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The New York Times: Risky Home Loans Are Making a Comeback. Are They Right for You?

December 14, 2018

By Paul Sullivan 


Interest rates have started to rise, and the housing market is cooling off, a combination that is putting a squeeze on mortgage lenders. Now, some of them are turning to more complicated loans, a remnant of the last housing boom, to bolster their business.

These risky offerings fall under the umbrella of non-qualifying loans, meaning they do not conform to standards set by the Consumer Financial Protection Bureau. But lenders are starting to push the loans on borrowers, who are using them to get into homes that may be bigger and more expensive than what they could otherwise afford.

One popular loan is the interest-only adjustable rate mortgage, with which a borrower pays only the interest for a period before the rate resets and principal becomes part of the payment. Another is the income verification or “ability to repay” loan, tailored to a borrower who does not have regular wages but is paid in large chunks of money — for example, from an investment partnership.

These types of loans may be a good strategy for a wealthy home buyer, but some say they still carry the taint of overeager and unscrupulous brokers who pushed them on borrowers unable to repay them, creating a bubble in the housing market that burst in 2008.

“All of these types of loans make anyone who is in this business cringe,” said Tom Millon, chief executive of Capital Markets Cooperative, a network of 550 small mortgage lenders and servicers.

Still, lending standards are higher, he said.

“We’re not talking about the no-asset, no-income, no-verification loans,” he said. “We’re talking about someone with a nontraditional income source that’s verified six ways to Sunday.”

Yet the slowdown in mortgage underwriting has pushed lenders to look at alternative loans, Mr. Millon said. “We all have time on our hands because business is so slow,” he said.

Banks and mortgage providers are careful to say they are marketing these products only to qualified borrowers. But the offerings can be hard to understand.

Tonaus John, chief operating officer of DBC Real Estate Management, recently moved to Pittsburgh for work. He and his wife bought a 4,000-square-foot home in Franklin Park, a suburb where they felt they could put down roots for their twin first-grade daughters.

“I fell in love with the house,” Mr. John said. “We saw it, put in an offer and closed in less than 30 days.”

He used an interest-only adjustable-rate mortgage to buy the house, which cost about $1 million. He looked at traditional fixed-rate loans as well, but the interest-only loan was half a percentage point lower, with the rate locked in for 10 years.

“I calculated that I was going to save $25,000 on the adjustable-rate mortgage,” he said. The possible increase in interest at the end of 10 years was capped at 5.25 percentage points. “The worst it could be was 8.75 percent, and saving $25,000, I could put that money somewhere else.”

The family’s plan, Mr. John said, is to make principal payments in addition to the interest, with the goal of reducing his mortgage faster than he would with a 30-year fixed-rate loan.

“We don’t like paying interest,” he said. “Our aim is to pay it off in 15 to 20 years.”

In many ways, this is the ideal strategy for someone taking out an interest-only adjustable-rate mortgage. But even a conscientious borrower faces risks with these types of loans, said Susan M. Wachter, professor of real estate and finance at the Wharton School at the University of Pennsylvania.

One is an unexpected downturn in pockets of the housing market. She said this was happening at the high end of the condominium market in New York, where demand for luxury residences is not keeping up with the supply.

“The supply-demand imbalance leads not to small price changes but to large price changes, even if a market as a whole isn’t showing stress,” Dr. Wachter said. “If you do need to sell to move or get a better job, or your own financial circumstances change, having a mortgage that exceeds the value of the home will put you in a spot.”

Of course, this could happen with a traditional 30-year fixed-rate mortgage, but the monthly payments help pay down the principal, which increases the homeowner’s equity.

Another concern, Dr. Wachter said, is in hot markets like San Francisco, where home values are growing so quickly that an interest-only loan may be the only feasible way to buy a house. If, for example, a big chunk of the borrower’s income comes from company stock or annual bonuses, then keeping the monthly payment low for the time being seems logical.

But when the local economy slows or the housing market stalls, interest-only buyers could be hit harder if they weren’t diligent in paying down the principal.

“In markets like San Francisco, the correction is going to be more severe,” Dr. Wachter said. “These are the properties that are going to be the most volatile and have the most price risk. The price falls will be higher because of the expectation that prices always go up.”

And not paying principal during the initial interest-only period just makes the amortization period of the loan shorter, said Richard K. Green, a professor of real estate at the University of Southern California.

In other words, instead of paying off a mortgage over 30 years, the borrower is paying it down over 20 or 25 years, increasing the amount of the payments after the interest-only period ends.

Both professors noted that interest-only loans could be smart choices depending on how the buyer thought about the house.

“If we’re talking about independently wealthy households and they’re thinking about cash management and they really do want more debt, this is a way to manage it with a view toward the entire portfolio,” Dr. Wachter said.

Peter Boomer, a mortgage executive at PNC Bank, which underwrote Mr. John’s loan, said the interest-only adjustable-rate mortgage made sense for the right client and had benefits over a traditional mortgage.

He offered three categories of borrowers for whom these loans work well: those who do not plan to stay in their homes for the full 30 years, those whose compensation includes a bonus that makes up the bulk of their earnings and those who look at the mortgage as another form of debt in their portfolio.

Borrowers are evaluated to see if they can repay a 30-year fixed-rate loan for the same home, he said, and they are often asked to put down 25 percent or 30 percent of the purchase price if they chose one of the non-qualified mortgages.

He added that PNC did a personal assessment of each borrower. “It’s not to just get someone into a house,” he said.

The risk of a change in a person’s financial circumstances could affect the ability to repay interest-only loans. But Dr. Green said a bigger problem was subprime borrowers, like the middle-class buyers who used them in the lead-up to the housing crash.

“In the past, the one most likely to blow up was the loan to the couple making $40,000 a year who bought a house in Bakersfield for $500,000,” he said. “It wasn’t the payment shock that blew them up. These people were on the edge and couldn’t buy a house with a standard loan. They were the first to lose their jobs.”

Today, though, even qualified borrowers need to be aware of the loans’ risks. After the initial interest-only period resets, the payment can go up as high as 50 percent, and some people cannot afford that, Dr. Green said.

Borrowers can refinance at a lower rate, but with interest rates rising, they need to be aware that may not be a possibility.

“I feel that you should have to be a qualified investor to get into the product, like you have to be for private equity,” Dr. Green said. “For the first-time home buyer, I say stay away.”

The original article can be found here.