Exotics are for a Rare Breed

These loans can be beneficial under the right circumstances
Home loans used to be fairly simple. They came in fixed rates and lasted 30 years and people stayed in the home until it was paid off and then threw a party. But then the late ’70s rolled around with 18 percent interest rates and the balloon payment was born. Since then, lenders have opened the door for home ownership to more and more people with a variety of mortgage types and terms.

Although consumers largely benefit from the choice of so many loan products, they also need to be far more diligent in understanding what they are getting than the old fixed-rate or no-house days. If they aren’t, they will likely suffer the consequences emotionally and financially.

Many consumers think the lenders and mortgage brokers will look after their best interests, when in reality they are selling a product and their compensation ultimately depends on the type and amount of loan they qualify you for. That’s why it is important, just as when hiring a real estate agent, to go with experience and reputation. It’s also important that you truly understand the loan you are getting and what the payments will be, not just after the one-month teaser or first year but in the future.

“These loans are good, as long as they are explained properly,” says Dawn Peck of Countrywide Financial in Oxnard. “Consumers need to understand the pros and the cons or they can get into trouble.”

Here’s a look at the basics of what are considered “exotic” loans. There are many more. In fact, if you can think of a loan, there’s probably one available as long as you are willing to pay the costs.

Fixed interest only
You will only be required to pay the interest portion of the loan for three, five, seven or 10 years depending on the loan you elect to get. The positives of this loan are that it will allow the borrower to qualify for a house for which they otherwise might not be able. People might also prefer this loan if they are happy with the equity they already have in their home and don’t want to have put any more money toward principal unless they want to. These consumers usually want to use that money for other investments or they decide it’s more important to get the house they want now and worry about building equity later. The cons to this loan are that the payments after the agreed upon interest-only term ends will significantly increase. If the borrower’s income does not increase enough to afford the adjustment, they will have to refinance or sell the house. Of course, if interest rates rose substantially over the period they were paying interest-only they may not be able to afford the new loan. Also, if their local real estate market is down, the house could have lost value or be difficult to sell in a timely manner.

Example: For a 30-year fixed-rate mortgage of $250,000 at 6.25 percent with interest-only payments for five years, the monthly payment would be $1,302.08. After five years, the payment would jump to $1,649.17 for the remaining 25 years. If you elected an interest-only term of 10 years, the payment would be $1,827.32 for the remaining 20 years.

Interest-only Hybrid ARM
This loan operates the same as the fixed interest-only loan except that when the fixed period expires, the loan switches to an adjustable rate mortgage and will be calculated based on the index + margin that you agreed to when you got the loan. There are so many adjustable rate programs and indexes that it is not possible to consider them all here. Basically, people choose the hybrid ARM for the same reasons as the fixed interest-only. The hybrid ARM will have a lower interest rate so the interest-only payment will be somewhat smaller than the fixed rate, but the downside is that you have no idea what the interest rates will be when the loan converts to an ARM. That’s why Peck, who has been in the lending industry for about 25 years, says these loans are better suited to those with a short window for owning, such as someone who is in a corporate relocation situation, where they will be protected if the house loses value or is difficult to sell. Military personnel may also be good candidates because they are usually stationed at bases for 3 to 4 years.

Example: If you had a 6 percent 5/1 ARM loan of $250,000, you would pay interest only of $1,250 for the first five years. With a predicted interest rate of 7 percent (it could be lower or higher) after five years, the payment would be $1,767 for the next 12 months and then re-adjust monthly or longer depending on the terms. The danger here is that it is impossible to predict what the interest rate would be in five years and it could be much higher than 7 percent. If the market is in a period of rising interest rates, payments can increase dramatically.

Option ARM
This adjustable rate mortgage allows the borrower to make one of several payment options each month. The borrower can choose to make a payment for 30-year fully amortized, 15-year fully amortized, interest only or a minimum payment. The option ARM can benefit consumers who have inconsistent income, such as those who are self-employed, or those that are concerned that a household member could lose a job and want maximum flexibility. Borrowers would also consider this loan if they plan to own the property for a short time or to refinance after a few years. “This loan would be good for people who have a lot of equity in their home,” says Peck. “It’s also good for those who are in high-commission sales. They can make the minimum payment when they’re waiting for commissions to come in and make larger payments when they get paid.” The minimum payment will not be enough to pay all of the interest due so the unpaid portion will be added to the loan balance (referred to as negative amortization). The minimum payment will actually increase the amount you owe the lender and should only be used in an emergency and for as short a period as possible. Dependence on the minimum payment will ultimately result in dramatic increases in payment amounts, often referred to as “payment shock.”

Example: A borrower has a 30-year option ARM tied to the 12-month Treasury Average (MTA) index (4.863 percent) and a 2.50 percent margin. Remember, there are at least seven common indexes that have varying rates and varying margins according to the lender. For this example, the fully amortized 15-year payment would be $2,298.11, the fully amortized 30-year payment would be $1,724.64, the interest-only payment would be $1,533.96 and the minimum payment would be $833.13 (this would cause $700.83 in deferred interest to be added to the borrower’s principal).