Thursday, September 14, 2006

Night Terrors and the Suitability of Mortgage Lending Products

Yes, there have been many different mortgage products that have come to the market in the last few years; this has much to do with creating affordability, and a newly mature secondary market for mortgage debt. The whole secondary mortgage market is only 20 years old, so when the Fannie and Freddie were the only game in town the products were much more limited due to the lack of funding.

As I see it, there are 2 types of mortgages: Adjustable Rate Mortgages and Fixed Rate Mortgages. Within those 2 categories there are a variety of characteristics that may be combined to tailor a mortgage to the borrower’s needs.

With adjustable rate mortgages there are characteristics such as: index, payment amount (interest only or fully amortizing), length of the loan, length of a fixed rate period, rate caps during the adjustable period.

With fixed rate mortgages there are characteristics such as: payment amount (interest only or fully amortizing), length of the interest only period (if any), length of the loan, and negative amortization.

These characteristics are combined in a manner that creates a mortgage suitable to the needs of the borrower and their plans for the real estate purchase.

A suitable candidate for something like a payment option adjustable rate mortgage with the possibility of negative amortization is someone whose income is largely from bonuses and who has significant knowledge of financial markets and the indices that are involved. So a Wall Streeter who makes $1,000,000 per year with $800,000 of it coming from his yearly bonus, who can show a 3 year track record of this bonus might make an excellent candidate for a payment option ARM with the potential for negative amortization. He knows the index, such as the 12 month treasury average is a lagging indicator, he knows that during the course of the year he can pay an interest only payment (creating no negative amortization, but servicing the debt only) or even elect to pay a minimum payment creating adding part of the interest that is due to the loan amount if he would rather do something else with his money on a month to month basis. When his bonus comes he can make a significant principal payment on the mortgage. This type of borrower may view his home as another of his many investment vehicles in his portfolio. In New York, the negative amortization limit is 110% of the original loan balance. This is much lower than the national 125% of the original loan balance limit for negative amortization.

I personally haven’t originated many of these negative amortization mortgages. I’ve originated a few in my career; one was on a $3,500,000 single family home purchase by an Art Dealer who makes around $1,000,000 per year. He put down $2,100,000 on the house and took an option ARM for the remaining $1,400,000 needed to make the purchase. In this case, his income, while large on a yearly basis, comes from the sale of multi-million dollar works of art. He may be better able to carry the payment if he can from time to time pay a minimum payment in order to keep his house payments up to date. He owns the majority of his home; he is savvy enough to know that he is going to add to the balance of his mortgage if he pays less than the interest only payment due. He also makes an income to support large principal payments during the course of the year should he choose to pay off his house further.

A suitable candidate for an interest only adjustable rate mortgage with a fixed period of 3, 5, 7 or 10 years without the possibility of negative amortization is someone like the case scenarios above as well as some others. One candidate might be someone whose plans are to stay in the property less than the fixed period. I have one person now who is going to stay in the property for 5 years. He is going to get married within the next year, his wife and he will live in the condo (new construction in Manhattan) for a couple of years until they have children at which time they are planning to move into a larger home. His fiancĂ© currently owns a Manhattan studio apartment; he is buying a 1 bedroom condo with a home office. When they are ready to move, they will have the proceeds from the sale of her apartment as well as the proceeds from the sale of the 1 bedroom condo in order to purchase the larger apartment. Both are on excellent career paths, so their income is also expected to increase. If you look at an amortization table for a $580,000 mortgage, you will see that for the first several years, the principal payment is fairly low for the first several years. Also since they are not planning to stay in the property for the rest of their lives, which is typical with Americans in general, they would rather take the money that they save in their monthly payments elsewhere to gain value. Another candidate for an interest only mortgage is someone like my mother, who at 62 years of age wanted to sell her larger 2 story and move into a ranch style townhouse. She is downsizing her home and the amount of maintenance that she needs to do (finally). She decided on an interest only mortgage because, at her age, she feels that she isn’t interested in paying off the home. She is unsure of what she will do when she retires (as if that is going to happen – it’s like pulling teeth to get her to take a day off), or whether she may prefer to move closer to me when my wife and I start having children. What she does know is that it’s unlikely she is going to stay in this house for 30 years at her age. So why should she pay more in monthly payments for a fixed rate amortizing mortgage now?

A suitable candidate for a fixed rate interest only mortgage is all of the above and those who are going to stay in their home for more than 7 years. At that point, they may as well finance they homes with a fixed rate mortgage paying interest only payments for the first 10 or 15 years of the loan. The payment isn’t much more than a 10/1 Interest Only most of the time, lately it’s the same if not lower. One nice feature of the fixed rate interest only mortgage over the fixed rate fully amortizing mortgage is the payment recast feature. I have a borrower right now who is moving up in housing. He’s buying a $1,200,000 coop on the Upper East Side; moving from a $790,000 condo on the Upper West Side that he purchase less than 5 years ago. Right now he has to carry both properties until he sells the UWS condo due to timing and the nature of coop approval. So he’s putting down $300,000 on the purchase of the coop which is the 25% minimum down payment required by the coop board. When he sells the condo, he will realize about $400,000, which he will pay toward the principal of the $900,000 mortgage on the new coop. This will immediately reduce his monthly payment because the payment will be re-calculated based on the new principal balance. Furthermore, this borrower plans on paying off his mortgage entirely within 10 years, so as he makes these larges principal payments, his monthly payment will be further reduced. Thus it was more appropriate for him to finance his coop purchase with an 30 year fixed rate interest only mortgage than a 30 year fully amortizing fixed rate mortgage because the fully amortizing mortgage’s payment would remain the same until the entire balance is paid. It’s nice to see the immediate benefit of principal payments and I think it’s an inducement to make extra principal payments if the borrower can immediately see the effects of prepaying his mortgage.

A candidate for the fixed rate fully amortizing mortgage is, of course, all of the above and those who are going to stay in their homes for more than 10 years. Particularly the couple in the interest only example when they buy the house where they want to raise their children. Then, most likely, they will want to stay in the house at least until their children are in college, so that will be close to 20 years. Then it certainly makes sense for them to finance the purchase with an amortizing fixed rate mortgage. Another suitable candidate is someone who has owned the home for several years who is looking to reduce the term of the mortgage and pay it off quicker now that their income is higher. Someone going from any of the above mortgages to a 10 or 15 year fixed rate mortgage.

The length and terms of the financing should be appropriate to the plans of the person who is buying the home. Here in New York, I’m sure there is some concern that static income individuals, or individuals with less than perfect credit are trying to squeeze into homes they can barely afford. And buying these homes with no down payments. I know the press has been about people who bought homes and are now in danger of losing the home due to the inability to pay the payments they promised to pay. On what level is the homeowner responsible? On what level is the mortgage originator? The lender? The secondary mortgage market? All tricky questions that we must navigate. There are several different factors at work here. One is the availability of mortgage products, one is the highest level of homeownership ever, one is the rapid increase in home prices over the last few years and another is the ability to purchase a home with a lower down payment than ever before.

The most important thing that we can do is to educate people on the process, the financing and the responsibilities of homeownership. I’m a big believer that knowledge is the key. Also when I read many of these horror stories, I can’t help but wonder why they didn’t read any of the disclosures, why they didn’t ask questions?

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