Although interest-only mortgages contributed to the financial crisis, and they are no longer approved by the Consumer Financial Protection Bureau (CFPB) as qualifying mortgages that can be resold to government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac, these home loans are still being offered to the rich.
Jumbo loans rise
In the nation’s highest cost areas, conforming loan limits top out at $625,000 for a one-family home. If finance prices are above this limit, banks have no hope of offloading the loans to a GSE, so they have to keep the loans on their own books. With expensive home prices back on the rise, these so-called jumbo loans have increased. Last week Bank of America reported that 36 percent of its fourth-quarter 2013 home loans were jumbo mortgages—an increase from 23 percent in the first quarter.
Risk of interest-only mortgages
Interest-only loans are popular at the top of the real estate market because the payments are lower, at least until the interest-only period ends—typically after 5 years.
During the mortgage meltdown, many borrowers could not maintain their mortgage payments when the interest-only period adjusted, leading to widespread defaults. What’s to prevent the same thing from happening again?
After careful analysis, lenders concluded that the rate of delinquency on mortgages during the crisis was lower with wealthier buyers, so banks are again ready to accommodate them.
Let’s see how an interest-only loan would work: Today, at 14 Breeze Street in Venice, California, there is a single-family three-bedroom, three-bathroom home for sale, near the beach, but not on it, for $1.4 million. Borrowing 80 percent would make it a jumbo loan, (although, for Venice, this was the median sale price in the third quarter of 2013). At 20 percent, the buyer would deposit $280,000 as a down payment and finance $1.12 million. On a 30-year fixed rate loan, at today’s best average rate of 4.33 percent, the monthly payment would be $5,562.31. Financing the same amount on an interest-only 5/1 adjustable rate mortgage (ARM) drops the payment substantially to $3,238.67 for five years.
That monthly savings is illusory because none of the principal will be paid down. After the five-year introductory period lapses, the entire principal—more than a million dollars—will still have to be paid off in a shorter time-frame, 25 years, at what will probably be a significantly higher interest rate than today’s 4.33 percent. The Federal Reserve Bank announced that, despite the stock market’s recent stumble, the bank will continue to back off its policy of quantitative easing, which will cause interest rates to float back up and are expected to be over 5 percent by year end. After five years, how high will the interest rate climb?
The rate reset on an ARM is typically governed by the London Interbank Offering Rate (LIBOR) plus a margin, which is the lender’s profit. If we go back five years, the LIBOR was 3.9091 percent. If we add a typical margin of 2.25 percent, we get an interest rate of 6.1591 percent. Multiply that by the principal of $1.12 million, now to be paid off over 25 years, and the monthly payment leaps up to $7,325.71, more than double the interest only payment. Remember, that the interest rate resets every year until the mortgage is paid off.
How to prevent new defaults
Are banks making the same mistake they made during the boom? Despite the fact that banks are allowing interest-only ARM jumbo loans, lenders are insisting on bigger down payments for this option, hoping that the lesser percentage financed, forestalls ARM reset shock.
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photo by Piotr Bizior