Teaser rates on mortgages approach 0 percent
Ruth Simon
Wall Street Journal
Feb. 15, 2005 10:42 AM
azcentral.com
Taking a page from credit-card companies and car makers, mortgage lenders are touting loans with rock-bottom introductory rates - in one case, nearly 0 percent.
Most of these loans are so-called option adjustable-rate mortgages, which carry an initial rate as low as 1 percent. One key and unusual feature: Borrowers get up to four payment choices each month. But the risks can be considerable and aren't always well-understood. For one thing, the low introductory rate can last for as little as one to three months, after which the rate typically jumps above 4 percent or more. Plus, rates on these loans adjust frequently, meaning borrowers could see their costs rise as short-term interest rates increase.
Still, at IndyMac Bancorp, 30 percent of mortgage customers are opting for the company's Pay-Option ARM, which carries a starting rate of 1 percent. At Washington Mutual Inc., short-term ARMs accounted for $19 billion, or 40 percent, of the company's mortgage originations in the fourth quarter, up from 24 percent a year earlier. In California, the nation's largest mortgage market, such loans account for as much as 20 percent of all mortgage volume, according to Todd Householder, an executive vice-president at National City Corp.
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For lenders, the low teaser rates are a way to attract customers at a time when business has slowed. Mortgage volume is expected to decline to $2.5 trillion this year, according to the Mortgage Bankers Association, from a peak of $3.8 trillion in 2003. The need to keep loan pipelines full has helped fuel the growth of interest-only mortgages and other creative lending products.
A number of big lenders are entering the market. Greenpoint Mortgage, a unit of North Fork Bancorporation Inc., and GMAC Mortgage, a unit of General Motors Corp., rolled out option ARMs last year. J.P. Morgan Chase & Co., Thornburg Mortgage Inc. and National City all have similar products in the works. Other lenders, including CitiMortgage, a unit of Citigroup Inc., Bank of America Corp. and Wells Fargo & Co., say they are looking into offering them.
With home prices still rising, the new loans offer borrowers a creative way to increase their buying power. "You can really put a borrower into a buying category for which they would not traditionally qualify," says Robert Moulton, president of Americana Mortgage Group Inc., a mortgage broker in Manhasset, N.Y. Lenders typically qualify borrowers for these loans based on the interest rate that's charged after the teaser period ends, which can be 1.5 to 2 percentage points less than the rate on a traditional 30-year fixed-rate mortgage, he says.
Lenders say that option ARMs appeal to borrowers who earn bonuses or commissions or are otherwise looking for flexibility.
The rise of loans with low teaser rates comes at a time when traditional fixed-rate mortgage rates still remain a bargain. Rates on 30-year fixed-rate loans currently average 5.75 percent, according to HSH Associates, while rates on 15-year fixed-rate mortgages average 5.32 percent.
One lender, Quicken Loans Inc. is offering a different kind of teaser rate. This winter, the online lender rolled out its Take 6 mortgage, which invites borrowers to "Pay practically nothing on your mortgage for 6 months!" The adjustable-rate loan, which carries a rate a hair above 0 percent for the first six months, was the byproduct of a brainstorming session last summer, says Quicken Loans chief economist Bob Walters. "We know 0 percent is real popular with autos," he explains.
But homeowners aren't getting a free lunch. Borrowers pay 2.25 points upfront, or $4,500 on a $200,000 loan. That works out to an effective interest rate of roughly 4.5 percent, notes Jon Eisen, a mortgage broker in San Diego. Most borrowers roll the fees into their loan amount, Mr. Walters says.
Borrowers typically get up to four payment choices each month - a minimum payment, which is set at the start of each year; an interest-only payment; or the standard payment on a 15-year or 30-year mortgage. Rates typically adjust monthly after the teaser period ends.
Some borrowers who opt for option ARMs could be in for a rude awakening. If interest rates rise, borrowers who elect to make the minimum monthly payment can suffer "negative amortization," meaning their loan balance swells. That's because, as rates rise, the minimum payment isn't enough to cover even the interest that is due. They could also be hit with sharply higher monthly payments several years down the road.
At least one lender, Chase, says it won't include a negative-amortization feature when it introduces its option ARMs later this year.
For borrowers who make the minimum payment regularly, the default rate is likely to be 20 percent higher than for traditional fixed-rate mortgages, even if interest rates don't rise, says Susan Kulakowski, a vice president at Dominion Bond Rating Service.
Loans with negative amortization were common in the late 1980s. But they fell from favor because many borrowers didn't understand the risks of a rising loan balance. When real-estate prices fell, some borrowers wound up owing more than their home was worth.
Lenders say they have tightened their lending standards and now do a better job of explaining the loans' risks. They have also added new features, such as limits on how big the outstanding balance can get.
To understand the pitfalls, consider someone who took out a $400,000 mortgage with an introductory rate of 1 percent in January. The introductory rate is used to calculate the minimum payment on the loan - in this case, $1,287. But after the first month, the actual rate on the loan is roughly 4.6 percent. If interest rates edge upward, a borrower who made the minimum payment each month could end up owing nearly $407,000 after the first year, according to DBRS.
A new minimum payment is calculated at the end of each year based on current interest rates and other factors. To reduce the potential pain, lenders typically set a 7.5 percent cap on how much the minimum payment can rise in most years. The cap is typically waived once every five years so that the borrower is put back on track to pay off the loan over the original 30-year period. The minimum-payment option is suspended if the loan balance reaches a preset level - typically between 110 percent and 125 percent of the original loan amount.
To see how far payments can jump when the cap is waived, assume that interest rates continue to move up gradually. The minimum payment would increase to $1,383 in the second year, according to DBRS, and by the fourth year rise to $1,598. The real bite comes at the end of the fifth year when the cap on payment increases is suspended. The minimum payment jumps to $3,109 - well over twice the original amount - so that the borrower is back on track to pay off the loan in the remaining 25 years, according to DBRS calculations. |
