By Bob Sullivan
updated 7/18/2005 2:35:54 PM ET 2005-07-18T18:35:54

It’s called the Stress Free Mortgage.  The interest rate is advertised as a rock-bottom 0.99 percent. Better still, initial monthly payments are almost a dream, nearly half what a traditional mortgage holder would pay. With the Stress Free Mortgage, offered by Great Financial Mortgage in Fullerton, Calif., a buyer looking at a $310,000 loan would pay only about $995 a month. For the first year.

The stress could come later. 

Minimum payments rise each year, so in five years the minimum is $1,330 a month.  Even at that, borrowers have not even begun paying for the house. In fact, they haven’t even paid all the interest they owe the bank. After five years of rising payments, the mortgage balance is actually higher, closer to $329,000. 

At that point, the real stress begins. When the loan payment is reset, because of the rising outstanding balance, the new minimum payment is $2,015 — more than double the initial payment.  And that assumes interest rates are flat.  Were interest rates to rise slowly – say from the current 5.5 percent to 6.4 percent — the new minimum monthly payment would be a knee-buckling $2,243.

Welcome to the high-stakes world of the negative-amortization loan. With skyrocketing home prices in America’s hottest markets, lenders have become increasingly creative in their efforts to stretch consumers into pricier homes.

Interest-only loans, nearly unheard of three years ago, have jumped in popularity.  “IO” mortgages, which come in many shapes and sizes, can shave 20 to 30 percent off monthly payments because they temporarily relieve borrowers of the need to pay any principal.  But after that temporary reprieve, mortgage payments jump sharply. Fully one-third of mortgages opened last year were interest-only loans, causing a stir of concern among economists including Federal Reserve Chairman Alan Greenspan.

But interest-only loans seem conservative compared to the latest lending rage, the negative-amortization loan.  Consumers who sign up don’t even have to pay the full interest owed the bank each month. Instead, they borrow more money as time goes by, making minimum payments in a way that echoes the world of revolving credit card debt.  In a housing market that goes suddenly flat, such a loan guarantees the buyer will be “upside down” after a few years — meaning their home will be worth less than the mortgage on it. 

Offered 'alongside Viagra ads'
Few financial experts or even mortgage brokers see these loans as a sound borrowing technique for most consumers. Yet according to UBS analyst David Liu, 40 percent of mortgages over $360,000 that have closed so far this year are “neg-am” loans.  And the Internet is crawling with all manner of come-ons, offering products with names like “Name Your Payment” loans.

“I always remind people that those things are offered on the Internet alongside Viagra ads and deals with shady folks from Nigeria,” said UCLA economics professor Edward Leamer.  He believes the rise in riskier mortgages is a sure signal that America is indeed in a housing bubble, and he worries consumers who are anxious to buy high-priced homes are getting in over their heads.  “I can't say everybody doesn’t know what they are doing, but this is a direction that is very worrisome.”

There is still plenty of debate about the size and scope of a possible housing bubble.  But there is little debate that soaring prices are stretching home budgets like never before.  Harvard University's Joint Center for Housing Studies recently found that nearly one in three American households spends more than 30 percent of income on housing, and more than one in eight spend close to 50 percent.

There is also growing consensus that the rising popularity of creative home loans could spell trouble. The gyrations of lenders alone should give consumers pause. 

Interest-only loans haven’t been this popular since the late 1920s; negative-amortization loans since the early 1980s California housing boom. Both those trends ended badly. But today, there are entire families of adjustable-rate, interest-only loans.

Consumers who choose negative-amortization loans — also called option ARMs — are not locked into additional borrowing each month.  Loan holders can choose one of four options — a minimum payment that results in “deferred interest,” increasing the mortgage balance; an interest-only payment; a payment that represents a traditional 30-year mortgage rate; and a larger payment that  represents an accelerated 15-year mortgage payment.  But a UBS  study recently suggested that 70 percent of neg-am mortgage holders make just the minimum payment.

'That's the risk you take'
Such monthly borrowing from your house spells real trouble, financial experts say.

