Increase in Risky Mortgages to People With Bad Credit Worries U.S. Regulators

A study of 100,000 cases found that buyers who take out payment-option mortgages tend to have poor or below average credit, syndicated columnist Kenneth Harney writes.

They are the new breed of “affordable” Florida home loan choices, and buyers in high-cost housing markets can’t get enough of them. Interest-only and payment-option plans that cut monthly payments sharply in the early years of a loan are gaining serious traction — and people should be worried.

Lenders are marketing both types of mortgages aggressively, often to people who need to stretch their incomes to afford a home purchase. Yet lending institutions insist that borrowers have solid financial histories, excellent credit scores and fully understand any and all of the possible payment-shock risks once adjustable-rate payments reset in a few years.

In some parts of the country, interest-only, payment-option and other exotic loans have soared from a single-digit market share two years ago to more than 50 percent in 2005. Federal regulators worry that all is not well, saying that too few borrowers really comprehend the risks involved and have a grasp of how the loans work.

Within weeks, a team led by the Federal Reserve and the Comptroller of the Currency is expected to issue new guidelines for lenders that could reduce the number of interest-only and payment-option loans being offered.

A new statistical study is now challenging some of the mortgage industry’s claims about borrowers’ sterling credit qualities. The Consumer Federation of America examined the case files of more than 100,000 mortgages closed between January and October 2005. The files contained detailed information on income, credit, down payments, and racial and ethnic characteristics.

Among the findings:

• Home buyers who take out payment-option loans tend to have below-average credit scores. Nearly 54 percent of payment-option users in the sample had FICO scores below 700. The median FICO score is 723. Sub-par FICOs are not what you really want to see in connection with payment-option mortgages, said Patrick Woodall, senior researcher at the CFA and the study’s author.
• Most payment-option mortgages permit borrowers to choose what they want to pay per month for a preset period, with amounts ranging from the standard, fully-amortizing payment, to the interest-only payment, to a rock-bottom minimum payment even lower than that.
• Some industry experts estimate that upward of 70 percent of payment-option borrowers elect to go with the minimum payment, which, in turn, causes the principal debt to rise in what is known as negative amortization.

Many of these consumers could find themselves facing rising debt burdens and minimal — even negative — equities. Such a scenario would be tough enough for borrowers with excellent credit histories and debt management skills, and it would be disastrous for borrowers with below-average scores and a higher-than-average likelihood of missing payments.

Although the jury is still out on the risks of payment-option and interest-only mortgages, the CFA findings suggest that lenders are hardly reserving them for high-income, high-credit-score applicants. While it may not be a blatant sign of predatory lending, it surely is cause for some concern. In an economic squeeze, some of these Florida home mortgage loan options could prove highly toxic — a prospect almost certain to weigh heavily in the new guidelines.