Specialized Mortgage Products: A Game of Chance?

Those returning to the home-buying market after several years will be surprised by the baffling array of mortgage products. Choosing the right mortgage is no longer as simple as knowing the difference between a conventional and FHA loan or a fixed rate versus adjustable rate.

On the contrary, specialized products such as the "piggyback" and "interest-only" mortgage are being offered to all segments of the market from the first-time home buyer to the more sophisticated investor.

Many of these products have been developed in response to the demand from home buyers for an affordable mortgage that requires little or no down payment on a home purchase. Other features offer more flexibility to accommodate the lifestyle changes of certain market segments over time. Although this industry shift has accounted for a significant increase in home ownership, what potential pitfalls await home buyers? Is the flexibility worth the risk?

Piggyback Loans

A piggyback loan is a combination of a first and second mortgage closed at the same time. Often involving 100 percent financing, the first mortgage loan can cover 80 percent of the cost of the home with a "piggyback" second mortgage valued at the remaining 20 percent.

The most common type, however, is the 80-10-10 in which the second mortgage product accounts for 10 percent of the purchase price and the borrower invests 10 percent as a down payment on the loan.

Although the second mortgage carries a higher rate than the first mortgage and extends for a shorter term, the advantage of the piggyback mortgage is that the interest expense is potentially tax-deductible while the mortgage insurance payment (typically required for loans exceeding 80 percent of the home's value) is not.

According to a survey by the National Association of Realtors, 25 percent of all home buyers financed 100 percent of the purchase price of their home. Forty-two percent of first-time home buyers bought with no money down.

Popular Alternative to Private Mortgage Insurance

The popularity of the piggyback loan has been partly fueled by home buyers who want to avoid private mortgage insurance (PMI). PMI is circumvented by keeping the first mortgage amount at 80 percent or less, and taking out a second mortgage for the remainder.

Piggyback loans have taken 40 percent of the market share from private mortgage insurers. According to Patrick Sinks, executive vice president of Mortgage Guaranty Insurance Corp. (MGIC), home buyers with FICO scores of 770 or higher account for 80 percent of the lost volume. These borrowers are considered to be the most desirable market segment.

Mortgage insurers are fighting back by pushing to make PMI tax deductible for families earning up to $100,000 by developing new products and by urging home buyers to compare the advantages and disadvantages of financing with a piggyback loan versus a PMI loan.

Mortgage Insurers Offer New Products

In response to the piggyback loan boom, MGIC developed its SingleFile lender-paid mortgage insurance product. Instead of the borrower paying PMI, the lender pays the mortgage insurance premium, but charges the borrower for this expense either in the form of a higher interest rate on the mortgage loan, a mortgage origination fee or a combination of both. When the lender charges a higher rate to cover the mortgage insurance premium, it is recast into a tax-deductible interest expense for the borrower.

SingleFile is cheaper than other mortgage insurance because it is a low-risk product offered to borrowers who have excellent credit. Eligibility requirements include a 700 credit score or higher and a total debt-to-income ratio of 45 percent or less. The discounted, lender-paid mortgage insurance premium is 40 to 65 percent less than regular borrower-paid insurance.

Interest-Only Loans Attract Both Wealthy and Low-Income Borrowers

One of the fastest growing adjustable-rate products in the last two years is the interest-only mortgage. As the name implies, interest-only mortgages allow the borrower to pay only interest on the mortgage in monthly payments for a fixed term of usually five to 10 years. At the end of the fixed period, the loan is fully amortized over the remaining term of the loan.

Historically the interest-only mortgage has been considered a product for savvy, wealthy borrowers who prefer to use the principal portion of their payment for more lucrative investments, such as the stock market. It also provides flexibility for individuals with cyclical income (commissions, for example) who can make lower payments during the lean months and repay principal when their incomes are higher. Another good fit is with young professionals who want to leverage future income potential for a larger home today.

Although not a new product, the interest-only mortgage has made a comeback in recent years as mainstream borrowers try to combat high home prices. Lower interest rates and more innovative financing options have increased the demand for housing and, in many markets, driven housing prices up. Consequently, home buyers are seeking ways to borrow more money without increasing their payment or income.

Interest-only loans are especially popular in markets where home prices are appreciating fastest, including California, Arizona and Florida. However, Georgia led the nation in share of interest-only loans in 2004 even though home prices did not appreciate as significantly as in other states. More than half of the "purchase" mortgages in Georgia were interest only, compared with less than one-third nationwide. In Atlanta, 55 percent of mortgages issued in 2004 were interest only.

The lure of the lower payment does come with increased risk for the borrower. First, borrowers are gambling that their incomes will rise enough to cover the future increase in monthly payments. Second, they are counting on market appreciation rather than debt retirement to build equity in their homes. Third, they are assuming the risk of possible hikes in interest rates after the fixed term expires as well as the potential for payment shock.

New Twist to Interest-Only Option

An interest-only option can be attached to both fixed-rate and adjustable-rate mortgages (ARMs). Interest-only ARMs are gaining in popularity, but misperceptions about this product's features can be costly for uninformed borrowers.

One common misunderstanding is that the quoted interest rate on an interest-only ARM is fixed for the entire interest-only period. This is not the case. The interest-only period is the period during which the borrower is allowed to pay interest only. An ARM with an interest-only option also stipulates a time limit for the initial loan rate.

In the case of ARMs with a very low initial rate, the interest-only period is always longer than the initial rate period. For example, an ARM with an interest-only option for 10 years may have an initial rate period of six months. So a 5 percent rate today may rise to 7 percent in six months. Consequently, borrowers should not shop for a mortgage solely based on the quoted rate without assessing the overall risk of the product.

A Cautionary Note

This new wave of real estate business poses risks to two segments of potential home buyers. The first consists of individuals who see real estate as a better way to accumulate wealth than investing in the stock market. They sell quickly for capital gain and refinance to "put equity to work," thus growing equity through property appreciation rather than by paying down their loan balance. However, this tactic ignores the fact that mortgage amortization is in the home owner's control, while appreciation is not. Even the savviest borrower must bear this in mind. If the value of the home does not appreciate as anticipated, the buyer will be liable to pay the difference out of pocket.

Individuals who want to realize the American dream of home ownership, but have not accumulated the savings for a down payment or need a lower payment to qualify for a mortgage product, are also drawn to these loans. Young professionals who can count on rising salaries or executives who receive annual bonuses may run less risk than others, but those who utilize one of these products to buy a house they cannot otherwise afford are taking a gamble. These loans are not designed to address affordability issues, and thus they can set up home buyers for failure.

Although these products may permit home purchase for little or no money down, allow for smaller initial payments or both, they all have costs, and they all have risks. These products should be used for their intended purposes. Consumers must shop to see which if any of these loans will work best for them.

This article was written by Sibyl Howell, regional community development manager at the Federal Reserve Bank of Atlanta. Reprinted with permission from Partners, Volume 15, Number 3, 2005, the Atlanta Fed's Community Affairs newsletter.