 2007 and posted with permission.

Mortgage Surprise? What Mortgage Surprise? is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

Technorati Tags: ARMs, failure, flop, forecast, interest, knew, market, Mortgages, only, option, predict, regulate, regulator, subprime, surprise, who

That term “in the process of being foreclosed” is important. Neither borrowers nor lenders benefit from foreclosures. For borrowers the loss of a home is a personal tragedy as well as a huge credit stain that will impact finances for years. For lenders, foreclosures suggest losses, legal bills, vanished interest, unrecovered principal and lots of explaining to regulators.

The result is that a large percentage of homes which are “in the process of being foreclosed” are never actually foreclosed. The property is sold before the foreclosure, the loan is re-worked, the property is refinanced or back payments bring the loan current and the matter is resolved with as little damage as possible to both lenders and borrowers.

But figures from RealtyTrac, the online foreclosure marketplace that gets data from 2,200 counties nationwide, show that in August 2008 the number of homes entering the foreclosure process reached a new plateau: For the first time in a single month more than 300,000 American families received foreclosure notices of some kind.

Eternal optimists may say this is good news for those who deal in foreclosures. But while foreclosure clean-up is necessary, if there’s an increased number foreclosures in your neighborhood and properties begin to sell at low values, guess what happens to local home prices? Guess what happens to the value of your home?

You have to wonder: Are we seeing more foreclosures than last year as toxic mortgages mature? These are “nontraditional loans,” a sterile description for mortgages with ridiculously low monthly costs at first (but higher costs later) as well as mortgages that feature limited documentation and overly-large initial loan balances. Specifically, we’re talking about option ARMs, interest-only loans, stated-income financing and super-jumbo mortgages.

In April 2005 we asked Rick Sharga, RealtyTrac’s vice president of marketing, about the impact of toxic loans on the rising number of foreclosures and here’s what he had to say at that time:

Question: Are toxic loans linked to the rise of foreclosures?

Answer: While we haven’t seen any report that definitively links the two, it’s logical to surmise that higher risk loans will default at a higher rate than more traditional loans. And the fact that a larger percentage of home loans fall into the high risk category than at any time in recent memory makes the possibility of a spike in foreclosures more likely.

Question: Have toxic loans begun to impact the marketplace?

Answer: It’s hard to assign the increase in the number of properties in default and foreclosure specifically to high risk loans, but they’re almost certainly a contributing factor. As large numbers of ARMs reset this year and next — we’ve seen numbers as high as $300 million in loans this year and $1 billion in 2007 resetting — we’ll be better able to gauge the impact on national foreclosure rates.

Question: Will we see a further increase in foreclosure levels?

Answer: We anticipate that foreclosures will increase throughout 2006 for several reasons.

First, the number of properties in foreclosure has been below historic averages for several years, and the market appears to be moving back toward more “normal” levels.

Second, increasing interest rates are driving up monthly payments for homeowners with ARMs, and will significantly increase monthly payments for people with 3/1 or 5/1 ARMs due to reset.

Third, house values appear to be cooling off, which gives homeowners less equity to leverage in the event that they find themselves in a financial bind — and limits the opportunity to sell a property at a profit for homeowners in default.

There are ancillary economic factors that also come into play. Rising interest rates have had an effect on monthly credit card payments in an economy with a very high amount of consumer credit card debt. Energy costs have risen faster than anticipated. In some parts of the country, major employers such as Ford and GM have announced plans for massive layoffs, and there tends to be a strong correlation between higher-than-average unemployment rates and higher-than-average foreclosure rates.

Question: How long will it take to clean out weak borrowers?

Answer: It’s almost impossible to answer that question because there are so many factors involved, ranging from house appreciation rates to rising and falling interest rates to supply and demand within any given market to how far lenders are willing to extend themselves to “save” a troubled loan and even to the overall strength of the economy.

Question: Any general industry comments?

