Friday, June 29, 2007

Would You Risk an "Extreme Mortgage?"

We recently met with new buyers to discuss the process of buying their first home. Since the first step in today's market is always getting pre-approval for a home loan, we spent a lot of time on the subject. With our advice and recommendations, these buyers were already pre-approved by the time of our face-to-face meeting. Although their credit and finances are strong, they were concerned with the loan broker's recommendation to consider an interest-only loan. With housing prices on the rise, loan products have gotten creative to meet the demand for more affordable payment structures. With a myriad of options out there, real estate agents can not be experts in the area of home financing and do not have access to all the answers to suit each individual buyer's needs. I am not an expert (although, I can recommend one.) I do, however, have first hand experience in the marketplace and can put my finger on two conflicting truths:

1.) A gamble on financing your biggest purchase is not worth the risk of foreclosure or a short sale. Short Sales and foreclosures are losing propositions and should be avoided at all cost.
A short sale occurs when a property is sold and the lender agrees to accept a discounted payoff, meaning the lender will release the lien that is secured to the property upon receipt of less money than is actually owed. Sometimes the debt in not "forgiven," but rather the difference is paid through a personal loan or alternative collateral.

2.) Home ownership is an admirable goal which can lead to increased financial security making some risk worthwhile. See MSN Money's article Why its smarter to buy than rent.

Reconciling the above concepts is a tasks best left to the experts. Real Estate agents can help you understand factors affecting the value of a particular property. Similarly, a loan broker can help you grapple with the value of a particular financial package. Today a loan broker sent me this insightful newsletter:

(excerpt From Cohns Loans Financial Newsletter dated 6/29/07)

As housing prices rise on the coasts -- $1,000 a day in some places -- buyers are taking on outsized mortgages and outsized risks. With the median home price in the Golden State nearing a half-million dollars, it's no wonder that fewer than 1 in 5 Californians can afford to buy a home. But plenty of people are snapping up high-priced houses anyway, on both East and West coasts, thanks to a burgeoning number of nontraditional mortgage loans. Can't afford a $100,000 down payment on a half-million-dollar home? Get a separate loan at a higher rate and borrow the money. Think you'll be richer down the line? Pay just the interest on your loan for a few years. Scared of high monthly payments? Get an adjustable interest rate that will stay low, at least for a while. It's a far cry from the days when 20% down payments and 30-year fixed-rate mortgages were the norm.

Borrowers on a precipice
But not everybody is so optimistic. A small band of skeptics is warning that homeowners are setting themselves up for a financial fall. If interest rates go up and home prices dip, owners may be forced to sell their homes at a big loss, some experts warn. "I'm nervous about it," says Elaine Worzala, professor of real estate at the University of San Diego. "I do worry about the borrowers in markets such as this one, where homes are so expensive." Her cautions are mostly ignored. To many aspiring homeowners, the housing market is issuing a clarion call they can't resist. In some parts of California, everyone seems to know someone whose home has skyrocketed $50,000 or even $100,000 in value in just the last two years or so.

A rush to buy, now or never
Although there are signs that local real-estate markets are cooling, "people act like we're going to run out of homes -- if they don't buy now they'll be left out forever," says Dan Ruiz, a mortgage broker who specializes in assisting Latino buyers in southern California. Because many of his clients can't afford to pay tens of thousands for a down payment, nearly all borrow the money, Ruiz says. And no wonder. In popular "80-20" or "100% financing" loans, potential homeowners borrow 80% of the purchase price of a home at one rate and the other 20% at a higher rate. Down payments used to be virtually mandatory "because the banks wanted you to have money in the investment to protect themselves," says Worzala. But now, the complex world of mortgage securities allows more flexibility.

Steeper risk in 'interest-only' mortgages
Adding to potential risk, buyers in California and elsewhere are turning to "interest-only" loans. By paying down only their interest for a few years, they keep initial payments low. Variable-interest-rate loans also woo potential home buyers. In many "hybrid" loans, the interest rates are fixed for the first few years, then can go up in the future, although the amount of increases is typically limited. For example, a homeowner might pay a fixed 3% interest for the first few years, with future increases limited to two percentage points a year or six points overall. The interest rate in this case, therefore, would never go above 9%. Sound reasonable? Lyndon Garcia thinks so. He had his eye on a $355,000 fixer-upper in the Los Angeles suburb of Whittier, but he didn't make enough as an environmental project manager to afford a $70,000 down payment. An 80-20 loan with an adjustable rate and interest-only payments was just the ticket. "There are so many positives to it," Garcia says. "Overall, it's an excellent plan. It helps the little guy." At least for now. But when interest rates go up, increasing monthly payments under adjustable rate mortgages? Combined with lower home prices -- something experts have been predicting in California for months, if not years -- they spell disaster. "A lot of people are already spending 50% of their income on their mortgage payment," says Worzala, the real-estate professor. "If the interest rates go up, they're all of a sudden very cash-poor, putting themselves in a position where they have to default on their loan and lose their house." Borrowers will be in especially bad straits if they haven't begun paying down the principal on their loans instead of the interest. "What's the incentive of staying if you have no equity?" Ruiz asks. But to new homeowners like Garcia, who bought his home with the help of Ruiz, the risk is worth it. Thrilled about his new house, he thinks his complicated mortgage loans are a "win-win."
One should consult with a qualified mortgage professional prior to implementing any mortgage strategies.
CohnsLoans is a full-service mortgage brokerage approved with numerous lending sources throughout the state. CohnsLoans provides conventional, nonconforming, jumbo, FHA and VA loans. We assist customers with great credit, bad credit, and no credit. CohnsLoans can also assist individuals who are self-employed and require either full documentation and no documentation loans. We can assist individuals and professionals with their financing needs whether buying, selling, or refinancing real estate. If we can be of assistance, please email us at or call us at 510-528-3400.

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