With interest rates on the rise, it may be time for home buyers to take a fresh look at some alternatives to the 30-year, fixed-rate mortgage, which has dominated the mortgage market since the financial crisis.
While many out-of-the-mainstream loans got a black eye in the subprime debacle, today’s versions have been shorn of the toxic features—such as negative amortization and prepayment penalties—that tripped up many borrowers during the housing bubble a decade ago.
Plan to move
Experts say today’s adjustable-rate mortgages, or ARMs, as well as interest-only loans, are especially suitable for borrowers who expect to move before any rate increases can wipe out the savings in the early years. They’re also useful for sophisticated borrowers wrestling with uneven income, borrowers who expect their income to rise, or borrowers who are willing to bet they can invest their mortgage savings for a greater return elsewhere.
“Many of the mortgage products that some may have thought slipped into extinction, such as interest-only loans, do still exist today, but in far less volume” than in the heyday of the subprime era, says Bill Handel, vice president of research and product development at Raddon Financial Group, consultant to the financial-services industry. Adds David Reiss, a law professor and academic program director at the Center for Urban Business Entrepreneurship at Brooklyn Law School: “The benefits of non-30-year, fixed-rate mortgages are legion.”
A sweet spot
Many borrowers can find a sweet spot, for example, in the so-called 7/1 adjustable-rate mortgage, which carries a fixed rate for seven years before starting annual adjustments. With a typical rate of 3.75%, the monthly payment on a $300,000 loan would be $1,389, compared with $1,449 for a 30-year, fixed-rate loan at 4.1%, saving the borrower $5,040 over seven years.
Even if the loan rate then went up, it could take two or three years for higher payments to offset the initial savings, making the mortgage a good choice for a borrower likely to move within 10 years. Once annual adjustments begin, they are generally calculated by adding a fixed margin to a floating rate, such as the London interbank offered rate.
“ARMs are very underutilized,” says Mat Ishbia, president of United Wholesale Mortgage, a lender in Troy, Mich. He expects the 7/1 ARM to account for 15% of new mortgages within the next few years, up from less than 5% today. Historically, ARMs become more popular as interest rates rise, making savings from the loan’s low initial “teaser rate” more attractive, he notes.
The interest-only loan, which isn’t widely advertised but available to those who search for it, can offer even greater savings for borrowers willing to take bigger risks. With a typical starting rate of 3.5%, a $300,000 loan would cost just $875 a month, compared with about $1,347 on a standard “fully amortizing” loan that included principal payments. The borrower would pay $39,648 less than on the 30-year fixed loan over an initial fixed period of seven years. (Of course, avoiding principal payments means building less equity.)
The catch: After seven years, the interest rate could jump substantially, pushing the payment far higher than it would have been in the 30-year fixed deal. And at some point—probably after 10 years or so—the borrower would be required to start paying principal, making the payment even bigger.
So who would take such chances?
Experts say most people would be wise to stay away, but an interest-only deal would suit a “disciplined” borrower likely to move during the interest-only period, as well as borrowers who have uneven incomes, are confident they can invest the savings more profitably or expect a rising income to make big future payments bearable, says Ray Rodriguez, TD Bank’s regional mortgage-sales manager for the metropolitan New York area.
Someone nearing retirement, for instance, might take an interest-only loan against his or her current home to buy a retirement home, then sell the first home to pay off the debt after retiring.
“Today’s interest-only loans don’t have the toxic features for which these loans were once known, such as prepayment penalties and negative amortization that would raise the loan balance over time,” Mr. Rodriguez says. David Doyle, lending product and pricing executive at Bank of America, says today’s interest-only deals aren’t like the versions offered to all comers a decade ago. (Those earlier loans were thought to encourage borrowers to overstate their assets and income by requiring little documentation.) These loans are now meant for more sophisticated borrowers.
New underwriting rules
“Today’s interest-only borrowers qualify within underwriting rules which usually require lower debt-to-income ratios, higher credit scores and larger down payments” than in the past, Mr. Doyle says. He says the goal is to ensure the borrower can pay even after rates rise and the principal payments kick in.
What’s more, interest-only products typically provide a smaller loan relative to the property value—perhaps only 65%—while conventional 30-year fixed deals may offer close to 100%.
Today, most nonmainstream products like interest-only mortgages are no longer converted to mortgage-backed securities with the major government-sponsored entities like Fannie Mae and Freddie Mac, says Mr. Handel of Raddon Financial. Instead, he says, they remain on the lender’s books, encouraging more scrutiny of the borrower’s ability to pay.
The key to loan approval is the borrower’s ability to pay, and lenders are looking at a range of options beyond income from a full-time job, including irregular income from self-employment and assets such as investment accounts.
Originally posted on the Wall Street Journal