Friday, October 14, 2005

Is your mortgage a monster?

Risky loans easy to get, hard to repay

By Brian J. O'Connor / The Detroit News

How the loans stack up Alternative mortgages differ from conventional fixed-rate mortgages. 30-year fixed-rate You save for a down payment, you buy the house and your payments don't change unless you refinance. No-down 3/1 ARM A three-year adjustable-rate loan with no money down. Rate is fixed for three years then adjusts annually, based on different indexes, such as the prime rate. The initial period in ARMs can also run for five years or longer. Interest-only 3/1 ARM A three-year adjustable-rate mortgage with no money down and interest-only payments for the first three years. 80-20 piggyback Another no-money down strategy, this one combines a conventional 80percent fixed-rate loan plus a home equity loan or home equity line of credit. Source: Detroit News research What's your best mortgage move? Picking a loan means balancing initial costs against the risk rates will rise. 30-year fixed-rate Benefits: Set payments and loan terms. Equity builds with each payment. This cushion makes it possible to refinance or, in the worst case, sell at a loss without owing money to the bank. Drawbacks: You'll need to save more than $40,000 to buy a $200,000 home, a barrier many lower-income and younger buyers can't surmount. Zero-down adjustable Benefits: You get in with no money down and have lower payments -- at first. Good if you stay in the house only a few years or, if home values are rising, you can refinance. Drawbacks: Refinancing is expensive or difficult if value doesn't increase, worse if it falls. Selling early means paying closing costs, commissions and loan balance not covered by the sale. If you stay, payments go up to include principal plus any rise in rates.   Interest-only zero-down adjustable Benefits: Everything with the 3/1 adjustable plus lower initial payments. Good for fluctuating incomes if you pay extra toward the principal, or if income will rise. Drawbacks: All the risks of an ARM, plus it builds no equity and guarantees higher payments if you stay and can't refinance. To sell, you'll owe about $14,000 on a $200,000 home, minus any appreciation. 80-20 piggyback Benefits: Fixed-rate 80% loan with a 20% home equity loan offers best 100% financing option. Builds equity with a mostly stable payment. Unlike an ARM, only the equity payment increases when rates rise. Drawbacks: You must pay off the equity loan, refinance it or refinance the entire mortgage in 20 years. Little equity cushion in early years. Source: Detroit News research Related links Loan news and advice from Bankrate.com Error processing SSI file Find more useful financing information miHomehunt.com. Previous coverage It doesn't take a genius to see how much home to buy Letting others use your credit is risky Mortgage maze baffles first-time buyer Mortgage myths can cost you money Comment on this story Send this story to a friend Get Home Delivery

Bryan Jendreas grabbed a great bachelor pad last September. One-thousand square feet, two bedrooms and three floors, right in fashionable Royal Oak. With a no-money-down mortgage, he could finance the entire purchase price and pay less than if he were renting.

A little more than a year later, however, the 29-year-old can't sell the condo for what he paid for it. Like a lot of recent first-time home buyers, he's discovering that zero-down financing and other creative mortgage options that make it easy to get into a home also can make it hard to get out during tough times.

Mortgage rates are up and home values across Michigan are stalling. Jendreas, who moved to California for a job, is feeling the pinch.

"I'm just trying to get out before the housing market goes farther south," he said. "I want to just unload it and get out of there."

Realtors and mortgage bankers in southeast Michigan report that they're seeing more and more homeowners discovering the dangers of alternative mortgages. Some, like Jendreas, end up owing more on the mortgage than the property is worth because of Michigan's troubled economy. Others are finding their monthly payments rising by hundreds of dollars as the initial period of the mortgage ends and rates adjust upward.

"These products have been around for some time but they've been marketed to wealthier home buyers," said Greg McBride, senior financial analyst for Bankrate.com. "The problem comes when these products intersect with mainstream borrowers who already have very tight budgets."

Virtually unheard of five years ago, alternative mortgages have soared in popularity since the late 1990s, offering consumers a way to buy homes with no money down, low introductory payments or both. During the same time, rising home values combined with a surge in home-equity lending to see homeowners using their properties like ATMs, refinancing into riskier mortgages whenever they wanted cash.

