Lenders peddle five-year teaser rates on toxic mortgages
Lenders want to pass interest-rate risk on to unsuspecting borrowers while working within the confines of the new qualified mortgage rules. Although some borrowers claim to understand the risks, if their bets prove wrong, most will petition for bailouts, and they have every reason to expect to get one.
For every good law, shysters find a loophole. Bankers proved, time and again, they will develop “innovative” loan products, designed to generate fees, which borrowers invariably fail to repay because disguised somewhere in the terms, a provision causes loan payments to increase, the borrower can’t afford the new payment, and the borrower defaults. The new qualified mortgage rules attempt to reign in the worst of these abuses, but on the margins, these rules leave enough wiggle room for lenders to brew a new batch of somewhat less toxic loans.
What risks should borrowers be allowed to take?
Most homebuyers using mortgages don’t believe they are taking a risk: they expect house prices to rise; they expect interest rates to fall; they expect to be bailed out if their expectations are met with an unpleasant surprise, and borrowers legitimately should expect bailouts given the new moral hazards engendered by everyone’s reaction to the housing bust. Of course, such moral hazard emboldens even greater risk taking and further destabilizes the system, but until housing finance blows up again and the assumptions everyone has about risk are tested, borrowers safely place blind faith in bailouts as risk mitigation.
Let’s assume for a moment that borrowers are mistaken in their beliefs; let’s assume no bailouts are forthcoming, and the terms of these new semi-toxic loans on the fringes of the qualified mortgage rules cause mortgage payments to dramatically escalate. In such circumstances, borrowers will either pay more or lose their homes. People today knowingly take these risks for the benefit of lower payments and occupying houses they otherwise couldn’t afford. How should we respond to these people if the risks they take cost them their homes?
Borrowers who take on the risks of adjustable-rate mortgages are likely to face higher interest rates and larger payments in the future. When that happens, and they struggle against the higher payments, they will conveniently forget the benefits they received for many years by using this dangerous financing, and they will whine and complain about how they didn’t understand the loan terms or some other such nonsense, and they will demand a bailout. Depending on where home prices are relative to the outstanding loan balance, they may be offered a loan modification, particularly if they are underwater; however, if the borrower is not underwater, lenders will likely tell the borrower to pay up or get out.
If future bailouts are denied because the borrower has equity — and such bailout requests should be denied — many borrowers will lose their homes. Of course, if enough borrowers suffer this fate, prices will fall, and lenders will be amenable to loan-modification bailouts, but in the end, people who buy homes they can’t afford will lose them. Should we let borrowers succumb to the pain of their own foolishness?
The conservative in me says they should reap what they sow and lose their homes. The liberal in me says we should regulate mortgages to prevent people from sowing the seeds of their own destruction; the standards of qualification for an adjustable-rate mortgage should prevent any borrower from facing unaffordable payments. Right now, the ability to repay rule and other qualified mortgage standards only require the terms to be affordable for the first five years, beyond five years, borrowers are on their own.
Lenders are touting the 5/5 jumbo adjustable-rate mortgage as a safer bet for home buyers, but critics say it’s a ‘crapshoot’
Wealthy home buyers are encountering a new pitch: an adjustable-rate mortgage with a twist.
Known as the jumbo 5/5 ARM, this loan has a fixed interest rate for the first five years before it resets to a new rate that the borrower ends up with for another five years. The process in most cases repeats throughout the life of the loan.
Lenders say this mortgage provides borrowers with more certainty because the required monthly payments don’t change as often as they do on other ARMs. Borrowers, therefore, are less prone to interest-rate swings. Many lenders are also touting 5/5 ARMs as a hedge against rising mortgage rates, telling borrowers that at the point of reset they stand to receive a rate that may be lower than those they’ll incur if it adjusts annually.
The rate might be lower in five years? If the lender really thought that, they would be encouraging borrowers to take out fixed-rate mortgages. This is a bullshit sales pitch designed to pass risk to unsuspecting and foolishly optimistic borrowers. Shameful.
But the opposite situation could also play out, with borrowers locking in a rate for five years just before rates start to drop. Critics say this mortgage only works in borrowers’ favor if they happen to time the market right. “It’s a crapshoot,” says Keith Gumbinger, vice president of mortgage-info firm HSH.com.