Answer: One of the trends we’re following is the number of properties that actually end up becoming REOs (bank repossessions). Over the past year, even as the general numbers of properties entering foreclosures has increased, the number of homes that actually end up as REOs has consistently stayed below 20 percent of the inventory. That relatively low number suggests that the market has been strong enough to allow owners to either re-finance, work out new terms with lenders, or sell the properties before they’re foreclosed on. It’s a statistic we’ll be watching closely, as we believe that a spike in the percentage would be a red flag.

The other statistic we’ve been tracking is the sales price of properties in foreclosure relative to estimated market value of the properties. In “hot” markets like CA, foreclosure properties have retained 80- to 88-percent of full market value over the past six months, whereas in other areas the numbers have been significantly softer (Minnesota, for example, was just below 50 percent). These relative prices also bear watching as a dramatically lower price combined with a high number of foreclosure properties could have a definite impact on home prices in a given area.

What we may be seeing is the coming together of slowing local markets at the very same time that large numbers of borrowers are facing stiffly higher payments. This combination of events will surely test those who believed that rising home values were assured, certain and guaranteed; an easy escape valve if monthly payments could not be met.

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Published originally by Realty Times on April 28, 2006 and posted with permission.

Foreclosure Numbers at New Highs: Are Toxic Loans To Blame? is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

Technorati Tags: application, ARM, foreclosure, income, interest, jumbo, loan, mortgage, only, option, stated, toxic

As someone now in the process of selling, I am elated by current market conditions: As long as the check clears I heartily approve of interest-only loans; I believe the availability of 100-percent financing is a Constitutional right and if lenders are content with drive-by appraisals it’s okay by me — even if the investment property I’m selling is barely visible from the road.

But I’m not a seller every day. When the property settles I will be a buyer and my view will quickly change. And regardless of which side of the transaction one is on, financial sanity on a national level is important to us all.

All of which brings us to Alan Greenspan, the chairman of the Federal Reserve. Despite all the yammering and mooing about a national real estate bubble, Greenspan has finally explained what readers of this column have long heard: There is no national real estate market. There are many local markets. A nationwide drop in average prices would have a modest economic impact in most areas and no impact at all for many owners.

“Although a ‘bubble’ in home prices for the nation as a whole does not appear likely,” says the Fed chairman, “there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.”

“The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets. Thus, while investors can arbitrage the price of a commodity such as aluminum between Portland, Maine, and Portland, Oregon, they cannot do that with home prices because they cannot move the houses. As a consequence, unlike the behavior of commodity prices, which varies little from place to place, the behavior of home prices varies widely across the nation.”

In other words, as has been said here repeatedly, real estate is a localized commodity. Looking at national trends does not tell us what’s happening down the street or across town.

One of the realities which dampens real estate speculation is that homes actually have a “use” value, it’s a place to live in or rent. If you own a house and local price trends moderate or even fall, it’s not great news but the practical impact may be zero, especially if you have a fixed-rate loan and no urge to sell.

So why do we talk about the national real estate market? Because it’s an easy benchmark to watch. What we really need to talk about are sales in the neighborhood and sales in a ZIP code.

“Speculation in homes is largely local,” says Greenspan, “especially for owner-occupied residences. For homeowners to realize accumulated capital gains on a residence — a precondition of a speculative market –they must move.”

There is a different market for mortgage financing, however. That market is nationwide and growing numbers of high-risk loans should make us all nervous.

It is here that my thoughts as a seller differ from my thoughts as a citizen. Yes, I am elated to sell property to anyone with a check of the proper size, but I wonder why lenders make such risky loans and whether the economy is well-served by such financing.

“The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern,” according to Greenspan. “To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.”

Lastly, in an oblique way, Greenspan touched on the matter of real estate commissions.

It is routinely said that real estate commissions should fall because commissions have dropped for stock brokers, travel agents and such. However, the electrons required to sell 100 shares at $2 each are no different than the impulses needed to sell 100,000 shares at $20 each — in both cases we merely have a few electronic blips moving from here to there.

