Home & Garden Columns

We recently had a call from a woman who wanted some advice about her current home loan and whether we would recommend a refinance. After investigating her circumstances, hearing her story, and questioning her about the process she had gone through, I understood why there are consumer-rights groups wanting to regulate the mortgage industry. Her story spoke not only about a mortgage professional who was more interested in their own paycheck than the best interests of their client, but to a very popular loan program, that in my opinion, should be regulated very carefully. 

The loan program that was “sold” to this client is very popular today and is called by several names, some of which are registered trademarks of various banks. It is an adjustable-rate mortgage whose interest rate adjusts every month, but the required payment adjusts either annually or in some cases may be fixed for a longer time. As I write this I realize that many readers will be lost just on that concept alone. Therein lies the first reason as to why I think anyone considering one of these programs should be required to read and understand a set of disclosures using a 14-point font.  

The big print would clearly state how the monthly payment is less than the amount of interest due on the loan and that the difference between the monthly payment and the amount you actually owe will be added onto the principle balance of the loan each month. This means that as you make your payment each month, you now owe the lender more money than you did the prior month (you may want to read that sentence twice).  

This loan program has a feature called negative amortization and is not new. The program originated in the 1980s and has long been popular for large commercial properties since it gives the property owner a lot of flexibility over their cash flow. Since most commercial loans are adjustable-rate mortgages and property owners cannot raise rents every time interest rates go up, they need some stability in their cash flow and can use a loan like this to control cash flow until they can increase their income to offset their expenses.  

Also in the 1980s, the loan was introduced to homeowners as alternative financing at a time when rates were quite high. The results were fairly disastrous as market circumstances held home prices flat, the loan balances were growing, and many of these loans had balloon payments due in five years, meaning that the loan ends and needs to be repaid. The loan balances grew to equal or go beyond the value of the property and many homeowners lost their properties in foreclosure. 

The loans were then redesigned so the initial payments were at least the amount of interest due on the loan and after five years the loans were then re-amortized (a new payment schedule was established that required monthly principal reduction) and extended for an additional 25 years. Now however, in an effort to extend the low payments that had been in effect due to low interest rates, many of the safeguards have again been abandoned.  

My biggest objection to the service that this particular client experienced was that she was also sold a loan with a three-year pre-payment penalty. This means that if she refinances in the first three years she pays a penalty, which in her case is about $15,000. As a reward for selling the client this loan, the mortgage broker received a big commission from the lender. To add insult to injury, the client says that she told the mortgage person that she wanted a fixed rate loan but was told repeatedly how this loan was superior.  

There are certainly circumstances where this type of loan is the right choice. Since financing in general is sometimes a confusing subject, great care must be taken with any client considering this type of adjustable-rate mortgage. There are always choices and in my opinion, you need an objective advisor who discloses their fees (as required by law), and does not have a financial stake in your decision (one loan yields a higher commission than another).  

At this time, the interest rate market conditions are such that we have experienced a narrowing of the gap between the rate you can get on a fixed-rate loan and the rate you get on an adjustable-rate loan. In other words you can get a fixed-rate loan for almost the same interest rate as the adjustable-rate loan, making the fixed-rate loan easier to choose as well as easier to understand. 

Russ Cohn is president of Cohns Loans in Albany. 

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