I had a so-called expert tell me the whole ARM reset problem was overblown during the housing bubble because when those loans reset, many payments actually got smaller, so people were wise to take out adjustable-rate mortgages back then; shocked at his ignorance, I was speechless. Interest rates were already well below normal in 2006, and nobody expected a zero-interest-rate policy from the federal reserve to bail everyone out; borrowers using adjustable-rate mortgages during the housing bubble were not wise — they were lucky.
The pitch for 5/5 jumbos comes as lenders try to drum up wealthy home buyers’ interest in ARMs. Banks stand to earn greater returns with these loans, which they hold on their books, once interest rates start to rise, …
No closing costs helped convince Stephen Miller, a cardiologist in Salt Lake City, and his wife to refinance their $1 million fixed-rate mortgage into a 5/5 ARM with Zions Bank in December. Their rate dropped to 3.6% from 6.6% on their old mortgage. The Millers plan to sell their nearly 9,000-square-foot home in roughly five years so they don’t expect to be impacted by a rate change. “It’s a calculated risk,” he says. “But I also wanted the burden of financing to be as low as possible.”
Stupid is as stupid does. You can be sure these people will ask for a bailout when their calculations don’t go by the numbers.
To boost demand further, some lenders are rolling out so-called rate-reset protection. The feature allows borrowers who are concerned that rates will be significantly higher by the time their reset arrives to adjust their rate earlier than scheduled. But they’ll pay for the option. At PenFed, for instance, their rates will be a quarter of a percentage point higher than the market rates at the time.
More toxic terms people won’t understand.
Borrowers who are considering signing up for a 5/5 jumbo should compare the cap structures that each lender offers. One of the most favorable is a 2/2/5 structure, where the maximum amount the rate can change in the first reset (after the first five years) is two percentage points; the most the rate can change at each reset thereafter would also be two percentage points; and the greatest amount that the loan’s initial rate can ever increase by would be five percentage points. With this structure, a 5/5 jumbo with an initial rate of 3% could only rise to a maximum of 5% five years from now and its rate could never be higher than 8%.
If the interest rate increases by a full five percentage points, can borrowers reasonably afford the payments? This is the real risk of an adjustable-rate mortgage. Ask any of these borrowers at 3.5% if they could afford the payment at 8.5%, and the answer you’ll get is that they will just refinance if that happens. People who are that foolish deserve the pain they will endure.
Here are other issues to consider:
• Lender’s margin. When comparing 5/5 jumbos, ask lenders what index the loan’s rate is pegged to (such as a specific Treasury) and the margin that the lender tacks on.
• Matching discounts. Lenders are eager to originate these mortgages. Borrowers who decide to get a 5/5 jumbo should ask their lender to meet the discounts other banks provide.
The main issue to consider is whether or not a borrower is willing to risk losing their family home. Adjustable-rate mortgages carry the highest risk profile of any loan available today; when rates go up — and they will likely go up — borrowers face higher payments and risk losing their homes. Fixed-rate mortgages are the lowest risk option; the payment doesn’t change, so as long as the borrower can sustain a payment, they keep their home. Plus, if interest rates do go down, the fixed-rate mortgage borrower can always refinance to take advantage of the lower rates. It’s the best of both worlds.
1823 West ASH Ave Fullerton, CA 92833
$399,000 …….. Asking Price
$500,000 ………. Purchase Price
7/11/2007 ………. Purchase Date
($101,000) ………. Gross Gain (Loss)
($31,920) ………… Commissions and Costs at 8%
($132,920) ………. Net Gain (Loss)
-20.2% ………. Gross Percent Change
-26.6% ………. Net Percent Change
-3.3% ………… Annual Appreciation
Cost of Home Ownership
$399,000 …….. Asking Price
$13,965 ………… 3.5% Down FHA Financing
4.41% …………. Mortgage Interest Rate
30 ……………… Number of Years
$385,035 …….. Mortgage
$108,096 ………. Income Requirement
$1,930 ………… Monthly Mortgage Payment
$346 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$83 ………… Homeowners Insurance at 0.25%
$433 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$2,792 ………. Monthly Cash Outlays
($439) ………. Tax Savings
($515) ………. Principal Amortization
$23 ………….. Opportunity Cost of Down Payment
$120 ………….. Maintenance and Replacement Reserves
$1,981 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,490 ………… Furnishing and Move-In Costs at 1% + $1,500
$5,490 ………… Closing Costs at 1% + $1,500
$3,850 ………… Interest Points at 1%
$13,965 ………… Down Payment
$28,795 ………. Total Cash Costs
$30,300 ………. Emergency Cash Reserves
$59,095 ………. Total Savings Needed