A CALL TO A.R.M.s

BusinessWeek's cover story is Nightmare Mortgages (revisited)

I just read the cover story of Business Week, How Toxic is Your Mortgage, as well as the recent MSN story 'Exotic' mortgages seen losing their allure. Both articles go into great deal about the various type of loans discussed here. Of course, there are some inaccuracies and individual horror stories that do not tell us anything. Why? Because, if lose your job you are in trouble, regardless of the state of the economy.

I have 3 goals with this post:

1) Identify objective reality with regards to the housing bubble
2) Point out where popular opinion gets it wrong.
3) I will answer and discuss the various scenarios and lend my advice for those who are worried about their own situation.

First premise: There are no bad loans, just bad borrowers.

Second premise: There is no reason to use a loan broker when you can use a direct lender, such as Washington Mutual or Bank of America. But, if you must use a sub-prime lender because of bad credit, look at my rule number one below: AVOID PRE-PAYMENT PENALTIES.

Third premise: don’t confuse an interest-only Adjustable Rate Mortgage aka ARM with an Option Arm. An Option ARM provides the borrower with 4 payment options. Only the Option ARM can put the borrower into a negative amortization position by paying less than the amount of interest accrued. Both products have economists worried as hell. Not me. Don’t buy a house if you think that the value will be less in 7 years.The theory behind both: a) Interest only – You can secure a fixed rate (and payment) for 3, 5 or 10 years. The rates are around 6% currently. – This loan is good for almost everyone.b) Option ARM – It holds down the minimum payment in the first 1, 3 or 5 years below the fully amortizing payment and even below the interest-only payment. If the borrower makes the minimum payment only, the deficit of interest is added to the “outstanding loan balance” on a monthly basis. Usually, the loan balance can not exceed the 125% of the original loan amount. This loan is good for someone who intends to hold a property short-term, especially investment property (and to help avoid negative cash-flow out of the box).

Fourth premise: These so called “exotic loans” are not new. They have been around forever! And, I have used them all personally. Option ARMs go back to 1981 and 40-year and interest-only loans back to 1930.

Fifth premise: 100% financing has no bearing or concern on this debate. It doesn’t tell us anything about how the loan was underwritten or what the payment reset structure is about. And, they do not create additional risk.

Here is what we are facing, as laid out in both articles: the theory is that after the initial payment period, the monthly minimum payment will adjust to a level that could double the payment and force people to lose their homes in foreclosure, causing the bubble to burst. Let’s say you had a $200,000 mortgage with a teaser start rate of 1.6% providing a minimum payment of only $557. Then, after year one, it requires a fully amortizing loan with a rate of 7%, your payment will increase to $1344! What I suggest is either sell the house, refinance into an interest-only loan (payment here would go to $1,000) or get another 1.6% Option-Arm that does not jump up for with 3 or 5 years. Problem solved.

Avoid big trouble when looking at loans by:

1. Always avoid first mortgages carrying pre-payment penalties.
There is no reason to accept that loan provision and it can come back to hurt you by preventing you from refinancing you loan at the right time or paying a huge penalty to refinance. Keep this in mind as you read on!

2. NEVER pay down the rate on a loan in the form of points or origination.
These are rip-off fees that you will never recover. In fact, the A.P.R. is the most misleading rate that you will be quoted. Why? Because it spreads out the points over 30 years instead of the more likely 2-5 years in which you will likely keep the loan.

3. Do not get suckered into a 30-year fixed rate loan.
Especially now, after the recent move up in rates, unless, of course, you find one with no points, no fees and no pre-payment penalty. Why? Because, you won't be in the loan more than 2-5 years and when adding in points and fees your actual rate may be wind up being closer to 8-9%.

4. Do not refinance your house and combine consumer debt for the purposes of Debt Consolidation.
Most lenders do not agree with me. However, why make unsecured debt secured by your home? Isn't that, in theory, putting your household at more risk than not in case something goes wrong? Also, you can not compare credit card rates (18%) to mortgage rates (6%) and conclude that it's "better" to take the lower rate when you are comparing unsecured to secured debt. You will no doubt be fooled by the lender's worksheet showing a lower combined monthly payment. But, simply call your creditors and negotiate lower rates.

HOW I GET IT RIGHT:
Go back in time and we find there have always been poor underwriters and careful underwriters. (Poor meaning that they qualify an applicant to the interest-only payment and not to the fully amortized payment). There have always been so called "exotic" loans: negative amortization, 40-year amortization and interest only. There have always been market tops (June, 1990 was such a top). I do not know of any lenders having to refinance borrowers in anything but an orderly process. In fact, appraisals are actually coming in higher than sales prices (not unusual considering they go back 6 months for comps).

Prime Resets(only) can all be met with orderly refinancing into......another negative amortization or interest only loan. Simply put, a reset means that after the period of time in which you are only required to pay the minimum payment, usually in the first 1, 3 or 5 years, below the fully amortizing payment and even below the interest-only payment, a loan provision allows for the lender to then begin requiring fully amortizing payments which may double a borrower’s payment. And, the beauty of just getting a new loan is that the rates for 5 or 10 year interest only loans are around 6%! So, the idea that we are facing an onslaught of foreclosures because of resets that will double a borrower's payment never made sense and will not cause housing to crumble. Like the economic cycle of autos, supply and demand (as well as regional job formation) and interest rates play into the cycle. A condo buyer in Phoenix should not care a bit what homes are selling for in upstate NY, for example.

As I said earlier, despite what has been said and written about by others, THERE ARE NO BAD LOAN PRODUCTS JUST BAD BORROWERS. You have no doubt heard ads from sub-prime lenders stating that “good people sometimes get in trouble”? To which I say, not everyone is (credit) worthy of having a loan, especially, if you have no equity, bad credit, no job, an IRS tax lien, or had a bank foreclosure.

CONCLUSION: Most reputable lenders offer Interest-Only and Option ARM products that do not reset in the first 5 years and carry a first year pre-payment penalty of only 2%. However, most loans are sold and few are “bought”. ARMs aren’t for everyone anymore than the 30-year fixed rate loan is. Loans are financial tools to enhance your real estate ownership. Handled as intended, these so called “risky” or “exotic” loan products not only can be fabulous borrowing tools, but can save you a lot of money when properly employed. Get advice, don't get sold.



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