But homes are not interchangeable — economic theory holds that real estate is a “nonhomogeneic” commodity — a fancy word meaning all properties are unique.

Greenspan says “because of the degree of customization of homes, it is difficult to achieve significant productivity gains in residential building despite the ongoing technological advances in other areas of our economy. As a result, productivity gains in residential construction have lagged behind the average productivity increases in the United States for many decades. This shortfall has been one of the reasons that house prices have consistently outpaced the general price level for many decades.”

Uniqueness, of course, is why no one buys a home over the phone, sight unseen. It’s also the reason local brokers who physically exist in your ZIP code consistently have value while brokers far away in some distant galaxy are irrelevant.

Greenspan says “although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications.”

If Greenspan’s comments had subtitles, they would say In English that even if home prices fall, they won’t fall everywhere and the overall impact is likely to be minimal on a national scale.

That said, do your part. If it requires interest-only financing, a stated-income loan or a 100-percent mortgage to buy property, if you can’t finance the home of your dreams with a fixed-rate loan, look toward the future: Buy small, buy less, save more and stop racking up credit card debt. You’ll be grateful if and when interest rates rise and home sales moderate on your street.

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Published originally by Realty Times on June 14, 2005 and posted with permission.

Is It Time To Buy Less? is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

Technorati Tags: caution, Greenspan, interest, interest-only, mortgage, only, rates

An interest-only loan is both what it seems and not what it seems. It’s interest-only debt for some or all of the loan term, but it’s also likely to be a form of “balloon” financing — a loan with a huge final payment, often as large as the original loan balance.

To see why, let’s compare a sample interest-only loan and a basic fixed-rate mortgage.

Imagine that we borrow $200,000 at 3.8 percent — that’s the six-month LIBOR index (2.3007 percent) when this posting was originally written plus a 1.5 percent margin. This is an adjustable-rate mortgage (ARM) where the rate can rise or fall. In the case of this mortgage, the initial rate is fixed for 10 years and the loan is an interest-only product during its first decade. After the first 10 years, the interest rate adjusts for the remaining 15 years.

For purposes of example, let’s also agree that the interest rate will not change after 10 years and that no points are being charged. Let’s also create a mythical 25-year fixed-rate loan at 3.8 percent. Here’s how the loans stack up.

In terms of monthly payments, the interest-only product costs $633.33 a month during the first decade while the fixed-rate loan with a 25-year term has a monthly cost of $1,033.71.

At the end of 10 years, the interest-only borrower has paid out $76,000 while the fixed-rate loan has cost the borrower $124,045 — a difference of $48,045.

The money paid out, however, is not the only issue to consider. At the end of 10 years the interest-only borrower still owes $200,000 while the fixed-rate loan balance has been reduced to $141,661.69. That means $58,338.31 has been knocked off the loan amount versus nothing from the interest-only loan.

If we compare the monthly cash saved in the first 10 years by the interest-only borrower ($48,045) with the principal reduction earned by the fixed-rate borrower ($58,338) we can see that the interest-only approach is actually more costly by $10,293.

In our example we have two 25-year loans. In the first 10 years rates and costs for both loan products do not change. However, for the remaining 15 years the fixed rate borrower will continue to pay out $1,033.71 per month while the story for the interest-only borrower is very different.

After 10 years the interest-only borrower still owes $200,000, a debt which must be paid out over the remaining 15 years of the loan term. At 3.8 percent the cost per month for principal and interest will be $1,459.41.

Over the 25 year term, the fixed-rate loan will have a total interest cost of $110,114. The interest-only loan? There was an interest cost of $76,000 during the first 10 years and an interest expense of $62,694 in the last 15 years, a total of $138,694. In effect, the premium for interest-only financing is $28,580 — a huge difference even if the interest-only rate remains unchanged during the life of the loan.

This analysis raises some questions:

Do most people have a loan for 25 or 30 years?

