By
msnbc.com contributor
updated 8/30/2006 2:50:22 PM ET 2006-08-30T18:50:22

"Joe" is a homeowner who did not want to give his full name for this story because he’s ashamed to admit that he soon won’t be able to afford his monthly mortgage payments.

In order to get the $800,000 house he bought early last year in California’s Silicon Valley, Joe got an “option ARM,” an adjustable-rate loan that lets him choose from a variety of payments every month. The smallest payment included no principal and less than 100 percent of the interest due. The unpaid interest was tacked onto the principal, creating “negative amortization.” 

This let Joe trade lower payments now for higher payments later. He initially thought his salary would rise along with his home’s value — he was a marketing executive for a small software firm he was confident would be successful. But when a lost deal closed the company and  “For Sale” signs popped up  — and stayed up — in his neighborhood, a now-unemployed Joe is wondering how he will afford those higher payments when his rates adjust.

Joe is not an atypical homebuyer in the Bay Area or other now-bursting bubble markets across the country. Nearly half of the homebuyers and thirty percent of people refinancing mortgages in California chose interest-only loans last year, according to research firm LoanPerformance. The nationwide numbers are not so high — 32 percent for homebuyers and 20 percent for refinancings — but they do reflect the country’s increasing reliance on these so-called “exotic” mortgages.

Payment shock
Now these cheap mortgages that fueled the real-estate boom are beginning to hurt the homeowners they once helped. Higher interest rates and the end of honeymoon periods for too-good-to-be-true teaser rates are increasingly causing payment shock for borrowers.

"Nationwide, approximately $400 billion of [home-purchase adjustable-rate mortgages] are scheduled to reset at some point in 2006," said Frank Nothaft, chief economist with Freddie Mac in McLean, Va. "A significant number of homeowners will face some adjustments." In fact, the ARMs with scheduled payment increases this year work out to about 5 percent of all single-family debt outstanding in the country now, he said.

Many of these mortgages carry negative amortization features that permit borrowers to pile on additional debt beyond their original balance, and make minimal payments for the first several years. Once the initial period is over, however, payments could shoot up by 100 percent or more as the loan resets.

Other programs allow interest-only payments with no reduction in the original loan balance until the reset point. Then payments can jump by 50 percent or more in order to amortize the debt balance over a compressed number of years.

Like Joe, more California homeowners are having difficulty making their mortgage payments, according to a report by DataQuick Information Systems. Banks and mortgage companies sent warning notices to more than 20,000 homeowners earlier this year, telling them they were in danger of foreclosure. That’s an increase of 67 percent, the biggest one-year jump on record. Though a notice of default doesn’t mean a homeowner will lose their house, it could be a key measure of financial distress.

Federal and state financial regulators are expected to issue mildly restrictive guidelines for lenders making new loans this fall, but these rules won't help homeowners who are heading for payment resets in the coming year, and may be unaware of the financial shocks they face.

To head off potential problems, Countrywide Loans, the largest mortgage originator in the U.S., has started sending out letters to thousands of its borrowers who have been making only the minimum payments on the company's pay-option ARMs. The letters are framed as “an early message” to alert homeowners that based on their current payment trends and potential future interest rate changes, they should prepare themselves for significant increases in monthly payments.

The letters contain hypothetical examples of what lay ahead. One is a California homeowner making only minimum payments on a $402,000 loan. The current full interest rate on the loan is 7.6 percent, but the borrower has been paying just $1,348.47, far less than what's needed to fully amortize the mortgage over its 30-year term.  If the loan reset at today's rates, the full payment required would be $2,887.50 — more than double what the homeowner is currently paying.

Countrywide does offer advice to customers who want to prepare for resets in the coming year: They should either switch from the minimum and move to either a 15-year or 30-year standard amortization plan, switch to an interest-only option if full payments are not feasible to fend off still-higher principal debt balances, or explore alternative refinancing options sooner than later.

Don’t be an ostrich
But some financial experts don’t see a doomsday scenario and say that due to frequent turnover in the housing market, exotic mortgages are here to stay.

“The average life of a loan is less than five years, so why get a 30-year fixed-rate loan which locks you into higher payments?” says Teresa O'Dette, owner of O'Dette Mortgage Group in Tahoe City, Calif. “People are not buying homes to stay in them forever.”

O’Dette could afford a 30-year fixed mortgage on a home in the upscale Lake Tahoe area she lives in but instead chose a negative amortization loan with fixed monthly payments but an adjustable rate, currently at 7 percent. “So far, I’ve added $12,000 to my $900,000 loan, but the value on my home has gone up $300,000 since I took on the loan. If someone offered me $1.5 million on my house, that $12,000 extra is not much of an issue.”

Still, not all homeowners can expect to use rising house prices as a cushion these days.

Greg McBride, a senior financial analyst at Bankrate.com advises exotic-loan holders to consider where they’ll be a year before their rate changes. “If you’re thinking that you’ll stay in your house longer than the four of five years you originally expected to, it’s time to refinance for a more appropriate loan.”

Long-term dwellers who started out with an exotic interest-only or pay-option ARM should take a look at fixed-rate mortgages, which are now at four-month lows, he said. “You’ll see a big payment increase but at least you’ll be certain that the payment will not change.”

Another option is to downsize to a more affordable home, especially if the current home was purchased three to four years ago. “You’re sitting on a nice chunk of equity that can give you some latitude to avoid payment shock,” said McBride.

Any homeowner with a loan can determine when their rates will rise and by approximately how much. The lender will typically send notice six months in advance of when the rate will reset, and the indexing margin used to determine that rate is stated in the loan paperwork. Bankrate.com has a “Rate Watch” page that tracks the lenders’ benchmarks weekly.

“Maybe your loan doesn’t adjust until March, but now is a good time to think about this,” said McBride. “Knowing your adjusted rate is not a mystery nor should it be a surprise.  Mortgage holders shouldn’t put their heads in the sand now only to wake up in a few months to see their payments shooting up by $500 or more. There is plenty of runway ahead of you to prepare for when that rate adjustment approaches.”

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Data: Latest rates in the US

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Home equity type Today +/- Chart
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Source: Bankrate.com