Now, however, home prices in Michigan are flat or declining in some areas. That leaves homeowners who owe more than the property is worth unable to lower payments by refinancing, and owing money to the bank if they sell.

"They may have to bring cash to the table just to go through with the closing," said David Acquisti, president of the Michigan Mortgage Brokers Association and owner of MSource Financial Group in Ortonville.

The typical tried-and-true mortgage involves a hefty down payment -- preferably at least 20 percent -- and gives borrowers a fixed rate for up to 30 years. This gives the buyer instant equity and a reliable, fixed payment.

There are a few drawbacks, though. Buyers first have to save up that cash, then keep all the cash tied up in the home for decades. In addition, interest rates are higher on fixed-rate mortgages.

Alternative mortgages get buyers around these barriers but not without risks -- the biggest being the assumption that home values will continually increase. Here's how they work:

The no-down risk

No-down mortgages like Jendreas' allow buyers to skip saving and finance 100 percent of the home's price, and sometimes adding in the closing costs. This helps get more people into homes, which is universally considered good for communities and the most reliable way for families to build wealth. The problem comes if the homeowner needs to sell or refinance.

In the case of a sale, the owner faces paying commissions, taxes and closing costs that could total close to $14,000 on a $200,000 home. Unless the property has appreciated or the homeowner has been in it long enough to significantly pay down some of the loan balance, the seller is faced with paying those costs in cash just to get out of the property.

Refinancing at the best rates won't be possible if the house is worth less than the loan balance.

Jendreas is selling because he was laid off from his job at a Warren wood products company. He spent four months looking for work before finally landing a position near his mom in California. Now he's sleeping on her floor and shelling out more than $1,200 a month to pay his mortgage back in Royal Oak while he tries to sell or rent the place.

With closing costs and fees, Jendreas initially financed $132,000, but he'll count himself lucky if he can get his asking price of $129,000, plus he's throwing in a new alarm system and a washer and dryer.

Adjustable rates

Adjustable-rate mortgages -- ARMs, for short -- offer lower initial interest rates, which then rise after three or five years. That keeps payments low in the first years, but they can quickly rise if interest rates head up -- which they have for the past two years.

ARMs are good for homeowners who will be moving before the rates adjust and don't want to tie up a lot of money. They're also good when the owners expect they'll see an increase in income, such as when a spouse returns to work. And when home values are rising, ARMs allow a homeowner to get in, build equity and then refinance into a fixed-rate mortgage.

If the homeowner ends up staying in the house and can't refinance, though, the monthly payment can soar. For buyers who stretched to get into a first house, the higher payment can be painful.

Interest only

Some alternatives offer an interest-only option, where borrowers are paying down none of the loan balance during the initial period. "Option loans" give the buyer a choice each month between paying interest only, principal and interest, or a set payment that's less than even the interest-only amount.

Again, these loans work to get buyers into homes but not in building any equity at all. In the case of the option loans, borrowers can end up adding to the loan balance when they use the set payment amount, which adds the unpaid interest.

When the payments on these loans adjust, borrowers have to start paying interest and principal, significantly raising their monthly bills. When these options are added to adjustable-rate loans, borrowers face a double whammy: higher payments with higher interest rates.

Stay if you're stuck

Homeowners who find themselves stuck in a risky mortgage have few options. The first is to start paying toward the principal so they can build some equity, says Greg McBride, senior financial analyst with Bankrate.com.

"You need to be putting some money toward that principal every month. That's not money that's spent, that money is equity, and that equity could be a valuable cushion at a sale or refinancing."

Other experts say borrowers should stay in the home if they can and wait for home values to increase, though that may take as long as five years.

"Do whatever you can to wait it out a little bit, suggests Susan Carter of Woodwardside GMAC Real Estate in Royal Oak. "Keep up with your payments and work with your lender. They do not want the houses, trust me."

When home prices were appreciating as much as 10 percent a year, she adds, homeowners weren't necessarily wrong to take out alternative mortgages.

"Those are no-brainer products in a strong appreciating market," Carter notes. "But for the next year or two, the no-equity people have nowhere to go."

You can reach Brian J. O'Connor at (313) 222-2145 or boconnor@detnews.com.