To my loyal legion of readers, I start this column with an apology. Traditionally, the month of December is so slow, most realtors pack it in on December 1st, and wake from their comas on the 2nd of January. However, for us mortgage brokers, the exact opposite happens, hence the column shortage.

To those of you looking to refinance your 5/1 Interest Only ARMs, yes, this is a good time. Rates are lower today than they have been for the last year. It’s possible to get a 30 year fixed loan in the 5’s without paying a massive truckload of discount points.

In our columns to follow we’ll start discussing the following topics and what they mean to you as a real estate investor, buyer, mortgage holder and note holder: Yield Curve Inversion (see the link in the 4th paragraph for instructional graphics), Private Mortgage Insurance and recent tax code changes regarding it, When to Prepay, and many more topics.

Until then, have a safe and Happy New Year

Grant

In the following few paragraphs, I’ll explain some of the industry terminology, some of which is above (Conforming loans, etc.) and give a few references to help explain what makes this a special situation for many home owners. Even for someone experienced, mistakes happen, and for the first time home buyers, knowing whom to trust can become a financial decision that directly affects both your financial well being (tolerances for risk and debt) and your wealth too.

What’s a Conforming Loan

A quick lesson in terms is in order here to appreciate what makes a Conforming loan, the significance of a conforming loan, etc. Please take a quick look at links in this section, as they are all relevant to our topic, and each educational in its own way. Each year, Fannie Mae, the Government Sponsored Enterprise (GSE) responsible for a substantial chunk of the American mortgage market sets a maximum loan amount that Conforms to it’s lending guidelines. Being a GSE means that Fannie Mae (and it’s smaller brother, Freddie Mac) are given purpose to enable more Americans to experience the joys (and sometimes woes) of home ownership, more specifically, by lending to the broader demographic of homeowners who are purchasing homes that are near the median home costs nationwide. For a little bit of background, and to see how unprecedented the current housing market activity has been over the course of the last year, take a look at this article from CNN. The summary is that Fannie Mae reads the same statistics that you’re reading ;), and derives a maximum loan amount that gives proper security to the institutions and investors that buy its Mortgage Backed Securities on the Secondary market”. These transactions increase the desirability of buying mortgage loans that was a largely local commodity in past decades, transforming blocks of mortgage loans into investment grade securities.

Bottom line (with some back of the hand calculations), Conforming Loan Amounts service people who earn approximately 70% to 300% of the national median income level. To create some perspective from the numbers, that means that Fannie Mae targets the roughly 110,000,000 working people in the United States who are members of the middle class

Henry Bemis: “And the best thing, the very best thing of all, is there’s time now… there’s all the time I need and all the time I want. Time, time, time. There’s time enough at last.”

[Henry goes to pick up a book, but in doing so his glasses fall off and break. He slowly raises his glasses to his face, seeing they are completely broken]

Henry Bemis: “That’s not fair. That’s not fair at all. There was time now. There was, was all the time I needed…”

- “Enough Time at Last” Quote from Rod Serling’s television series, The Twilight Zone

As mentioned in the first post in this series, there are two general types of Payment Shock that affect homeowners due to the rapid increase of payment obligations. We’ve covered the first extensively, but the second is less known, and there are movements afoot to abate the issue as we speak. We’re talking about:

First Time Home Buyer Payment Shock

Just to give a rule of thumb to your ideas of what would constitute a Payment Shock to a first time home buyer (FTHB); most A lenders use 200% mortgage payment increase compared to the current rental obligation in their calculations, especially when a borrower’s income is not fully documented, B or C lenders might allow up to 300% or even 400% or even waive the requirement altogether. This is a good way to issue a foreclosure, and we like to avoid those . . . . . .

There are various reasons why someone might endure this kind of increase in obligations, and why there is more tolerance for it, and more risk too. In a rental situation, owing to the lack of tax benefit, combined with the obvious lack of appreciation in a rental, most people spend significantly lower sums and percentages of their income to rent a home or apartment.

