What is all the talk about “Exotic” Mortgage Products?

There has been a lot of buzz lately about exotic mortgage products and many of the federal regulatory agencies are implementing policies to control their use. What is an exotic mortgage product? Well, if you follow the Feds thinking then an exotic mortgage product is one that has interest only pay options or is an ARM product that carries with it the potential for negative amortization or deferred interest. None of the programs under scrutiny are bad loans. In fact, there really are no bad loans, just bad loan agents!

What do I mean by that? Quite simply, it is the role of an originator to educate the consumer thoroughly on the nuances of any loan product that a client may be considering. The problem lies in the fact that many originators are focused solely on how much they will make on a loan and not what is right for the client. Some originators go so far as to map out a “chain” of loans that they can secure for their unsuspecting borrowers. In this way, they put the client into a loan that may work for them for a short time, knowing full well that they will have to or need to refinance in a short period of time and then the originator can cash in on another commission. Loan originators have a sacred responsibility to act in the best interests of their clients and often times they simply do not!

Back to exotic mortgage products. Interest only products burst onto the scene a number of years ago and have become extremely popular. With these type of loans, the borrower makes a payment each month to cover the amount of interest charged on the loan but is not required to pay down any principal. Any payment made toward the principal will in turn lower the next months required payment as the interest being charged is now charged on a lower balance. This is a valuable loan for use as a cash flow tool and is extremely popular in higher cost areas.

Another exotic mortgage product, and the one that is most often the subject of attack and ridicule is the Option ARM. Also known as Payment Choice or MOnthly ARM. With this type of loan, your rate and payment move somewhat independently of one another. A typical loan in this category will post a start rate of 1% and look very attractive in terms of payment requirements. The trick is that the 1% start rate is really not a starting INTEREST RATE but a starting PAYMENT RATE. The required payment is based on a 1% interest rate but the actual rate charged is based on an index plus the preset margin. A typical loan in today’s market would have the 1% pay rate but the actual interest rate charged on the outstanding balance would be somewhere around 7.00%. The reason this loan is called “Payment Choice” is that when you receive your monthly statement, you have the choice of making a number of different payments. The payment options typically are:

1. The minimum payment based on the 1% pay rate.
2. An interest only payment based on the true rate of interest being charged.
3. A fully amortized payment based on the underlying rate and a 30 year amortization.
4. A fully amortized payment based on the underlying rate and a 15 year amortization.

Let’s look at some real numbers to see what this would look like. On a $250,000 loan with a 1% pay rate. The index is currently at 4.880 and the margin is 2.75. The index plus the margin gives us the underlying or true rate of interest which would be 7.630%. Based on this information, the four payment options on this loan would be:

1. $804.10
2. $1,589.58
3. $1,770.34
4. $2,336.04

Remember, if I choose number 1, then the difference between 1 and 2 is deferred interest and increases my loan balance. In this example, if I were to pay the first option then my new loan balance would be $250,000+($1,589.58-$804.10) = $250,785.48. Now the interest cost of my loan for the next month will be higher and if I again pay the first option then the resulting increase will be greater. And so on and so on and so on.

The reason these loans are under a great deal of scrutiny is not because they are bad but because they are mis sold by us! This is not a program for first time home buyers or buyers or homeowners with little or no equity. They are loans for sophisticated clients who understand the machinations of them and can utilize them effectively as cash flow tools. The only reason this type of loan product may now be subject to regulation is that we as an industry have stood by while unscrupulous loan agents made fortunes off of unsuspecting homeowners by misrepresenting this and other products.