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01/31/2005: "The world’s worst mortgage"

The Basics


-- Greg McBride, Bankrate.com

Here's a deal for you: Put no money down, pay only interest, or skip payments entirely. Mix too many of these features and you dig a hole you can't ever hope to escape.

By Bankrate.com

I have tried to devise the absolute worst mortgage loan that I can imagine. Fortunately, this loan is nothing more than a figment of my imagination -- at least, as far as I know.

I made it hard on myself. Although I dreamed it up, the world's worst mortgage couldn't include anything that doesn't exist in the market today. So that disqualifies imaginary elements, such as mortgages written on acid-spraying exploding clay tablets. I just took the worst elements of all the existing mortgages and assembled them. Here's what I came up with:

The world's worst mortgage: An interest-only, payment skipping/minimum-payment-option-enabled, negatively amortizing, no-money-down, no documentation, prepayment-penalizing, 3-month LIBOR 40-year adjustable-rate mortgage with a balloon.

Options borrowers love
This fictional loan would contain many of the elements that appeal to borrowers hemmed in by affordability. Like today's option, adjustable-rate mortgages, borrowers would be able to choose an interest-only payment or even a minimum-payment option. While the borrower is lured by the minimum payment, what results is a loan balance that grows through the initial years of the loan. This is known as negative amortization. Find a loan that's
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What is worse than making a payment so low that it doesn't cover the interest? Not making a payment at all. The option to skip a payment or two each year makes the eyes of prospective borrowers light up.

There is a trade-off many borrowers are unaware of: The lower the initial rate, the quicker the rate begins to adjust upward. How many people are in this boat? According to the Mortgage Bankers Association, more than half of ARMs originated in the second half of 2004 face the first rate adjustment within three years. So accordingly, the rate on this mythical loan would adjust monthly and would be pegged to an index such as the three-month LIBOR, so that rising interest rates impact the borrower immediately.

The day of reckoning does ultimately arrive as repayment of the loan balance must begin, at least in some modest measure. To limit the payment shock on this loan, the loan balance will be amortized over 40 years, 10 years longer than the old standard. While the future payment shock is reduced, so is the accumulation of equity.

No proof, no papers
OK, so I have devised a way to shield the prospective borrower as much as possible from the burden of mortgage payments, at least for the first few years. But how should I address the lack of available funds for a down payment and be marketable to borrowers that don't have a steady paycheck or have launched their own businesses? These contingencies are covered through the no-down-payment, no-documentation feature. By making 100% financing available on this product, no down payment is necessary. Neither is the need to prove your income. We'll take your word for it.

This loan would also have two features that are profitable to lenders -- a prepayment penalty and balloon payment. According to a survey by the University of North Carolina, the presence of a prepayment penalty increases the risk of foreclosure by 20%, and the presence of a balloon payment increases the foreclosure risk by 46%.

The presence of both on the same loan would indeed be rare, but we're talking worst-case scenario, so why not? The borrower would have limited flexibility if either provision were present and would be effectively handcuffed in the case of both. A balloon payment mandates a future refinancing on the lender's timetable and a prepayment penalty limits the ability to refinance on something less than the lender's timetable.

Not that big a stretch
As I noted previously, such a loan doesn't actually exist. Or does it? Each of the components that make it so dreadful exists on other loans currently being offered. The continual evolution of mortgage products is justified with the lip service of "appealing to borrowers with unique cash needs." But the frothier the housing market gets, the riskier new mortgage products become. And unfortunately, borrowers are lapping these up as quickly as the products come to market.

With a loan like this, a borrower with unverifiable income, poor credit, no savings and a tight budget could buy a ridiculously expensive home and be perfectly positioned for the rocket ship of future home-price appreciation that will surely continue forever. After all, this is the American dream, right?

On second thought, the idealistic scenario could give way to the reality of a budget-busting financial commitment that leads the borrower into a downward financial spiral. Instead of counting on the best-case scenario of low rates, rock-bottom payments, sizzling home-price appreciation and maximum household earnings, it does pay to consider a less favorable, and perhaps inevitable, scenario. Household emergencies do arise, and income can drop due to a variety of reasons from illness to job loss or reduction of overtime. That home-based business may not get off the ground as originally envisioned.

Rising interest rates spell higher payments in the future and continued price appreciation is hardly assured. Mix together one too many of these conditions with a loan designed to address affordability only on closing day, and the safe haven of the home could be something far different to household finances.

-- Greg McBride, Bankrate.com