Creative Financing Could Hurt Borrowers When Housing Market Cools

September 14, 2005

Specialty mortgages are lowering the financial threshold for admission into the red-hot real estate market. But one topic that isn't getting much notice is the potential economic impact of this type of lending when new homeowners find themselves paying the literal and figurative price for using creative financing.


"Buyers are pursuing unusual and aggressive financing -- which sometimes includes a loan from a second institution to cover the down payment -- in order to participate in this market," said Dennis Hoffman, director of the L. William Seidman Research Institute at the W. P. Carey School of Business. "Some of these deals are getting really close to the edge."


According to the National Association of Realtors, among the more popular forms of specialty mortgages are:


  • Interest-Only Mortgages: Monthly mortgage payments only cover the interest on the loan for the first five to 10 years of the loan, and nothing on the principal. After the interest-only period ends, homeowners must start paying higher monthly payments that cover both the interest and principal over the remaining term of the loan.


  • Negative Amortization Mortgages: Monthly payments are less than the amount of interest owed on the loan. However, the unpaid interest gets added to the loan's principal amount, causing the total amount owed to increase each month instead of being reduced.


  • Option Payment Adjustable Rate Mortgages (ARMs): Homeowners have the option of making different types of monthly payments, such as a minimum payment that is less than the amount needed to cover the interest and increases the total amount of the loan; an interest-only payment; or the payments are calculated to pay off the loan over 30 years or 15 years.


  • 40-Year Mortgages: A home loan is paid off over 40 years, instead of the more customary 30 years. While a 40-year term will reduce monthly payments and help a person qualify for the home, the homeowner eventually will end up paying more in interest.


The sky's the limit


The upshot of these specialty mortgages is that homeowners risk having the monthly payments on their creative loans –- payments they already may be struggling to make –- skyrocket.


The National Association of Realtors reports that when the interest rate on a mortgage changes from 4 percent to 6 percent, the monthly payment could jump by as much as 50 percent. For example, a person who bought a home for $300,000, put 10 percent down, and chose a 5.75 percent interest-only adjustable rate mortgage will pay just under $1,300 a month. After five years, if there has been no increase in mortgage interest rates, the monthly payment increases to just under $1,700 because payments now include principal in addition to interest. If after five years there has been a 3 percentage point increase in mortgage interest rates to 8.75 percent, monthly payments jump to $2,220 –- nearly $1,000 more than the interest-only payment.


People who choose specialty loans will also find that it takes longer to build equity. In fact, some may see the amount owed on the home increase rather than decrease over time.


"These loans enable people who would not qualify in a normal underwriting procedure to obtain loans on houses that, under the old strictures, are too expensive for them," said Herbert Kaufman, professor of finance at the W. P. Carey School. "This is where the danger comes in."


If the economy continues to grow, Kaufman said, people who took out specialty mortgages are more likely to see their incomes grow as well -- which should enable them to service their rising monthly payments.


On the other hand, incomes may not rise sufficiently to allow those people to make their higher mortgage payment and keep spending in other areas, Kaufman warned. Since the national economy is largely driven by consumer spending, the diversion of spending dollars to mortgage payments could have broad impact. In the event of an economic downturn, the institutions that are issuing the specialty mortgages, the housing market, and the economy in general could be at risk if the incomes of these buyers don't keep up with rising monthly home loan payments. In the best of circumstances, some default on specialty mortgages could impede a growing economy. In the worst, large numbers of defaults could drag a sinking economy lower.


"I'm not forecasting either of these scenarios," Kaufman said. "What I'm trying to lay out are the threats growing out of these changes in our basic underwriting standards with respect to mortgage qualifications." 


Federal Reserve Chairman Alan Greenspan is also sounding a note of caution. In testimony before the House Committee on Financial Services in July, Greenspan said that the "increase in the prevalence of interest-only loans and the introduction of more exotic forms of adjustable-rate mortgages are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market. Moreover, these contracts may leave some mortgagors vulnerable to adverse events. It is important that lenders fully appreciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change."


Kaufman acknowledges that there are valid reasons for people to opt for specialty mortgages, particularly in light of the fact that housing prices in some markets -- notably in parts of Arizona, Nevada, California, Florida and certain cites on the East Coast -- are rising at spectacular rates. As long as such increases continue, these "bets" will continue to look very good.


Housing sales: hyper-mode


"I would characterize the housing market as being in hyper-mode. The unique aspect of this is that it's not just in Phoenix, it's throughout the world," said Jay Butler, director of the Arizona Real Estate Center and associate professor of real estate at ASU. "In a good percentage of the country very little is happening. But in the markets that have usually been very strong, like California, Florida and the East Coast, you're beginning to see quite a bit of activity."


The National Association of Realtors recently released its second-quarter numbers for existing single-family home prices, and the results -- particularly for parts of the South and West –- are astonishing. The national median existing single-family home price was $208,500 in the second quarter, up 13.6 percent from the second quarter of 2004 when the median price was $183,500. The strongest price increase in the nation was in Arizona's Phoenix-Mesa-Scottsdale area, where the second-quarter price of $243,400 was a whopping 47 percent higher from a year earlier. Cape Coral-Fort Meyers, Fla., saw a 45.2 percent increase to $266,800; median prices in the Palm Bay-Melbourne-Titusville area of Florida rose 40 percent to $204,000.


The strongest increase was in the West, where the median existing single-family home price rose 19.5 percent year-over-year to $312,600. After Phoenix-Mesa-Scottsdale, the greatest gains in the West were in Reno-Sparks, Nev., where the median price of $357,400 rose 32.1 percent, followed by the Tucson area, up 30 percent at $228,500, and Honolulu, up more than 28 percent at $577,800.


Butler said housing prices, which have been rising for almost 10 years, are accelerating at a pace not seen since the early 1970s and late 1980s. A strong economy, a growing job base and creative financing are some of the forces that have gathered to increase housing prices in certain areas to unprecedented levels.


"One, you have lenders who were willing to lend, and were aggressively competing against each other to attract borrowers," he said. "Second, people have learned over the last 10 years that the only people they can count on are themselves. President Bush has told us that Social Security is in deep trouble. United Airlines showed us that even if you're retired, you can't count on your pension. You don't have careers lasting 25 years anymore. With companies going in and out of business, there are significant layoffs. So starting in the '90s, people began taking hold of their own investment portfolios."  More than ever before, Butler said, the home is considered an investment -- to build equity, rent out or flip for a profit while the market is still hot.


Ahead: continued high heat or flame out?


But of course, nothing lasts forever. As Hoffman said, logic suggests that such rapid price acceleration can't be sustained indefinitely. "At the same time," he said, "There is so much momentum in place, such a frenzy to buy housing, that it is very, very difficult to predict the end game here. It is very difficult to know when this market will cool."


Butler said there already is anecdotal evidence that the market is starting to slow; listings are beginning to increase and deals are falling through because the appraised value won't support the price.


He also believes that the use of unusual financing techniques to draw borderline or even unqualified buyers into the market is a sign that the end may be near.


"If this market is so great and glorious, why are we doing all this exotic and creative financing?" he asked. "We are shoehorning people into houses they cannot afford -– getting them in over their heads -- people who maybe should not be in the market at all."