Day after day through all manners of advertising, we are exposed to the new lowest rates and “get out of debt” schemes. Mortgage "professionals" are selling the idea that you can buy your family anything from your first home to the home of your dreams by signing up for Interest-Only, Option Payment, or 40-year Fixed new home loans (at rates under 1% in some cases).
If you haven’t heard of these over-advertised home loans, it's only a short matter of time before you do. These are all extremely risky loan programs that, unless you are fully educated by a reputable source, you should avoid.
These loan programs work well for families that have a guaranteed bonus, allowing them to make minimum payments during the year with a lump sum payment at the end of the year to reduce their outstanding balance. However, mortgage companies are marketing these loans to families that in most cases would not be able to afford the home through traditional loans.
The significant risk these programs carry includes information that is commonly overlooked. The Federal Reserve recently released numbers that these loans now account for nearly a quarter of the new business at a third of the nation’s largest home lenders.
So, how do these programs work? With home prices "though the roof," these loans allow families that could not normally afford traditional loan payments purchase a new home. For example, an average transaction in the Denver market with a purchase price of $300,000 and a down payment of 10% ($30,000) from a buyer with an average credit score of 660 or higher. Choosing a 30-year Fixed at a current interest rate of 5.75% the principal and interest payment would be $1575/month, versus a Pay Option ARM with the same parameters the lowest payment option available to the borrower would be $878/month. The $878 payment is only a partial interest payment and it would result in a negative amortized loan. In essence, a negative amortized loan assumes you are lagging behind on the full interest due and the additional interest is tacked on to your principal balance raising your outstanding balance on your mortgage every month.
You will be paying interest on interest!
The following paragraph recently appeared on CNN's Money website, outlining why experts are increasingly concerned about these types of loans:
The trouble with these loans is that there is no guarantee that the housing market will continue to increase in value. In fact, the market is stagnant or trending in a downward direction. It was recently reported that gas prices are going to continue to stay at all time highs. President Bush even asked Americans to moderate driving, and to car pool if at all possible. August’s new home sales numbers were down even prior to the two monster hurricanes hitting the Gulf Coast region. All of these factors were reflected in the Consumer Confidence Index reporting a two-year low of 86.6 in September.
It is obvious that a difference in payment of $697/month is enticing and hard to resist. Keep in mind,though, that the $1575 payment is a guaranteed fixed payment with a portion of the payment reducing your principal balance and will not change for the life of the loan. By comparison, the Pay Option ARM is an adjustable rate mortgage that has a short-term fixed period usually less than one year.
As many of you know, my wife Stacy is a senior residential mortgage specialist and she refuses to use these loans. Rather, she educates her clients about the real consequences of them. She has assisted two clients that have ended up getting a divorce as a direct result of entering into these loans. As families can’t keep up with these loans and default on them banks will inevitability tighten lending rules hurting all home buyers. A high number of defaulted loans lead to an increase in the number of homes on the market and home prices fall because of it.
So my friends, make a smart and educated decision about your family’s future. Stay in that rental until you can afford a reasonable home with a reasonable payment and wait for the home of your dreams.
*Chris is a close friend and business professional living in Denver, Colorado.