“The only way you can assume that kind of risk is you are saying the house is going to appreciate substantially, you are assuming your income will increase significantly, or you are assuming interest rates will fall or remain the same,” said Robert Manning, author of "Credit Card Nation" and a personal finance expert. “If interest rates rise, property values fall or your income stays the same, you are absolutely screwed.”

Richard and Jamie Henriquez just refinanced their home in Granada Hills, Calif., with Great Financial Mortgage and chose a negative-amortization loan with low initial payments.

“We looked at 30-year fixed,five-year fixed, three-year fixed, and we chose that one because with the payment, you can’t go wrong. It’s flexible,” Henriquez said.  Asked if she was worried about what might happen in three or four years, she said, “I'm really not. I could sit here and worry about that right now, but I don't know what's going to happen three or four years down the road. I know if interest rates skyrocket that’s going to put us in a bad position, but that’s the risk you take.”

In Congressional testimony last month, Greenspan called such loans “exotic” and said their popularity was a development of “particular concern.” Federal banking regulators have made noises about additional scrutiny on banks that make such loans. And credit rating firms Fitch and Standard & Poors have announced they are mulling a re-examination of investments tied to such loans.

Yet the popularity of these loans has turned the mortgage industry on its head, confusing consumers, said Liz Weston, author of “Your Credit Score” and a personal finance columnist at

“I'm talking to mortgage brokers in their 20s who say that only an idiot would have a 30-year fixed mortgage right now,” Weston said.

Blamed for extending the bubble
Some experts say these non-traditional loans are artificially extending the housing bubble. The math is simple — consumers who can make a $2,000-a-month mortgage payment can afford a $350,000 loan using a traditional mortgage.  With an interest-only loan, their buying power jumps to over $430,000.  With a negative-amortization loan, that payment could get an eager couple into a $600,000 home.  Consumers who want to buy a home with a traditional mortgage are easily outbid by those with exotic loans, pushing prices higher.

Not all interest-only loans are equally risky. The real danger is an interest-only mortgage tied to an adjustable rate.  Should rates rise a point or two, consumers could face a punishing double-whammy when the interest-only period expires and they are forced to start paying higher rates along with principal. Monthly payments could double for some.

“A lot of people getting that loan don't understand the risk. If this is the only way you can get into a house, it's the worst possible choice,” Weston said. “Even if rates stay the same — and no one expects they will — you have a guaranteed time bomb ticking away.”

Brokers are so willing to peddle interest-only mortgages that a note posted on a housing bulletin board by a reporter looking for nervous mortgage holders elicited this e-mail response: “My name is Oscar and I'm a Senior Loan Officer and Mortgage Analyst, give me a call to qualify you for an Interest only loan. No Obligation.”

Brokers who offer such loans say they are helping people who might otherwise not be able to afford the American dream of a new home. 

“It's a strong product with a real purpose in today's economy,” said California-based mortgage broker James Rothstein.  “Quite simply it has allowed more people to buy a first home than ever before.”

A lack of understanding
But the idea that an interest-only loan can get you into a home you couldn’t otherwise afford is a fallacy, other experts say — unless you are the only one shopping with that kind of loan.  As a rising tide lifts all boats, the availability of risky mortgages lifts all prices.

“An interest-only loan is an admission you can't afford the house you are trying to buy,” said Bill Fleckenstein, president of Fleckenstein Capital, an investment firm. “The assumption is you will refinance. The unsaid assumption is prices are going up and you will get bailed out. These loans are being made when both sides must know that the loan wouldn't work if it weren't for this little fudge. … But if the math doesn’t work, sooner or later, you’re going to be tripped up.”

Manning has just completed a set of focus groups around the country quizzing people on their understanding of the mortgage market. The results were alarming, he said.

“What's intriguing about Americans is that they have bought into the world view that everything will be better in the future,” he said.  “People are willing to spend money because credit companies convince them that things will be OK. In our focus groups,  people said they are counting on their house doubling in value in 5 years. … People are in worse shape then I thought.”