No. But when an interest-only loan is paid off during the first 10 years, the most-likely scenario, the entire debt remains outstanding. That means that compared with an amortizing loan there are fewer dollars from closing which can be invested in a replacement property or used for other purposes.

Why consider a 25-year fixed-rate loan when most people use 30-year financing?

For purposes of example only. With a 30-year term, a $200,000 fixed-rate loan at 3.8 percent interest — if there were such a thing — would have a monthly cost for principal and interest of $931.91. If the fixed-rate loan was paid off over 30 years the total interest cost would be $135,489.29.

Is interest-only financing a good choice for people with limited incomes?

If their income continues to be “limited” when the interest-only loan switches into phase two, the amortization years, the borrowers may be in trouble because of higher monthly loan costs. If a borrower has a good and growing income then the matter of higher monthly costs need not be a problem.

The example uses the same rate of interest for 25 years with the interest-only mortgage. Do you believe that interest rates will be essentially unchanged from today’s rates for the next 25 years?

I believe it’s more likely that web-footed fern people from the planet Norkvar VII will land in Iowa.

What happens if the interest-rate rises after 10 years?

In our example with a $200,000 loan, the monthly payment would increase from $633.33 to $1,479 (4 percent), $1,582 (5 percent), $1,688 (6 percent), $1,798 (7 percent), $1,911 (8 percent) and $2,029 (9 percent). If the loan has a 6-percent lifetime interest cap above the start rate (3.8 percent) then the highest monthly cost in the last 15 years of the loan would be $2,125. In all cases, of course, property taxes and insurance are extra.

Why not just refinance with a new, fixed-rate 30-year loan after five years?

This is possible, assuming that the property has sufficient value and that the borrowers can qualify for a new loan. However, since the principal balance has not declined, refinancing $200,000 after five years means that you effectively have a 35-year mortgage — a loan with much higher overall interests costs plus the expense of an additional closing. A $200,000 mortgage financed over 35 years at 3.8 percent has a potential interest cost of $161,921.32.

Converting to a 15- or 20-year loan might make more sense in terms of potential interest costs, however monthly payments will be higher than with 25- or 30-year financing.

Why not just re-sell the property as home prices increase?

First, home prices do not always increase. Second, if home prices do increase and a property is sold, the owners must move elsewhere. Will a replacement home be less expensive than the one which was sold?

Why worry about future monthly costs? With inflation we’ll be paying with cheaper dollars.

The value loss from inflation will be offset or exceeded by rising interest levels. If you want to benefit from cheaper dollars in the future, get a fixed-rate loan at the lowest possible interest rate and let the lender worry about inflation.

I hear advertisements saying that I can save hundreds of dollars each month with interest-only financing. Isn’t this true?

Here’s what’s true: With an interest-only loan your initial monthly cash payments each month will be — and be sure to read the rest of this paragraph — lower than with a self-amortizing loan of the same size and with the same rate and terms. However, the interest-only borrower has more debt for a longer period and thus higher total costs. And if rates rise, monthly costs and overall interest costs could be substantially larger than with fixed-rate financing. One way or another, Miller’s first law of financing holds true: The lender always collects.

Can you think of any cases where an interest-only loan might be attractive?

Yes. In a situation where (1) the value of real estate is reasonably expected to rise at or above the rate of inflation because local population growth is outstripping new home construction and the local job base is growing; (2) the borrowers have rising incomes; and (3) the borrowers faithfully prepay each month during the initial 10-year period to reduce future risk.

With prepayments allowed in whole or in part and without penalty, disciplined borrowers with good incomes and appreciating properties can effectively convert interest-only financing into ARMs with lengthy and cheap start rates. By making pre-payments and reducing the loan balance during the initial fixed-rate period, borrowers will owe less when the loan converts to ARM status or is refinanced. With less principal outstanding, the borrowers will have less interest than if the loan had remained at its original size.

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Published originally by Realty Times on November 30, 2004 and posted with permission.

