CHAPTER 6
Payment Option Loans and
Other Loan Types

AT THE SAME TIME that subprime, reduced-doc, and no-doc loans became increasingly available, there were and are other types of mortgage loans.

These new types of loans came with benefits as well as with potential problems. The loans arose under various labels, some even under proprietary trade names, but they all offered new benefits for the borrower.

One of the new types of mortgage loan, which attracted a lot of borrower attention and became very popular in many high-priced real estate areas, was a loan with monthly payment amount choices or options that the borrower could select. For the first time in a widely available mortgage product, consumers could select from a number of monthly payment amounts and each following month have the same choice of payment amount, at least for a number of years.

The industry and financial press called these types of loans payment option loans. Typically, the loans were thirty-year loans, and payment options generally included the following choices:

1. The lowest payment option: Usually, this consisted of a very low monthly payment determined by a formula but still satisfying the terms of the loan. This payment option was available to the borrower for a number of years—say, the first five years of the loan term—after which larger catch-up payments were required.

2. Interest only on the outstanding principal balance: Again, this option was available for a certain period of the loan term, after which the borrower was required to make larger catch-up payments.

3. Regular amortizing payment: This is the monthly amount calculated to pay off the loan at the end of its term in years. This is the type of mortgage and payment on a thirty-year fixed-rate loan that most consumers are familiar with.

4. Higher payment: If made regularly and on time, this option would allow a borrower to totally pay off the loan balance in a shorter number of years than the full term of the loan. Lenders offered ten-, fifteen-, twenty-, or twenty-five-year payment options. On payment option loans with a pre-payment penalty, this is actually more restrictive than a standard or regular fixed-rate loan without pre-payment penalty.

Some payment option loans were fixed rate. With others, the interest rate was adjustable.

Here are the central characteristics of payment option loans:

• They have interest rates higher than fixed-rate conventional loans (the tradeoff for the payment option feature).

• If the lowest monthly payment is selected, the loan balance increases each time the lowest payment is made. This is growing loan principal or negative amortization, and it’s why the catch-up payments may start earlier than under the interest-only option.

• These loans can seem to make sense in an appreciating or rapidly appreciating real estate market. If the lowest payment only is made in a flat or declining market, equity can be quickly eaten up. In fact, the borrower can end up upside-down (owing more than current market value of the property).

• The lowest monthly payment option is an artificially low amount. Its purpose is to appeal to the consumer. (It’s usually computed by a simple formula so that local lenders can compute an actual monthly payment figure to sell to prospective borrowers.)

These loan types have built-in features that can lull the consumer into what can later become a very challenging or untenable position. In the declining real estate market of many cities, these loans can be very problematic.

Many readers are familiar with adjustable rate mortgages (ARMs), which have been around for a long time. Just a few words about them: A typical ARM loan has a fixed low interest rate for a given number of years. Typically, the initial rate is set for one, two, three, or five years. After that, it adjusts annually based on a formula set forth in the loan documents.

• Many lenders call the initial rate for the initial period a teaser rate. It is an artificially low rate whose purpose is to tease or entice the consumer to take the loan.

• Adjustable mortgages make sense in some limited circumstances, such as if you’re given a two-year job assignment somewhere and you know your employer will transfer you to another state at the end of your assignment.

• After the initial period of the teaser rate, an index-plus-margin formula applies. It is higher than the then-available fixed rates.

• In a flat or declining real estate market, adjustable rate loans can be very problematic.

Forty-year fixed-rate loans became widely available in 2005 or so. Their purpose was to provide some payment relief to borrowers. Here are a few words about this little-used loan product:

• Interest rates are somewhat higher than on thirty-year fixed-rate loans.

• The amount of payment relief to the consumer is very small.

Alt-A Loans

Alt-A is the name given to another type of loan for borrowers who fall just below the criteria for becoming a prime Fannie Mae or Freddie Mac conforming borrower. One characteristic necessary for approving the loan (or more than one) may be lower than on prime loans.

For example, the borrower’s credit score might be twenty, thirty, or forty points or more lower than that required for a prime loan, but he or she could still be approved for an Alt-A loan. Loan pricing for these loans is lower and, accordingly, the consumer interest rate is somewhat higher than for a prime loan.

This type of loan has been widely available since 2002 or so. It was a major break for those borrowers whose credit history was just shy of the mark. Alt-A loans likewise became readily available and marketable through the same sources for funding as conventional loans. Alt-A loans funded many first-time buyers who previously couldn’t buy at all, and they were a factor in increased demand for starter and move-up properties.

Along with the new or increased usage of all the available mortgage options, millions of people were able to purchase the homes of their dreams. Almost all of them would have been well-performing borrowers had a perfect storm not come their way.