The Upside Down Loan Game

The Commonwealth of Massachusetts Division of Banks released a Regulatory Bulletin this week providing guidance to Massachusetts mortgage lenders and brokers in regard to the increasingly popular use of what are termed “nontraditional mortgage products,” most commonly adjustable rate mortgages, interest only mortgages, deferred interest mortgages, negative amortization mortgages, and mortgages with balloon payments due at maturity. While the bulletin was directed at lenders, encouraging them to adopt sound practices, a summary of the major points of the bulletin is provided here to give guidance to our consumer clients so that they may make relevant inquiries to a prospective mortgage lender before entering into a loan commitment for a “nontraditional” loan.

The recent popularity of nontraditional mortgage products was fueled by two major factors: rapidly escalating housing costs and increased competition within the mortgage lending industry. As housing costs climbed in the 1980s and 1990s, many borrowers found that the initial monthly payments on fixed rate mortgages were too high to allow them to qualify for a mortgage loan. To adapt to this reality, mortgage lenders first developed products offering a low initial rate, typically fixed for a period of three or five years. After the initial period, the rate adjusted annually, based on a published rate of interest plus a margin. In the majority of cases, the adjusted rate was higher, creating a higher monthly payment. As a practical matter, this increase in the interest rate, and the corresponding monthly payment, rarely caused significant hardship, for several reasons. First, many borrowers in adjustable rate mortgages were first-time buyers, who were ready to sell their first home and move to a new home during the initial fixed period. Second, the majority of adjustable rate products allowed the borrower to refinance without penalty, and as the borrower’s income increased over the years, they were often able to refinance into a fixed rate if they didn’t sell during the fixed period. For the same reason, borrowers who kept their adjustable rates typically had the financial ability to maintain the higher adjusted payments.

In the last several years, however, the continued upswing in prices, along with greatly increased competition in the booming mortgage lending industry, led to the development of more creative, but also more risky, nontraditional products. In an effort to push the initial payments even lower, banks created “interest only” and “deferred interest” mortgage programs. In an interest only program, no principal is repaid to the lender during the initial period. At the end of the period, the payments increase to reflect the need to both pay the interest and pay down the principal by the end of the loan term. A deferred interest program actually adds to the principal over the initial term, creating an even higher monthly payment once adjusted to amortize the remaining payments. To offset the significant jump in the monthly payment, an alternative program with a lump sum, or “balloon” payment due at the end of the loan became popular.

As the Division of Banks Regulatory Bulletin points out, consumers must take adequate steps to get full information and disclosure at the outset of the mortgage application process. In selecting between loan alternatives, consumers must understand what the estimated increase will be in their interest rate and payment in any adjustable or deferred loan product, and factor that number, not just the initial fixed number, into their decision making process. Borrowers must know with certainty whether their payments are paying down principal, or simply paying interest, because as we have seen recently, when housing prices slump, equity can be eaten away unless a mortgage loan is being steadily paid down. The same is true with programs with a balloon payment, which can often represent much of a properties equity at the time of sale.

Parker|Scheer takes pride in working with mortgage brokers and lenders who take the time to carefully explain each of the mortgage programs available to any particular borrower, and tailor a product to every borrower’s individual needs. We encourage our clients to call us before embarking on a mortgage loan, so that we may give guidance and assistance to find a suitable lender to handle a loan application or pre-approval.

Contact a Massachusetts Real Estate Attorney

For more guidance on choosing a mortgage product in Massachusetts, or if you are looking for a real estate attorney in Boston, please contact Rob D. Stewart. If you prefer, you can also telephone our offices in Boston seven days a week at toll free 866-414-0400.

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