Lenders Must Do More to Rein In Dangerous Florida Mortgages

You may have seen reports about tough new federal rules aimed at curbing the availability of popular payment-option and interest-only mortgages — both of which feature low payments in the early years, followed by big payment jumps later on.

Those cutbacks, in turn, make it more difficult for many buyers in high-cost markets to stretch their budgets and afford the houses they want.

That’s all true — to a point. The guidance jointly released September 29, by the Federal Reserve, the Comptroller of the Currency, the Office of Thrift Supervision, the National Credit Union Administration and the FDIC did not ban or attack payment-option and interest-only loans, per se.

On the contrary: The regulators acknowledged that both types of Florida mortgages are legitimate ways to finance a home.

A payment-option loan allows borrowers to choose among several payment levels each month — a bedrock minimum amount so low the loan balance increases; interest-only payments that do not reduce the principal owed; or fully-amortizing payments that include both interest and principal. At a specific reset point, payments increase to cover deferred interest and principal contributions, shifting to a fully-indexed rate.

An interest-only mortgage will cut homeowners’ payments for anywhere from the first 3-10 years by dodging principal reduction; at the end of that period borrowers have the same balance they started with, but their payments jump considerably to begin reducing their principal over a new, shorter period.

Marketed to qualified borrowers who fully understand what they’re getting into, these Florida home loan options are fine, the regulators said. But when lenders begin to mass market them and add on a lot of other features, payment-option and interest-only loans border on toxic.
Among the risk features the government wants lenders to avoid piling on:

• Borrowers with low incomes that can’t support the full costs looming down the road. Extending such a loan to home buyers at a 1-2 percent effective payment rate in a 6-7 percent market is okay if the applicants can afford to pay the full Florida mortgage rate. Some choose to make minimum payments because they have more profitable uses for their cash.

But if homebuyers can’t afford the house and the mortgage, extending a payment-option Florida mortgage becomes a crapshoot. Once low payments of the introductory period are over, will they have gotten raises or won the lottery and have the cash to handle monthly payments double or more than they’ve gotten used to?

• Minimal or no doc loans, allowing for little to no disclosure of home loan applicants’ incomes and assets. Popular among self-employed earners and professionals, so-called stated income underwriting can push the risks of payment-option and interest-only loans off the charts. If banks don’t verify that the incomes applicants are claiming are real, they should generally avoid extending payment-option and interest-only mortgages.

• The so-called piggyback loans that allow minimal or zero down payments through the use of simultaneously closed first and second mortgages. For example, a borrower who applies for a payment-option first mortgage equal to 80 percent of the price of the house might also ask for an interest-only credit line equal to 20 percent of the property value.

In effect, the borrower is buying the house with no down payment, paying zero per month to reduce the principal, and is likely to face huge payment-shock increases in the future. Avoid such time bombs at all costs.

• Subpar credit scores. No need for explanation: A poor credit history doesn’t mix well with mortgage programs with built-in payment shocks.

• No-nowner occupancy. When a buyer doesn’t plan to live in the house but rent it out or flip it, that raises the likelihood of default and foreclosure. The risks soar even higher when lenders allow investors to buy properties they really can’t afford using payment-option plans.

The new guidance requires lenders to make certain that all loan applicants for payment-option and interest-only Florida mortgage loans understand the mechanics, especially the lurking dangers of payment shocks. But these dangerous products are still out there in force, so a lot of the responsibility rests with you as well.