The sound of carpenters at work in subdivisions or the sight of building cranes rising above street corners are the obvious clues that Chicago has participated in the great housing boom of the early 21st Century.
A less obvious sign is the surge in popularity of the interest-only mortgage.
These loans have grown from just a sliver of the market in 2003 to a slice today, says Frank Nothaft, chief economist at Freddie Mac, a government-sponsored mortgage agency.
But many experts forecast a different economic climate in 2006, one that may alter consumer preferences in mortgages.
The number of homeowners whose adjustable-rate mortgages (ARMs) will become more expensive is set to soar next year. With interest rates rising, some consumers are already seeking to refinance into fixed-rate loans.
And, borrowers may take out interest-only loans, but with some of the conservative trappings of the traditional fixed-rate loan.
A dose of conservatism is just what’s needed in the mortgage market, experts contend, citing widely offered loans that allowed borrowers to pay a bare minimum each month but add to their mortgage balance at the same time.
This summer, banking regulators issued risk management guidelines for home equity lending. Soon, they will issue similar guidelines for first-mortgage loans, says Kevin Mukri, spokesman for the U.S. Comptroller of the Currency. Moreover, private agencies that rate pools of mortgage loans sold to investors are taking a closer look at how borrowers will be able to handle their debt and imposing tougher ratings, says Nicolas Retsinas, director of the Joint Center for Housing Studies at Harvard University.
It wasn’t just home buyers or sellers who participated in the housing boom. Homeowners took advantage of low interest rates and rising property values to refinance their mortgages into a lower rate and many times rewarded themselves with extra cash, taking on a larger mortgage or opting for a home-quity loan or line of credit.
Now, however, interest rates are rising, property appreciation is cooling in many areas and lending standards may soon get stricter. What can buyers and owners expect in the next year?
For one, interest-only loans aren’t going away.
A key reason that these loans caught fire in the last couple of years is home prices and household income. The former raced ahead while the latter barely moved.
“If home prices slow and incomes have a chance to catch up, it might modify the desperation” of those struggling to afford a home, Harvard’s Retsinas says.
Historically low interest rates have enticed buyers, but the low rates weren’t enough to keep monthly payments affordable for many home seekers. So lenders started marketing interest-only loans, which do not require a borrower to pay back a portion of the principal each month.
Lenders also have many ways to tinker with when and how principal must be paid or how interest rate charges are calculated.
One type of interest-only loan popular for minimizing payments started with an interest rate below market, as low as 2 percent. Borrowers were required to pay only the interest for five or 10 years, for example, but no principal.
Many of these loans whose interest rates were adjustable allowed borrowers to pay a minimum amount that was even less than the interest. Because interest-rate charges can adjust quickly, sometimes monthly, that 2 percent interest can become 6 percent within a year.
The loans are deemed risky because the principal mortgage balance, which the borrower eventually must start to pay back, could grow above what a home is worth and make the monthly payment unaffordable.
That won’t stop borrowers from trying to keep payments low, however, and interest-only loans “will have a permanent place in the marketplace,” says Doug Duncan, economist for the Mortgage Bankers Association, a trade group based in Washington, D.C.
He predicts, though, that more borrowers will select interest-only loans that don’t have risky features, such as rates that change often.
Lots of borrowers are taking interest-only loans that look a lot like the standard, 30-year, fixed-rate mortgage, says Donna Doberstein, executive vice president at 1st Advantage Mortgage in Evanston.
Adjustable-rate mortgages have become less attractive as the Federal Reserve has acted to raise short-term interest rates and loan payments have adjusted higher.
“People are looking for fixed [rates] because the adjustable rates are heading up,” says Doberstein.
Despite the surge in interest-only loans, the standard 30-year fixed was still the most popular type this year at GMAC Mortgage, says Mike Mahfouz, senior vice president.
With short-term rates rising, securing a fixed-rate loan at 6 percent, or slightly above, looks attractive, Duncan says. And, should rates on the 30-year fixed rise to near 7 percent, more borrowers may elect five-year ARMs, which have a rate slightly below the 30-year fixed for the first five years, Duncan adds.
For buyers who need to trim their monthly payment, there are 30-year, fixed-rate, interest-only loans in which the borrower doesn’t have to pay principal for up to 10 years.
The interest rate on this loan is slightly higher than a standard fixed-rate loan, Doberstein says.
For instance, a traditional fixed-rate might carry a rate of 6.25 percent. On a $200,000 loan, the monthly principal and interest payment is $1,233. The same $200,000 loan as an interest-only might have a 6.5 percent rate, and interest payments alone would be $1,083. After 10 years, you would have to start paying off principal, so your payment would be $1,493 for the next 20 years, Doberstein says.
Many home buyers will have moved in a decade or seen their individual incomes rise, Doberstein notes.
Trying to “stretch” what you can afford, however, may get tougher.
Lenders will be more likely to scrutinize credit scores and the size of a down payment before they’ll grant interest-only or minimum-payment options at advantageous rates. Borrowers who don’t meet certain standards will pay higher interest rates, says Rick Palandri, president of 1st Mortgage of Illinois, Bloomingdale.
Banking regulators will soon issue guidelines calling for stricter underwriting, but many lenders are already tightening standards, Palandri says.
Still, they say many home buyers focus only on what their starting payment will be, ignoring how high future payments might be.
Many homeowners are seeing higher interest rates and mortgage payments on ARMs taken a year or two ago, reports Kathy Stoughton, a financial specialist with ComPsych Corp., a Chicago-based provider of employee assistance programs.
“We are hearing from people whose loans have adjusted up just at the same time their real-estate taxes and gas prices and commuting costs are going up,” says Stoughton.
So, it now might make sense to refinance your adjustable-rate mortgage into a fixed-rate loan.
Many homeowners who take a mortgage where the rate is fixed for three or five years and later adjusts annually (whether it’s an interest-only or a more conventional ARM) tend to forget about that rate adjustment, says Greg Gwizdz, executive vice president of Wells Fargo Home Mortgage.
This year, homeowners nationwide held about $85 billion worth of ARMs that were due to reset, and in 2006, there will be about $380 billion in ARMs scheduled for a rate adjustment, Gwizdz says.
If homeowners don’t understand their contract and how an adjustment can be calculated, they should contact their lender, he says.
Evanston resident Thomas Minar was one of the millions of homeowners who took an adjustable mortgage in 2003, when rates dipped especially low.
Though the rate in the low 4 percent range holds for five years, he recently refinanced into a 15-year loan at 5.75 percent.
Minar said he did an “analysis looking at how high the rate [on the adjustable] could possible go and how much it might cost. It could go up to 9 percent.”
Fixing the rate now costs more in the short-term, but Minar believes it will be cost-effective in the long run.
Lenders are anticipating other homeowners may make similar refinancing decisions and are trotting out a host of fixed-rate options. Some, like 15- and 20-year loans, allow homeowners to refinance without stretching their term for another 30 years.
“I know of one lending company where the management meets every week to figure out what new wrinkles they should have on their mortgage products,” says Harvard’s Retsinas. “Never underestimate the innovation of the marketplace.”