The Beauty of Interest-Only Loans — And The Beast is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

Technorati Tags: dangers, interest, interest-only, loan, mortgage, only

Term — or “straight” financing — pretty much came to an end in the 1930s because as homes and farms lost value during the Great Depression, loans could neither be paid off nor renewed. One result was the movement pioneered by the FHA toward long-term, self-amortizing mortgages which offered more security to borrowers during hard times.

Today self-amortizing loans, mortgages in which the entire principal is paid off during the loan term, are a given — but term loans are making a comeback. We don’t call them “term” mortgages, but in a practical sense that’s probably the best way to view today’s new crop of interest-only loans.

Around the country we have seen enormous increases in home values in the past decade. If you own real estate for five years or more the odds are overwhelming that you have an appreciating asset, one which simply reflects the growing imbalance between supply and demand seen in many communities.

Alternatively, 40 percent of all existing homes are bought by first-time buyers, people who tend not to be at their peak earning years or to have accumulated much in the way of savings. By definition, of course, they have no real estate equity to invest in a residence.

Interest-only loans address this issue by lowering monthly cash costs for borrowers. With an interest-only loan at $993 a month and 6.25 percent interest, it’s now possible to borrow $190,656. With 10 percent down, homes in the $212,000 range are suddenly approachable — homes which may be better located, bigger or with more amenities than less expensive offerings.

Since the interest is likely to be entirely deductible and the initial monthly cash cost is lower than with amortized debt, it’s easy to see how buyers can be attracted to such financing. No less important, many borrowers justify such loans on the grounds that only monthly payments count, not total debt. An interest-only loan is somewhat like “rent” in this view, only with the possibility for appreciation and better tax write-offs.

The catch is that interest-only loans are not without risk.

Such financing, for example, is often based on a fixed-rate, interest-only payment for five years after which the loan becomes a one-year ARM for the balance of the term. If the loan is then amortized, it must be amortized over 25 years, not 30 years. If future rates hit 7 percent, here’s what happens: Monthly payments for principal and interest after five years go from $993 to $1,497. At 8 percent, the new monthly P&I will be $1,635.

Will higher monthly costs be a problem down the road? Probably not for most borrowers — just think of what most borrowers earned five years ago. But what if incomes don’t rise or don’t rise much?

An alternative option is selling after five years or so — if home values rise sufficiently.

Can past home price movements guarantee future trends? No — there’s always risk in the marketplace.

I’ve recently heard that borrowers will “save” money each month with interest-only loans, an imprecise expression which may raise concerns with regulators.

Interest-only loans reduce monthly payment costs when compared with fixed-rate financing, however to say these lower costs are a “savings” is debatable. Why? An interest-only loan and a fixed-rate mortgage are different loan products. The term “savings” implies a benefit which isn’t there: The cost of the loan is not lower, instead borrowers are paying less per month because they have elected not to reduce the principal balance for some or all of the loan term.

There’s demand for interest-only loans, there are logical and reasonable arguments to be made for and against such financing, but in the end they’re merely loans past generations have seen before — and sought to avoid.

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Published originally by Realty Times on August 10, 2004 and posted with permission.

Should We Return To Straight Mortgages? is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

Technorati Tags: avoid, FHA, interest, interest-only, mortgage, only, real estate, risk

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.

Toxic Loans & The Art of Denial is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

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I always tell folks there is no shortage of either lenders or loans, the real question concerns borrower preferences. If a borrower is sufficiently “motivated” then there are always loans to be had. Of course, when there is sufficient motivation there are also borrowers to be had, a thought which brings us to the subject of loan-to-value ratios.

This may sound like a real snoozer, but LTV is a subject which may soon haunt lots of people. Across the country there are now incidental reports of falling home prices, especially in the upper brackets. “Price changes” now seem to be more common in listing notices, and by “price changes” no one means sellers are asking more.

If we are seeing a pause in the remarkable series of price increases seen during the past few years, and if in some cases we are seeing actual declines, then the game changes. Millions of people who bought at or near full price may suddenly find that they own a property which is worth no more and perhaps less than what they paid.

