It’s usually argued that full and fair disclosure is one of the best forms of consumer protection, but when it comes to mortgage loans there’s often much that borrowers don’t know — especially with today’s newer loan formats.
Now a new Government Accountability Office study says new standards of consumer education should be required for “alternative mortgage products” or “AMPs” — that’s a fancy term for interest-only loans and option ARMs.
What’s the problem?
Today’s paperwork simply does not work with interest-only and option ARMs. For instance, a typical disclosure statement might say that monthly payments may rise or fall. Such language is literally true — but artfully does not disclose the magnitude of potential payment increases, the idea that monthly payments might double in a few years.
Federal rules at this time do not require special disclosures for interest-only mortgages or option ARMs. Advertisements for such loan products often focus on low-up front costs rather than all loan terms. When higher monthly costs kick-in borrowers may be faced with stark and unexpected financial choices.
“Although AMPs have increased affordability for some borrowers, they could lead to increased payments or ‘payment shock’ for borrowers,” says the GAO.
The result for many borrowers is that “unless the mortgages are refinanced or the properties sold, AMPs eventually reach points when interest-only and deferred payment periods end and higher, fully amortizing payments begin.”
But what if loans cannot be refinanced? What if properties cannot be sold for enough to pay-off bigger loan balances? As we are seeing, home values do not always rise.
“Many buyers are purchasing with little or nothing down,” says James J. Saccacio, chief executive officer of RealtyTrac, the largest online marketplace for foreclosure properties. “Buyers with nontraditional financing in a slow or declining market could easily find themselves with a home which has actually lost value while the mortgage balance has grown substantially.”
“After a few years a buyer could be stuck with unaffordable monthly costs plus a home that cannot be sold for enough money to pay off the mortgage. When you look at the risks associated with interest-only mortgages and option ARMs — loans that together now represent more than 70 percent of all new mortgage originations — you have to wonder why more disclosure is being studied and debated when the immediate need is obvious.”
Once “start” rates for interest-only and option ARMs end a significant number of borrowers will be unable to make monthly payments. How many borrowers? No one knows.
“Because the monthly payments for most AMPs originated between 2003 and 2005 have not reset to cover both interest and principal,” explains the GAO, “it is too soon to tell to what extent payment shocks would result in increased delinquencies or foreclosures for borrowers and in losses for banks.”
Put it all together and you have armies of borrowers with loans they don’t understand. In too many cases, you also have borrowers with loans they will be unable to repay.
A borrower with option financing can typically make monthly payments sufficient to amortize (pay off) the loan in 30 years. Or, by making bigger monthly payments, the borrower could pay off the entire loan in 15 years.
Alternatively, option financing also allow the borrower to make interest-only payments during the first few years of the loan term. Lastly, option financing allows borrowers to make low payments during the first years of the loan that do not even cover the cost of interest. The interest not paid is added to the loan balance each month, a process called “negative amortization.” Of course, as the debt grows so do interest costs.
The GAO offers this example:
Someone gets a $400,000 option ARM. The loan has a 4.41 percent initial interest rate, however during the five-year start period the borrower can pay as if the interest level is just one percent. Required monthly payments during the start period can be increased no more 7.5 percent a year.
Here’s how the monthly payments and loan balance change for a borrower who only makes the minimum payment.
Increase in Minimum Monthly Payments and Outstanding Loan Balance with an April 2004 $400,000 Payment-Option ARM, Assuming Rising Interest Rates
Minimum Monthly Payment
If you look at the chart you can see that by the start of the sixth year the monthly payment has more than doubled. However, an option ARM is an adjustable-rate loan product. The chart assumes that the interest rate does not change. In the real world, the interest rate over a five-year period could easily rise or fall. If it rates falls, no problem. If rates rise, then negative amortization could increase substantially and future monthly payments would rise sharply.
“There’s no reason lenders cannot offer clear and concise brochures that explain the pros and cons of nontraditional financing,” says RealtyTrac’s Saccacio. “Such disclosures could detail how interest-only and option ARM financing increase affordability. With equivalent space and the use of clear charts and graphs the same brochures could also describe the potential costs and risks.”
“Current loan disclosure forms do not fully outline the potential risks associated with interest-only mortgages and options ARMs,” added Saccacio. “Even if borrowers read today’s disclosure forms from end-to-end they will not find needed loan information or illustrations. The result is more risk for borrowers — and that means more and unnecessary risk for lenders and mortgage investors.”
Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 90 newspapers.