Exotic Mortgages

The word exotic may seem better suited to describing a faraway locale for a "Survivor" episode than a mortgage. But if lenders were to call these "riskier mortgages" instead, they might not attract as many consumers. In truth, riskier is precisely what exotic mortgages are.

Their appeal to borrowers: They offer lower monthly mortgage payments, even if they last only for a while. Payments go up later, perhaps doubling or more. But some borrowers shun thinking about later. They want to buy a home, and with high home prices in some markets, they may have trouble qualifying for conventional mortgages. They see an exotic mortgage as one of the few routes to home ownership--or as a way to buy more house than they otherwise could afford.

Other consumers turning to exotic mortgages already are homeowners. They're switching out of traditional mortgages, lured by the prospect of lower monthly payments. They, too, will get hit with spiraling payments. And they can't escape from the mortgage without paying thousands of dollars in penalty fees.

Whether first-time home buyers or refinancing homeowners, these consumers end up in the same dire situation. They no longer can afford their mortgage payments. And they face losing their homes and ruining their credit standings. 

Risky and befuddling

Part of the problem with exotic mortgages is that consumers don't understand them. "Dissecting these loans is a daunting task for the average borrower," notes Allen Fishbein, director of housing and credit policy for the Consumer Federation of America in Washington, D.C.

Turn to a lender you can count on to look out for your best interests: your credit union.

These mortgages usually include two loan types:

  1. Interest-only mortgage (IO)--With a traditional mortgage, your monthly payment includes both principal and interest. An IO mortgage requires that you pay only the interest during a limited period, usually three to 10 years. Thus, you trim your monthly payment during that time. But the principal you owe doesn't just vanish. Eventually, you have to pay it back, as well as the interest, and your monthly payment jumps. Most IO mortgages also have adjustable interest rates. So if interest rates climb, your monthly mortgage payment jumps higher still.
  2. Payment-option adjustable-rate mortgage (payment-option ARM)--This is an ARM that allows you to choose from among several payment options month to month. You could, for instance, pay interest only. Or you could pay a minimum that's even less than the interest amount. In that case, the interest you don't pay gets added to the total amount you owe on the mortgage. You could end up owing more than you borrowed in the first place, a condition known as negative amortization. Payment-option ARMs typically start out with extremely low interest rates, and then rates can rise. These loans get more confusing yet, with such features as built-in "recalculation periods" and "ending-the-option payments." Suffice to say that, in multiple ways, you can get socked with a huge surge in your payment.
    Dissecting these loans is a daunting task for the average borrower.

In for a shock

The common trait, and the root of the trouble, for both of these types of mortgages is payment shock. Most regular home buyers simply don't have enough wiggle room in their budgets to absorb a mortgage payment hike of 30% to 100%, perhaps more.

Speaking of payment shock, another type of mortgage some consumer advocates see in the same dangerous light as exotic mortgages is what's called the "exploding ARM," such as the 2/28 ARM. This carries a low interest rate for the first two years, and then the interest rate adjusts every six or 12 months for the life of the loan.

Typically, exploding ARMs are thought of as subprime mortgages--those aimed at high-risk borrowers. But many middle-class borrowers also have entered into 2/28 ARMs in recent years, according to Evan Fuguet, policy counsel for the Center for Responsible Lending in Durham, N.C. "No one is immune to predatory lending," he says. Based on a study of subprime mortgages issued in 1998 through 2006, the Center predicts 2.4 million families have lost or will lose their homes to foreclosure due to subprime mortgage lending. Exotic mortgages contribute to foreclosures, too.

The common trait, and the root of the trouble, for these mortgages is payment shock.

With exotic mortgages, a common trap borrowers fall into is the belief that "If a lender is willing to give me a mortgage, I must be able to afford it." That's a lender's job, after all: to lend money only to those who will pay it back. Such an assumption is out-of-date in today's mortgage environment, Fishbein points out.

"Somewhere along the line in recent years many lenders became what I'd call loan facilitators as much as gatekeepers," he says. "Most consumers don't realize that, at their peril."

Some lenders don't worry as much anymore about making mortgage loans that might go bad, as they don't hold the loans themselves. They sell them to investors who invest in big pools of loans, in which a few bad loans among a lot of good ones have little negative impact overall. Added into this scenario are mortgage brokers who are eager to close loans because that's how they earn fees. The more loans they close, the better. So they're not inclined to point out risky loan features that might scare off potential borrowers.

Meanwhile, homeowners strapped with exotic mortgages face tough choices, or maybe none, in today's weakened housing market. "Before if people were in a loan they couldn't afford," Fuguet says, "they could refinance out or sell their house, even if they lost money. But with the cooler real estate market, those exits are being taken away."

People can get into trouble quickly if they don't understand what a loan can do.

Ward off trouble

The upshot is that mortgage borrowers face a "buyer-beware environment," Fishbein says. In September 2006, federal regulators called on lenders to pay more attention to borrowers' ability to repay before issuing mortgages. But federal guidelines don't apply to mortgage companies, who are major vendors of exotic mortgages. These companies are subject only to state regulations. As of April 2007, 33 states have followed the federal lead on setting stronger guidelines.

Still, consumer vigilance is critical, experts say. Ask lots of questions about any mortgage you're considering. How much can the interest rate climb? How often can payments rise? How big a payment shock could you face someday? Does the payment you're being quoted include property taxes and property insurance? Is there a penalty fee for exiting the loan?

"People can get into trouble really quickly," Fuguet says, "if they don't understand what a loan can do."

Your best safeguard is to work with a lender who will answer all your questions and fully disclose information about mortgage options. To help you look out for your best interests, turn to a lender you can count on: your credit union.