A Growing Tide of Risky Mortgages


By Peter Coy Here are some scary statistics: In 2004, fully 50.4% of the mortgage loans issued for purchases of single-family homes in Georgia were to pay interest only. That made the Peach State No. 1 in the nation in its share of interest-only mortgages. But a whole bunch of other states were not far behind: California was second, at 47.1%, Colorado third, at 45.5%, Nevada fourth, at 44.7%, and the District of Columbia, fifth at 43.8%.

Nationwide, the share of mortgages that were interest-only shot up from 1.5% in 2001 to 6% in 2002, 13% in 2003, to 31% in 2004.

STICKER SHOCK? The numbers come from LoanPerformance, a San Francisco-based real estate information firm that's part of First American Corp. They're for loans that were packaged for resale, so they don't cover quite the entire market, but they give a pretty good picture of the trend.

Why is the surge in interest-only mortgages so frightening? Because many people are using them to buy houses that they couldn't otherwise afford. The monthly payment on an interest-only loan is lower because there's no amortization of principal. So people can qualify for bigger loans and buy bigger houses. The availability of such loans has probably contributed to the upward spiral in home prices, as shoppers armed with cheap financing try to outbid each other for choice properties.

The trouble comes when the interest-only feature expires, which is often after 10 years. If it's a 30-year loan, then the entire principal has to be paid off in the final 20 years. So the monthly payment could abruptly jump by 50% -- even assuming no increase in the interest rate (nearly all interest-only loans have adjustable rates, so the borrower can get whacked if they rise as well).

WRONG USERS. Interest-only mortgages were designed for wealthy families who used the loans as cash-flow management tools and could, if necessary, pay off the entire sum by liquidating some stocks and bonds. They can also be a good choice for people who have irregular incomes and strong self-discipline.

Such families can pay interest only in the lean months, then voluntarily make big principal payments in months when they have lots of income. Other natural candidates: People who are quite sure that their incomes will be rising sharply, like young doctors just out of medical school.

Trouble is, the sheer numbers indicate that the loans are also being taken out by a much bigger sector of the public -- people who are struggling to get into a rising housing market and feel that they couldn't get the properties they want any other way.

"BUYERS HAVE NO IDEA." Often, interest-only borrowers argue that they will refinance or sell their homes before the principal payments start coming due. But the risks are high. If they refinance, the new payment could be higher than the old one. And if they sell, they need to hope that prices have kept rising. Otherwise, they won't even recoup all of their downpayment.

Lenders that make interest-only loans argue that there's little risk of a wave of defaults as long as the economy remains reasonably strong and housing prices don't crash. But even some parties that benefit from the rage for interest-only mortgages, like homebuilders, are wondering if the trend may have gone too far. "In most of those cases, buyers have no idea how they're going to pay" the higher payments that will be owed once principal payments begin, says William J. Pulte, founder and chairman of Pulte Homes (PHM).

Buyer, beware, indeed.

The Good and Bad

Here's an example of the benefits -- and risks -- of an interest-only mortgage loan. It was supplied by Brent van de Graaff, assistant director of marketing for East West Mortgage, a mortgage broker and lender in McLean, Va. Van de Graaff argues that interest-only mortgages can be a good choice for many homebuyers.

MONTHLY PAYMENT THAT HYPOTHETICAL BORROWER CAN AFFORD:

$2,120

PRICE OF HOUSE THAT BORROWER CAN AFFORD USING A CONVENTIONAL 30-YEAR FIXED MORTGAGE*:

$500,000

PRICE OF HOUSE THAT BORROWER CAN AFFORD USING AN INTEREST-ONLY MORTGAGE**:

$620,000

CHANGE IN MONTHLY PAYMENT ON INTEREST-ONLY LOAN ONCE PRINCIPAL PAYMENTS BEGIN***:

Before: $2,210

After: $3,310

Increase: $1,100, or 50%

*Down payment of 20%, and adjustable-rate, principal-and-interest loan of $400,000 that is fixed for the first five years at 4.875%.

**Down payment of 20%, and adjustable-rate, interest-only loan of $496,000 that is fixed for the first five years at 5.125%.

***Principal payments on 30-year loan begin after 10 years.

Risky Mortgages

Percentage of new single-family home mortgages that were interest-only in 2004*State

2004

Georgia

50.4%

California

47.1%

Colorado

45.5%

Nevada

44.7%

District of Columbia

43.8%

Arizona

40.3%

Virginia

40.2%

Washington

34.6%

Maryland

31.9%

Oregon

31.2%

National

31.1%

Florida

30.6%

South Carolina

30.2%

Minnesota

29.9%

North Carolina

29.4%

Utah

26.9%

Hawaii

25.1%

Massachusetts

20.8%

New Jersey

19.8%

Alabama

18.5%

Idaho

18.3%

Michigan

17.2%

New Mexico

17.0%

Ohio

16.5%

Tennessee

16.1%

New York

15.1%

New Hampshire

14.8%

Kentucky

14.8%

Connecticut

14.8%

Illinois

13.9%

Pennsylvania

11.3%

Kansas

11.3%

Texas

11.0%

Missouri

9.2%

Wisconsin

9.0%

Louisiana

8.0%

Indiana

5.8%

*For states with sufficient data

Data: LoanPerformance

Coy is economics editor for BusinessWeek


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