A changing climate for low-down-payment loans: under worst-case and best-case scenarios, payment shock is a factor undermining the appeal of interest-only and payment-option adjustable-rate loans. Under a six-year scenario, fixed-rate loans look pretty hard to beat.

Author:Smith, Steve
Position:Cover Report: Secondary Market - Cover story

Right across the bay from The PMI Group's headquarters, in San Francisco's Golden Gate Park, is one of the most beautiful buildings in the area--San Francisco's Conservatory of Flowers. Built in 1878, it's the oldest surviving conservatory in the western hemisphere, and the easiest tropical vacation you can take: Just step inside; inhale the warm, humid air; and feast your senses on the hundreds of exotic, tropical plants that flourish in this protected environment. [??] Like the plants in the conservatory, we in the real estate and mortgage finance industry have enjoyed a unique environment in recent years, protected by rock-bottom interest rates and skyrocketing home-price appreciation. In it, once-exotic alternative mortgage products such as interest-only (IO) loans and payment option adjustable-rate mortgages (option ARMs) have flourished, as the mortgage market has searched for ways to meet borrower demand for affordable, low-down-payment financing.

But just as the conservatory's cycads and palms would suffer in fog-shrouded San Francisco without the building's protective glass, these products may be ill-suited to a more normalized climate characterized by rising interest rates and slowing appreciation. In fact, in today's environment, an insured, fixed-rate loan may offer a more borrower-friendly alternative.

Figures 1-4 show how four of the most popular loans used in low-down-payment environments would be affected over a six-year period. The selected loans are an IO loan; a "piggyback"; an option ARM making the minimum payment (which industry studies tell us the vast majority of borrowers are doing); and a 30-year fixed-rate mortgage (FRM).

While no one can accurately forecast interest rates, I've chosen two scenarios that I believe are reasonable to illustrate my point. The "best-case" scenario shown in Figures 1 and 2 assumes that interest rates remain unchanged for the entire time. The "worst-case" scenario shown in Figures 3 and 4 assumes an increase in interest rates of 1 percentage point per year for four years.

In both cases, I've assumed a home priced at $300,000, purchased with a 5 percent down payment and a mortgage for the remainder, resulting in a combined loan-to-value (CLTV) ratio of 95 percent. I've also assumed home-price appreciation of 4 percent per year, which is consistent with long-term historical averages.

Because of the low down payment, the interest-only, option ARM and 30-year FRM carry mortgage insurance. The piggyback, instead, uses an 80 percent LTV first mortgage and a 15 percent home-equity line of credit (HELOC). The IO and piggyback assume a fixed period of three years.

Not surprisingly, the risks are magnified in the worst-case rising-interest-rate environment, shown in Figures 3 and 4, when interest-rate risk is layered on to the built-in risk of payment shock commencing at the start of principal amortization. The total payment shock ranges from almost 50 percent on the piggyback to nearly 170 percent for the option ARM, resulting in a clear advantage for the 30-year FRM by year four.


What is a little surprising is what happens in Figure 1. Here we see that even under a benign interest-rate environment, the...

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