This is not really much of a practical concern for those who stay put, but what about those who move? If you paid $500,000 for a home that is now worth $485,000 can you sell?

In this example the price drop is just 3 percent, not a lot in the context of the purchase price but enough to sink two groups of buyers, those who purchased with little down and those who bought with high-risk financing.

Over the years the amount down required to buy a home has fallen dramatically. If you were a buyer in the 1970s your financing choices were largely limited to conventional loans with 20 percent down, FHA mortgages with 5 percent down and VA financing with nothing down.

Today downpayment requirements are non-existent. You can buy with nothing down and you can even buy with 110 or 125 LTV loans — in other words, you can borrow more than the house is worth, enough to finance both the purchase and closing costs — plus maybe something extra.

Loony loans with little or nothing down are a philosophical worry when home prices are rising — and a real disaster when property values are stagnant or falling.

Go back to that $500,000 home, the one now worth $485,000. Guess what? It’s can’t be sold for $485,000, at least not in the sense of getting a check for that amount at closing.

Sell a property for $485,000 and you have a starting point from which to deduct taxes, marketing expenses and settlement expenses. You may wind up with $460,000 or maybe less.

The difference between a $500,000 debt — the sale price of our model property purchased with nothing down — and a $460,000 net selling value is minus $40,000. Do sellers have such money? Some do — but many who bought with nothing down or extra-jumbo loans cannot bring such cash to closing. And that $500,000 purchase price does not include settlement costs to buy, perhaps another $10,000 or $12,000.

In some jurisdictions the ability of lenders to recover purchase-money loan losses is limited to the value of the property. In effect, the seller cannot be sued by the lender for a loss on the mortgage when the property is sold. However, such protection does not exist in most states, does not apply to properties which have been refinanced and does not apply to home equity loans.

In effect, many who bought at the top of the market with little or nothing down cannot sell because if they sell they will be bankrupt even if home prices fall just a touch. The good news, in a sense, is that by not selling such folks hold down supply and thus keep prices up.

But the other problem is that many who have purchased with no money down, with interest-only financing, with stated-income (no-tell) loans, with adjustable-rate mortgages and with option payment financing also cannot stay.

Many loans today allow buyers to acquire homes with small monthly payments — at least at first. But the point comes when those microscopic up-front payments soon require full-blown monthly remittances.

A recent letter said I could borrow $500,000 and pay just $1,608 per month. That’s $19,296 a year in loan costs, a payment rate equal to 3.8 percent — at least at first.

However, rate caps may result in “deferred” interest. In other words, that initial monthly payment may not be the amount actually needed to reduce the debt. If the real interest rate is 4.7 percent, then the required interest-only payment would be $1,958 per month. With interest-only payments the loan is not getting any smaller, but at least it’s not getting any bigger.

You might think the loan with the low payment rate would save the borrower $350 a month ($1,958 less $1,608). However, if the missing interest payment is added to the loan balance, and if interest rates do not change, then at the end of five years another $21,000 in monthly shortfalls would have been added to the loan. Of course, interest rates might rise and each monthly addition to the principal balance would also increase the interest cost.

In general, let’s say that after five years the debt is now $521,000 and that the interest rate increases to 6 percent — a minimal interest level for most of the past 50 years. The loan now has 25 years remaining and the monthly payment will be $3,356.80 for principal and interest. That’s more than twice $1,608.

The prevailing theory seems to be that higher monthly costs are not a problem because one can just sell the underlying property. But such thinking assumes that property values will rise — and that is not guaranteed. If property values merely stay the same large numbers of people in the next few years will be both unable to make monthly payments and unable to sell for enough to pay off growing mortgage debt.
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Published originally by Realty Times on November 1, 2005 and posted with permission.

Real Estate Exit Strategy: What If There’s No Way Out? is a post from: OurBroker.com -- Refinance, Home Mortgage Loans & Rates, Home Equity Loan

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