At last it’s possible to report a nugget of good news from the real estate marketplace: Mortgage rates are down, really down. According to Freddie Mac, a 30-year fixed-rate mortgage can now be had for less than 6 percent interest.
Perhaps the strangest real estate story of the past year concerns mortgage rates. Given daily headlines, a rational person might think that investors would take their money and buy everything except mortgages. The result would be soaring mortgage rates and foreclosure levels far greater than anything seen to date. And yet, somehow, investors have remained in the home financing arena.
It may be that there is actually less mortgage money available at this time but that rates have fallen because there’s even less demand. However, given the vast need to unwind toxic loans, it seems difficult to imagine falling demand. The Mortgage Bankers Association, as one example, tells us that in early December loan applications were up 14.8 percent when compared with a year ago.
The current situation raises a question: Can the low rates seen in today’s marketplace be used to reduce the foreclosures and failures which now dominate the headlines?
Among the worst loans popularized in the past few years has been the interest-only mortgage. The problem with this loan format is that in most cases the interest rate is adjustable, the cash savings are minimal and when the loan terms ends the usual result is a vastly-higher monthly cost because there is less remaining time to amortize the loan.
As an example, imagine that we have a fixed-rate $200,000 mortgage at 6 percent. The monthly cost for principal and interest is $1,199 over 30 years.
The same loan on an interest-only basis would have a monthly cost of $1,000 per month for principal and interest during the start period, say three years. At the end of the start period, the loan balance would still be $200,000 but only 27 years will remain on the loan term. If the interest rate is unchanged, something not very likely, then the new monthly payment will be $1,248 — a 25 percent jump from the first three years. Of course, if rates rise, then even steeper monthly increases will occur.
It’s fairly obvious that the only purpose of an interest-only loan is to hold down monthly payments. This makes sense in an environment where home prices are rising because the borrower can sell the property before the loan re-sets. Unfortunately, if home values don’t rise, then the borrower will face higher costs — costs which may be impossible to meet.
Given the grossly unattractive nature of interest-only loans, here is a modest proposal: We should make interest-only residential mortgages illegal — except when five conditions are met:
1. The mortgage is used to refinance a home which now has toxic financing.
2. Any prepayment penalty on current loans refinanced with an interest-only mortgage is taxed at 100 percent. In effect, lenders would gain no benefit from charging prepayment fees so they will be dropped. There’s no issue here with violating “contract sanctity,” the right of parties to collect on existing agreements. However, tax rules change all the time and there’s no reason why the tax treatment of prepayment penalties should not be modified.
3. The interest-only loan must have a term of at least 30 years.
4. The combined origination fee and points for a new interest-only mortgage would be limited to 2 percent.
5. No regulated interest-only loan can have a prepayment penalty.
In effect, interest-only loans will not be illegal, however they will be regulated — financing allowed when certain terms and conditions established by law and regulation are met.
One can hear the instant cries and screams from the lending community objecting to this proposal — of course, one can always hear the instant cries and screams of the lending community if any idea other than the unlimited plucking of free-range borrowers is suggested. That said, thoughtful members of the financial establishment — and there are many — might well support limits on interest-only financing.
Trades and Choices
What’s being proposed is a swap, toxic mortgages for new financing, not great financing but loans that are the best-alternative mortgages available for many borrowers — and many lenders.
Let’s say we have a new class of regulated interest-only loans we will call “FedOK.” Mortgage investors would want such loans because it means that toxic loans would be refinanced out of their portfolios. Borrowers would want such loans because they would have lower monthly costs, and monthly costs which would not change.
The result of this arrangement is that fewer homes would be foreclosed or sold under distressed conditions. With less pressure on the sell-side of the marketplace, there would be more opportunity for prices to firm. Better pricing would alleviate the lower property tax revenues now faced by many jurisdictions while at the same time increasing the value of investor portfolios.
To make the FedOK loan product work there would have to be some changes in the underwriting process. For instance, missed and late payments would have to be ignored — such payment problems should be seen as a by-product of toxic loans, loans which should never have been originated in massive numbers in the first place.
As to equity requirements, forget it. Many toxic borrowers already have negative equity. The only way their situation is going to change is by paying down their loans and having home values rise. They can’t pay down their current loans now because their cash is going to inflated mortgage payments and values won’t rise until distressed inventory is reduced.
What about the “moral hazard,” the idea of rewarding people for bad choices? Forget that too. It’s a far larger greater hazard when the value of your home goes down because your neighbor financed with a toxic mortgage.
Loan counseling will be necessary for FedOK borrowers — both when the loan is originated and on a regular schedule thereafter, say once every three months in the first year, once every four months in the second year and once a year thereafter. Borrowers will need to be aware that the FedOK program is last-chance financing; if you fail to make your payments you’ll be foreclosed and your credit rating will be in the dumpster.
Like the rate freeze proposed for a limited number of homeowners by the White House, the Treasury and HUD, the FedOK program would be open to anyone with a toxic loan — a loan where the initial re-set payment is at least 15 percent higher than the payment required during the start rate. Any ARM or interest-only made since 2000 would qualify for refinancing under the FedOK program.
Would mortgage investors, Wall Street and lenders support a FedOK program? What’s better? What would produce equal results with less cost and risk? With the FedOk program there would be less need for costly short sales and far fewer foreclosures.
As to the federal government, it would have no financial role in the FedOK program — no funding and no insurance. Given the state of federal finances, what other option is available?
“We have a massive national crisis on our hands,” says James J. Saccacio, Chairman and CEO at RealtyTrac, the leading online marketplace for foreclosure properties. “It will get significantly worse unless we reduce the pressure on borrowers and local markets. The FedOK plan is one approach to consider, and given that it takes advantage of the unusually low interest levels now available it’s a concept which should not be ignored.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.