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Take a look at personal finance columns and economic outlook
stories in your local newspaper, and youre likely to notice that
journalists have taken a keen interest in one of our industrys most
popular products: interest-only (IO) loans. You know its a topic
worthy of consideration when everyone from Alan Greenspan to local
consumer advocates is talking about it.
The issue, as they see it, revolves around a convergence of two
factorsrising rates and declining home prices in some markets.
Heres one potential scenario: If rates rise, those with adjustable
rates who cant afford higher payments will attempt to refinance.
But if they happen to live in an over-inflated market where there
is a downward adjustment of home prices, they will suddenly owe
more than their house is worth and be unable to refinance.
Historical perspective
When the current version of the IO product rolled out a couple of
years ago, it was geared toward higher-end borrowers, which
translated into high credit scores, high incomes, plenty of cash
reserves and the ability to manage money well. But as the market
saw an opportunity to make more money with the product, the
industry became more liberal in determining who qualified.
Industry leaders and Wall Street investors are rightly concerned
about the performance of IO loans in the absence of long-term,
historical data. In that regard, IO loans are not that different
from the 125 product you may remember from the mid- to late 1990s.
With a loan-to-value (LTV) of 125 percent, this over-equity product
was based on the borrowers ability to repay rather than the value
of the home.
Many mortgage companies entered the 125 LTV market and initially
did very well with it. However, the product did not perform as
expected and investors lost their appetite for it. Additionally,
property values decreased in many areas, especially in the West,
where the product was most popular. Although the product is still
offered by a few investors, it remains more of a specialty product
today.
The mortgage business seems to have a short-term memory. We often
embrace a new product early on and are blinded by the possibility
of increased business and record originations. When a new product
takes off, we seem to think, If this is good, this would be better.
It is important for the industry to study the product and
performance of what we offer the consumer. It is also important to
use the product as it was originally intended.
The ideal IO borrower
All of the above notwithstanding, IO is a great product for the
right borrower. It seems custom-made for the borrower who either
earns commission, or a salary and significant bonus. Combine a
high-commission, high-income person with someone who manages money
well, and you have someone who consistently pays down their
principle balance and uses the product as it was intended.
Even for A-minus and sub-prime borrowers, IO could work if theyre
good money managers and are disciplined in their spending and
saving habits.
Borrowers who should avoid IO loans
Im sure there are many brokers and loan officers who will disagree,
but in my opinion, IO loans may not be well-suited for the
first-time homebuyer, despite the fact that many markets in the
country price starter homes into the $300,000 range. If an IO loan
were the only way for an individual to qualify, this may not be the
right loan for this situation and it may not be worth the risk for
the lender or the buyer. First-time homebuyers may not have the
necessary experience in paying home-related bills, managing their
money and saving for major expenses, much less setting aside
reserves to pay down principle in the event of a rate
increase.
Beyond first-time buyers, those who lack financial discipline as
well as those who want to use the lower payment of an IO loan
solely to afford a more expensive home should reconsider their
options.
Focus on education
Originators have an obligation to explain the IO product in as much
detail as possible. Borrowers are often blinded by the lower
payments, but they should really understand what can happen with
that loan when rates rise, which they will most likely do.
Most salespeople will tell you that it is considered
counterproductive to take the time to tell your customers all of
the reasons why they shouldnt buy your product. But look at it this
way: We normally dont talk about our faults on a first date, but
theyre generally common knowledge before a more committed decision
is made. Our potential partners either accept us or run the other
way. If they accept us with our imperfections, we know theyre in it
for the long haul.
A final word
So, whats my answer to those who discredit IO loans and predict a
problem with them in the near future? If everyone in the mortgage
industry is doing his or her job by educating the consumer and
using the product wisely, there wont be a problem.
The most important step in the origination process is to match the
right loan with the right borrower. Then we have to take that extra
step and educate the borrower on the positives and negatives of
each choice, especially as it relates to IO loans.
On the other hand, if we continue selling IO loans to those who
only want to buy a more expensive home than they could otherwise
afford, we may be adding to the problem and doing a disservice to
our customers and our industry.
Joe Amoroso is a senior vice president with Opteum Financial Services. He may be reached by e-mail at [email protected].