Gavin Fenske, president of Great Financial, said people who accept his loan offer are willing to make that gamble.

“(In California), people are not making money by paying down principle. They are making money because the market moves,” he said.  “So who cares if I go down $20,000 in negative amortization when my property just went up $120,000? That's the logic behind it.” But he cautioned that the loan is not for first-time home buyers with little money for a down payment.

Some observers find the logic flimsy. They sense an eerie similarity to the technology stock  bust five years ago. And there is an additional concern: In many large cities there is no such thing as affordable housing, says Ben Jones, who runs a popular blog called The Housing Bubble.

“I don't understand why it's not a national crisis,” Jones said. “Housing is a basic need. If you saw the price of milk or bread going up like this, Congress would be asked to do something. ... The market didn't need to be juiced with all this easy money.”

Confusing elements for consumers
There is a story economists tell about the difference between locals and tourists when selecting restaurants. Tourists usually overpay for average food because they don’t know better; locals have figured out where the best cooks are and who’s overcharging.  The problem with the mortgage market is that consumers are almost all tourists because most buy homes only a few times in their lives. That makes them vulnerable to come-ons like low introductory interest rates and low monthly payments. But the new loans have complex elements many consumers might not immediately grasp.

Jack Guttentag, author of "The Mortgage Encyclopedia,” points out many pitfalls on his Web site,  Many people seem to believe that interest-only and negative-amortization loans give them access to lower interest rates; they don’t.  In fact, lenders charge a premium rate for the right to pay less each month.  Rates for such loans are lower only because most interest-only loans are also adjustable-rate loans. An interest-only option on a 30-year fixed loan — which is offered by some lenders — would have a higher rate than a traditional version of the same 30-year-fixed loan.

Many mortgage buyers also confuse the time schedule of the interest-only loans — principal payments can be put off as long as 15 years — with the time their interest rate is fixed, which can be as short as six months.  That can lead to major monthly payment surprises.

Of course, the most confusing element of all is amortization, which is the rate at which the consumer actually buys the house from the lender.  While low early payments look attractive, they can be costly.

For a $400,000 option-ARM loan, a borrower who chooses minimum payments over 30-year fixed payments will spend $50,000 more in interest over the life of the loan, assuming interest rates remain flat. If rates climb slowly by one point during the 30 years, the penalty is $70,000. In a nightmare scenario, where interest rates steadily climbed to 9.95 percent, a negative-amortization loan holder would pay $1.1 million for that $400,000 home, compared to $816,000 for the holder of a 30-year fixed loan — a $300,000 penalty.

New approach to borrowing
There is hardly universal agreement that non-traditional mortgages are bad. In fact, some suggest they merely represent a change in mind-set among house buyers — namely, that they have no intention of buying their house. Instead they are essentially renting the home until they move to another one.

“Consumers are managing mortgage debt like revolving credit. I don't think it's necessarily bad. It's different,” said Pam Martin, a spokeswoman for RMA, a Philadelphia-based association of bank and thrift risk managers..  “Consumers look at a mortgage differently than they did 20 years ago. ... There is a new emerging phenomenon.  People don't look at paying off their mortgage because they know they are going to go buy something else in a few years.” 

But that is a gamble of timing. Consumers who aren’t buying equity in their homes through their mortgages are betting on a force beyond their control — an unpredictable housing market.  A falling, or even flat market could leave many “upside down.”

Should they have to relocate, they will not be able to sell their homes without paying the bank. And refinancing likely will be too costly. Manning, who lived in Washington, D.C., in the early 1990s, recalls entire blocks of homeowners simply “walking away” from their places in the 1990-91 recession because they were tens of thousands of dollars upside down.

“People couldn’t sell their homes because they didn’t have $50,000 to pay the bank at closing,” he said.

For consumers who choose these non-traditional loans, there is most certainly a day of reckoning sometime in the future — perhaps one, three or five years out, depending on the terms of the mortgage.  Unless the buyer has sold or refinanced by that time, their mortgage payments will rise, perhaps substantially.

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