One of the greatest shocks of homeownership obligation is the property taxes. In Florida where the homestead laws cap local tax assessments at 3% annual increase, the FTHB distress has become dire. Many FTHBs have no inkling of what’s coming and are poorly equipped to read their way out of it, having been swamped by the 100 pages of fine print in the first place. If you examine Florida’s Property Tax Disclosure, it’s very brief and doesn’t cover all of the in’s and outs. Another resource that most FTHB’s don’t know about is the wide availability of estimators at sites posted by the County Property Appraisers.

Typically, most of them do not know when taxes are not in escrow on the year that they purchase their homes and wind up with a tax bill that very same year, increasing their monthly obligations by 20% above expectations off the bat. Then, the following year, the localities adjust their taxes up to their market rate purchase and the joy turns to frustration or grief. That 400% tax bill increase is enough to sink their hearts (and wallets), and lands completely out of the blue to most FTHBs.

Further increasing the likelihood of Payment Shock is that the percentage of population that owns homes is skewed in favor of married couples. A sizable percentage of first time home buyers are recently married, or long time renters who have discovered the advantages of home ownership. According to the November 2001 issue of U.S. Housing Market Conditions published by HUD:

Historically, homeownership rates have been highest for households headed by married couples. The 1999 AHS, a national survey of the housing market funded by the U.S. Department of Housing and Urban Development and conducted by the U.S. Bureau of the Census, shows an 81.1-percent ownership rate for married couples, compared with 33.8 percent for households headed by separated individuals and 51.6 percent for households headed by singles (never married, divorced, or widowed).

Sometimes, people ask for it! In our example, a foreclosure waiting to happen arrived in the way of a FTHB, whose loan was declined . . . . This first timer is a former Mortgage Brokerage Business owner, (you’ll meet more of them like he in coming months, I suspect) who was unfamiliar with the term Payment Shock. This gentleman had the audacity to request that I obtain for him a 100% financed purchase money loan for $2,000,000 to buy a home down the street from our offices at Morningside Mortgage Corporation as his first purchase.

As one of the industry terms that I think most ordinary folks can take a guess at, but my former business owning potential client (being a non-permanent resident and new to this country) had never conceived of the notion that raising a person’s obligations dramatically might create significant financial and psychological implications within someone’s life.

After asking this esteemed gentleman a few additional questions about his monthly obligations, it came out that his current rental payment is $1600 a month! Total Payment Shock = 1100%. Imagine!

There are unscrupulous persons in the lending industry that might ignore that fact and waste his time, their time, a banks time, or worse, a couple of million dollars of the banks money trying to make it fly. This is why it’s a good idea to shop around or look for a professional referral to obtain a home loan. Even some of the supposed gate keepers may not be the most informative chaps.

Check out our next column on Wednesday for a primer on Conforming loans and Government Sponsored Enterprises (Fannie Mae). Before long, you’ll be searching the back pages for news on OFHEO . . . .

“I wake up in a hotel room in Honolulu, and it’s 1941, but I mean I really wake up and it’s really 1941,” - “The Time Element” Quote from the first episode of Rod Serling’s television series, The Twilight Zone

The next category is one that many ARM loans will affect, persons with good credit, nice homes and 5/1 Interest Only ARM loans. As the reference article states (now that I have made some edits to ensure accuracy), there are various safeguards against Payment Shock in different loan terms known as Caps. Most borrowers don’t even know that there is an option to request a 2/2/5 cap structure rather than a 5/2/5 cap structure on these loans, or, when given the option balk at the higher initial interest rate for the safer adjustment cap structure. The results are predictable if you’ve made it this far . . . .

In this example, the Interest Only loan you obtained (with 5/2/5 caps, 2.25% margin and 5.01% 1 year Constant Maturity US Treasury index)for $100,000 at 4% costing $333.33 per monthly payment is now costing $722.81 to pay at 7.25% with a 25 year amortization schedule. Payment Shock factor 217% of original payment. Ouch! That smarts! Of course, during that 5 year period of initial savings, you saved a substantial amount of money to put towards this time of increased obligations, right? Not if you’re American.

Even with the 2/2/5 cap that most consumers decline to save .125% interest for 5 years ($625 payment savings over 5 years in this example), you’re still looking at a recast of $644.30 with a Payment shock of 197% which is a little closer to our tolerance levels for payment shock. At this point in the ballgame, most homeowners are refinancing when facing this type of shock. Here we go from bad to worse . . . . .

