High risk loans...
Here is an explanation of some of the high and higher risk loans that are offered in the mortgage market;
Adjustable Rate Mortgage (ARM)
There are several types of adjustable rate mortgages ranging from prime to hard money loans. Prime ARM loans are the least risky of the high risk loans. The primary feature of an ARM loan is that the interest rate adjusts periodically.
The interest rate is comprised of two parts. The first is the "index" that the loan is tied to. There are several indexes that can be used and include the cost of funds index or the yield rate of Treasury notes.
The second part of the rates is the "margin" which is the amount that the lender charges over the index.
The interest rate charged to the borrower is calculated simply by adding the index rate to the margin rate.
One of the other features of ARM loans is that lenders will normally offer lower interest rates than they offer on similar fixed rate loans because they are shifting the risk of changes in the future cost of funds from the lender to the borrower.
Alt-A
These are mortgage loans in which the borrower possesses a strong credit history, but is in need of non-traditional underwriting and processing guidelines. Examples of such non-traditional guidelines include limited documentation, both asset and income, and expanded debt-to-income ratios.
Pay Option ARM (or Option ARM)
Borrowers are given flexibility in how much they pay each month during the initial term of the loan. The four options normally given are;
1. An amount that will fully amortize the loan over 30 years.
2. An amount that will fully amortize the loan over 15 years.
3. An amount that will pay all of the interest that accrued during the previous month a.k.a "interest only."
4. A minimum payment that is less than the monthly accrued interest a.k.a. "negative amortization." Negative amortization results in an increase in the outstanding loan balance.
The loan "resets" at the end of five years. The payment is then calculated to be the amount that will fully amortize the loan over the remaining 25 year term of the loan.
However, if the borrower chooses the negative amortization feature, then the loan will reset whenever the total loan balance equals 115% of the original loan balance. The amortization period used to calculate the monthly payment will equal the number of years and months left on the loan.
Sub-prime
Loans made to borrowers who do not qualify for the best market interest rates because of their deficient credit history.
Loan rates and terms vary but a popular subprime loan is the 2/28 ARM. This loan carries a fixed interest rate for the first two years. The rate is normally higher than the prime rate. At the end of two years, the loan becomes a variable rate loan. It is common that the margins on these loans will range from 5% to 7%. When combined with the index, it normally results in very high interest rate loans.
Our recommendation
As a general rule, we believe that borrowers should avoid these loans. This is especially true of the Alt-A, Pay Option ARM and Sub-prime loans. People who use any one of these three loan products normally find it necessary to refinance when the loan hits it's reset period. There are many times when refinancing is not possible because of declining real estate values, changes in the borrower's circumstances or changes in lending criteria.
However, these loans are not totally without merit. Here are some situations when they might be appropriate;
Prime ARM loans are appropriate for borrowers willing to take on additional risk and who do not plan on owning a home for more than a few years. Make sure that you can afford the payment even if the interest increases to it's capped rate.
Many prospective buyers find themselves watching real estate prices in a declining market while they wait for prices to reach an affordable level for them. Prospective buyers, especially those young buyers who anticipate substantial increases in their income, may want to consider Alt-A or Pay Option ARM loans if home prices start to increase before they decline to an affordable level. These loans should be avoided when prices have appreciated substantially. Buyers who used this strategy and did refinance into fixed rate mortgages have probably benefited greatly. Most buyers who used this strategy near the peak of the real estate market now find themselves in great financial difficulty or have already lost their homes.
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