Wednesday, October 04, 2006

What is an Exotic Hybrid Mortgage?

I subscribe to a couple of mortgage finance/real estate blogs via RSS. It has been interesting to see the traffic there recently, say, over the last six months.

Lots of talk (even at the FED/Bernanke level) about "exotic hybrid mortgages" and such. I thought I'd spend a moment here and talk about what they are talking about when they use that term.

In the FED language, an "Exotic Hybrid Mortgage" is one where the rate is tied to a financial index, and adjusts every month. Or, should I say, a PORTION of the rate adjusts every month. I'll explain index-based mortgages in general in a future post. Specifically, these mortgages have four payment options on the payment coupon/statement every month.

First option: "minimum payment" - the cheapest option
Second option: "Interest-only payment" calculated on the note rate for that month
Third option: "30 year fully amortized payment"
Fourth option: "15 year fully amortized payment" - the most expensive option of the four

If you have one of these loans, you can choose, every month, which option to take. If you feel like it, you can choose the cheapest option, or next month you can choose another option... doesn't matter.

There are people (uneducated) who think this "Exotic Hybrid Mortgage" has only recently been created. The loan is properly called an "Option ARM" loan, and it has been around for a long time. This loan has been available to people for many years, actually. The lenders who have offered it for a long time will cite the following borrower characteristics to whom this loan was originally offered:

Property investors who didn't intend to take the loan to its fully amortized period
Home buyers who had at least 20% of the purchase price as a down payment
Home buyers who are self- or otherwise-employed in a seasonal field
Home buyers with EXCELLENT credit

If you were fitting any or all of those characteristics, you could qualify for this type of loan.

Now, before I go further, let me explain the terms of this loan more fully, so you can see its pitfalls and impacts:

Fact: All loans have two components to the payment: Principle, and Interest.

When a home owner elects to pay the "minimum payment" on their loan that month, the payment amount IS NOT EVEN COVERING ALL THE INTEREST THAT IS DUE, LET ALONE ANY PRINCIPLE. Sometimes that minimum payment is as little as $100. You are basically paying the lender to keep your loan account open. If you're astute, you will ask, "since we know interest doesn't take a day off, where does it go then?" It gets tacked on to the principle balance of your loan. We call this Negative Amortization.

When one elects to pay the "Interest-only payment", there is no principle in your payment, only interest. That one is pretty self-evident. Note though, that if one owes $200,000 as principle at the beginning of the month, and one makes an interest-only payment, you STILL owe $200,000 at the end of the month. It's like only paying the finance charges on your credit cards, never paying down the actual amount owed.

The other two payments are easy - traditional loan types there.

If you're a person who qualified for this loan, using the criteria above, you are inherently:

Good at managing your money
Financially astute
Financially solvent and stable
Living within your means
Not trying to accomplish something that is outside your means to accomplish

But here's the thing, see.

Most big lenders are public companies, and they are in the business of selling money. That's what *I* do for a living as well, I don't sell real estate, I sell money. Anyway, those public companies have numbers to hit.

And in the last run-up/frenzy in home appreciation, making "paper millionaires" out of hundreds of thousands of homeowners in California and other places, the lenders saw the opportunity/need to try and attract those borrowers into THEIR boat. Gotta make those numbers.

How to do that. Well, among other things, they made loans available to more people, by doing the following two things:

Lower the personal credit requirements to get a home
Offer to lend more of the purchase price (as in 100% of the purchase price)

These two things led to the availability of the Option Arm to almost anyone who asked for one. The recent statistics show that at least 70% of the time right now, those who have this type of loan choose the minimum payment. What does that mean? It means that 70% of the time, borrowers are going further upside down on their residence. They owe more than it's worth, because their BEGINNING loan balance was 100% of the purchase price/value. That also means that if they have/choose to sell the place, they owe more than it's worth - they would have to PAY to get out of the mortgage... that's not fun. Rather than do this (because they have no money) people are simply choosing to walk away from their mortgage, ruining their otherwise okay credit history, and jeopardizing their future ability to qualify for a mortgage of any type, ever.

So now we have a VERY LARGE GROUP of people who DON'T know how to manage themselves, but took advantage of lax credit requirements to buy more home than they should have, and now, they are swallowing the bitter pill of financial ruin.

Bernanke has offered up some "guidance" on these types of loans, and when the FED offers Guidance, it's not just advice, it's the law. He has put some things out there that lenders need to do to better qualify people for these loans.

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