I’m sure all of you have heard all the advertisements for refinancing and home equity loans. Most of them mention the ability to get you a loan regardless of your past credit history. Some even claim they can get you into a new home even if you’ve declared bankruptcy or have had a foreclosure in the past.
How do they do this? How can they get a poor credit risk an interest rate low enough to allow them to afford a new home? Three simple words: adjustable rate mortgage.
A conventional, or fixed rate, loan keeps the same interest rate for the life of a loan. An adjustable rate mortgage, or ARM, holds the initial rate for a set period of time (from 1 month to 10 years) at which point it can go up or down, dependant on the terms of the loan and the index upon which it is based. Indexes vary greatly and some can change by points per year, while others remain relatively steady. Why is this a bad thing? Mortgage companies will loan people money based upon the initial rate, rather than a realistic projection of the interest rate after the first adjustment. To simplify: the mortgage payment you can barely make today will be the mortgage payment you have no chance of making a year from now. On top of the principal and interest payment, there will be taxes and insurance, which can also change yearly. This spells foreclosure or bankruptcy for the homeowner.
Unfortunately, a standard ARM isn’t the only type of loan where people can find themselves in difficulty. An interest only loan will, for a set period of time (usually 10 years), require only interest payments. After that first 10 years, the remaining principal balance will be spread over the next 20 years. What does this mean? This means the loan you couldn’t afford spread over 30 years is now spread over 20, and is now a fully amortized principal and interest payment. These loans are typically adjustable rates and can change rates as frequently as monthly.
But wait! There’s another, more insidious, loan out there! It’s called a negative amortization, or neg-am, loan. This loan provides a minimum payment amount (typically set for the first 10 years). It also normally starts with a very small interest rate (usually 1.0%). These loans are also ARMs which adjust MONTHLY. Because it is an ARM and because there is a fixed minimum payment, you can actually make an accepted payment which is less than the interest only payment. When this happens, the principal balance is increased by whatever amount is necessary to make the interest only payment. This can increase the principal balance to as much as 115% of the original amount. If that happens, the monthly payment will be increased to an interest only payment, regardless of the loan terms which dictate a minimum payment, until the principal is decreased. After the first 10 years, the remaining balance (which can, remember, be larger than the original balance) is spread over the next 20 years. So, again, the loan you could barely afford is now increased in cost and spread over a shorter term.
Why not refinance when this happens? Why not sell when this happens? Ahhh, the prepayment penalty. When a customer with bad credit comes in, the investor in the loan may want some guarantee that they will make money off the loan. A prepayment penalty will last for 1-6 years, normally, and can easily total over $10,000.00.
What’s the solution? Honestly, I don’t know. Buying a larger house than you can realistically afford is definitely not the way to go.
Postscript... I wrote this article in March 2005 and posted it to morons.org. Recently,the sub-prime market has effectively tanked. The very loans I mentioned in this article are part of the cause of the crash in the market. Unfortunately, I believe it’s only going to get worse before it gets better.