Hybrid mortgages under scrutiny

There has been recent debate about the pros and cons of some of the most popular mortgage products offered in recent years: Interest-Only and Option Payment ARMs (adjustable rate mortgages). According to industry mortgage brokers’ and bankers’ trade associations, Interest-Only loans accounted for nearly 30% of all new loans in 2005, and Option ARMs have increased from 5% in 2004 to over 25% of loans made in 2005.

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While traditional fixed-rate 15 and 30 year mortgages were the mainstream loans for our parents and grandparents through the 1970s, higher interest rates during the Carter and the Reagan administrations fostered the climate for lenders to create loan products that fit the needs of lenders and borrowers alike- thus the introduction of adjustable rate mortgages. These loans met the needs of banker and investors to more closely track their cost of funds. And, for borrowers, ARMs offered lower initial monthly payments as compared to fixed-rate mortgages.

Early ARMs adjusted monthly or annually and did not offer the protection of annual or lifetime rate caps. Consumer advocates at the time viewed the loans as dangerous for borrowers due to the possibility of "payment shock" during periods of rising interest rates; payment shock defined as when homeowners may face the prospect of monthly payments that could be 50% or higher than their original payments. Lenders reacted by adding annual or semi-annual interest rate caps and lifetime ceilings to ARMs.

During the 1990s, lenders introduced innovative hybrid mortgage products that offered the benefit and comfort of a fixed-rate for periods of 1,3,5, 7 or 10 years that were tied or "indexed" to various Treasury rates and eventually evolved to include other indexes such as the LIBOR, COFI and COSI. In more recent years, creative financing products such as Interest-Only and Option ARMs were introduced to provide borrowers with lower initial payments as a way to deal with rapidly increasing real estate prices.

Reasonable concerns have been expressed that these products are being offered to unsophisticated and uninformed borrowers who may not realize that they are not paying down the loan principle with Interest-Only products, and that Option ARMs could result in higher loan balances than originally borrowed if only the minimum payments are made. Interest-Only loans and Option ARM products can be risky for clients who are borrowing 90-100% of the home value, need the lower payments to meet their monthly financial obligations and in real estate markets with declining home values. 

Many lenders have been tightening requirements for these loans in response to industry and government concerns. For instance, some lenders qualify a borrower based on the interest-only payment versus the full principle and interest amount- the latter being the more conservative requirement and will likely become the standard. Don’t be surprised if lenders begin to require higher credit scores and limit total loan amounts to 90-95% of the home value in the near future as a way to restrict the loans to qualified borrowers.

Interest-Only and Option ARMs can be good financial management tools for savvy investors in appreciating markets such as Charleston; if the borrower has financial resources, and when the improved cash flow resulting from payment savings is used for other investment purposes such as in other real estate, stocks & bonds or college education funds. Option ARMs can benefit the self-employed and commissioned wage earners that may have erratic monthly incomes by providing the flexibility of choosing the minimum payment during lower income periods, and then contributing extra dollars toward future payments or by making the higher payments in other months.

Aside from the benefits noted above, the average homeowner purchases a new home or refinances their existing home mortgage every 5-7 years, thus limiting the amount of principle reduction on an amortizing loan- since the largest portion of payments made in the early years of a mortgage is toward interest expense. For homeowners that move or refinance frequently, an Interest-Only or Option Payment ARM with their lower payments may be a good tradeoff.

With real estate sales slowing in many parts of the country and refinancing activity easing due to higher interest rates, the market is increasingly competitive. You can bet that there will continue to be many creative and affordable loan programs offered by lenders to assist buyers in their purchases of real estate. A good loan officer will work with their clients to select a mortgage plan that meets their family’s current and future financial needs.

Steve Smith is a Daniel Island resident and co-owner with his wife Karen of Core One Mortgage Corporation. The firm is located at 280 Seven Farms Drive.