Our financial lives automatically become more complex. Even something as simple as selecting a mortgage has become a complicated undertaking fraught with danger. As in many other financial transactions, the interests of the lenders and brokers are not always in line with those of the individual. As riskier products are being marketed to the public, borrowers have a greater responsibility to look out for themselves or else seek objective advice.
The changing mortgage landscape
A recent study that appeared in the Journal of Financial Planning showed that twenty-five years ago, borrowers had a choice of 9 mortgage products; today there are over 200. Most people would agree that choice is good. The problem is that some lenders have been pushing mortgages that are difficult to understand and downright risky. The option adjustable rate mortgage (ARM) is a good example.
Option ARMs
With an option ARM, you have several payment choices each month. Take the example of a $200,000 loan with current rates of 6.5%. You would have four payment choices:
- $1,742 – the equivalent monthly payment of a 15-year fixed rate loan.
- $1,264 – the equivalent payment of a 30-year fixed rate loan.
- $1,083 – an interest-only payment with which the loan balance never decreases.
- $250 – a minimum payment option with which your loan balance increases every month!
The biggest danger lies in option 4. The minimum payment is calculated based on an introductory or teaser interest rate, in this case 1.5%. Since this is not sufficient to cover all the interest you actually owe on the loan, the unpaid interest gets tacked onto your principal balance. What many people do not realize is that when the balance reaches a certain level or when the introductory period ends, the minimum payment will suddenly be recalculated to start paying down the loan at current rates. This means you could suddenly have a monthly payment 5 times greater than what you expected. In addition, steep prepayment penalties may apply if you try to refinance the loan.
Initially, option ARMs were targeted to affluent individuals, particularly those who regularly earn large bonuses or commission payments. Option ARMs allow them the flexibility to make low payments most months, and then make large payments when the bonus checks come in.
Unfortunately, as home prices soared in recent years, option ARMs were sold to the masses as a way for them to purchase a home they really could not afford. The vast majority of these borrowers are making only the minimum payment. Now those in the first wave of them are about to see their monthly payments skyrocket.
Conflicts of Interest
Clearly, many individuals who got lured in by the low monthly payments did not read the fine print or carefully assess the risks. However, they are not solely to blame; unseen forces were working against them. In 2004, banks began giving larger commissions to mortgage brokers for option ARMs than for other mortgage types. Not surprisingly, as brokers were given incentives to push these loans, the number of them being written soared. In 2003, option ARMs made up only .5% of all new mortgages. That percentage has grown to 12.3% through the first half of this year.
More than a fifth of option ARM loans are now greater than the value of the borrower’s home. If home prices fall, that percentage will increase dramatically. Many borrowers will be stuck with the choice of making huge payments they cannot afford or losing their homes.
Looking out for you
As financial decisions become more and more complicated, individuals have an even greater need for objective advice. Whether you are considering a mortgage or an investment, it may be well worth hiring someone to give you an honest analysis of the risks. This would have saved countless borrowers thousands of dollars and even saved some of their homes.