One of the prime movers on a class of loans that is and will be increasingly well known for its Payment Shock is the Option ARM, which was popularized (and at one time, even advertised and sold in retail branches) by Washington Mutual. As you might imagine, they have more experience with the loan, having beaten the fierce competition to the punch, rolling out the aggressive product at “Just The Right Time” when a consumer really could pay 1% interest on this type of loan, and amortize (pay down the balance) at that minuscule pament. Washington Mutual defines payment shock as:

A situation that occurs when an adjustable-rate mortgage (ARM) monthly mortgage payments rise very sharply at an adjustment. The borrower may not be able to afford the payments the loan will require.[Bloggers's emphasis here]

Shame on you WAMU!

Had something like this been part of the disclosures, in simple bold letters, possibly 50% of the Option ARMs out there today would not be written.

In this, our most extreme example, but a true horror story that IS Happening to some homeowners, mostly unsuspecting ones, the 30 year Option ARM loan you obtained in December 2003 (with a 2.5% margin and 5.01% 12 month MTA average currently at 4.827%)for $100,000 at 3.75% costing $321.64 per monthly 1% minimum payment (this even paid $9.14 that month towards principal, wow!) is now a loan with a $115,000 balance costing $819.31 to repay at 7.375% over the remaining 27 year amortization schedule.

Payment Shock factor 255% of original payment.

ZINGO!
As if to add insult to injury, the mechanics of the index dictate that you’ve still got another .25% increase coming in the next 6 months on top of that!

In the interest of avoiding Blog Shock, don’t forget that there will not be a new update until Monday morning. The next installment has to do more with the other form of payment shock, that being an overly large continuing obligation for a first time home buyer. This installment also includes some caveats about who is originating these high shock loans . . . . .

[insert Twilight Zone scary music here]
You have entered the Twilight Loan
Beyond this world strange things are known
Use the key, unlock the door
See what your fate might have in store

Now that we are in the Twilight of the great real estate boom of the new millennium, it’s a good time to take stock of a term that more homeowners are becoming familiar with in the US of A. As mentioned in our previous entry, more middle class homeowners are faced with payment increases than is usual historically.

Payment Shock!

Payment Shock is what the populace holding adjustable rate loans is the prime mover behind refinance activity today, and in the mid-term future (think 1-3 years). There are two primary types of payment shock. This first relates to adjustable rate mortgages, the second relates to home purchases by first time buyers.

An excellent definition of Payment Shock is located at realestateagent.com:

A very large increase in the payment on an ARM that may surprise the borrower. The term is also used to refer to a large difference between the rent being paid by a first-time home buyer and the monthly housing expense on the purchased home.

As a residential loan originator, my personal opinion is that payment shock is anytime that a monthly payment increases to 200% of the prior payment on a loan under $200,000 (payment doubles) and 150% increase of the prior payment on loans greater than $200,000 due to the greater obligations that arise from these loan adjustments (payment rises 50% above past payment).

Let’s start with the most common form of shock, the 2/28 Adjustable Rate Mortgage loan. This is something experienced by many homeowners who have Sub-Prime characteristics in their lending profile or purchase properties which have traits undesirable to lenders or prospective buyers (condominium that Fannie Mae won’t warrant, unique property like a duplex in a commercial zone, etc.) Typically, these loans are issued with 2% initial interest cap and a fully indexed rate that is already at or near the capped initial interest adjustment level.

Our example in this category, the Interest Only loan you obtained (with 2/1/6 caps, 5% margin and 5.38% 6 month LIBOR index) for $100,000 at 6% costing $500 per monthly payment is now costing $746.76 to pay at 8% with a 28 year amortization schedule. Payment Shock factor 145% of original payment. Not too bad
This type of loan offers the rewards of home ownership to a group of people who were long term renters in bygone days. However, with the higher interest rates in this category of loans today, someone with even fair credit cannot obtain this type of 6% initial rate loan right now. Part of the reason for real estate’s soft sales picture is the prevention of this type of borrower from getting their first home loan.

Our next installment on this topic will be published on Saturday, then we’ll skip ahead and post the next article on Payment Shock promptly on Monday morning.