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Are Non-traditional Mortgages Contributing to a Bubble?
Forecasting an impending real estate bubble seems to be a favorite topic of media pundits lately. Whether it's a bubble, a burp, or a blip, the news coverage frequently mentions "non-traditional" mortgages as an indicator of a market suffering from irrational exuberance. Nothing could be further from the truth.
"Non-traditional" mortgages are interest-only mortgages and mortgages with a negative amortization feature (a.k.a. deferred interest loans). The terms of these loans don't require you to pay any principal. Additionally, with a negative amortization loan you can pay less than the interest due, thereby deferring the difference and adding it to your original loan balance.
The perceived risk is that homeowners will never pay off their home. Or worse, their loan balances will grow to a level that may exceed the value of their home when (if) home prices fall. There are limits to the amount that a homeowner's loan balance can grow due to deferred interest, so the chances that your balance would exceed the value are low.
Non-traditional loans can't be held responsible for any perceived "froth" in the real estate market because the type of mortgage that you have has no bearing on what others are willing to pay for your home. Are borrowers using these types of loans to qualify for more house than they can afford - thereby driving up home prices? This is doubtful since lenders require that borrowers qualify at higher rates.
Is this a rare phenomenon? No, these types of loans are growing in popularity. According to a Federal Reserve Board survey, 25% of residential loans underwritten in the last 12 months were non-traditional mortgages. Why are they so popular? The obvious reason is that the monthly payments are lower, so home buyers can afford to purchase a larger home.
Are these homeowners over-extended? Some may be. But not necessarily. Many homeowners realize that they may not be in their homes or have their current mortgage for more than a few years. The average life of a mortgage is 4.2 years. And most people move, on average, every 7 years.
In the first few years of a conventional amortizing (principal + interest) loan only a nominal amount goes towards the loan balance, so many homeowners feel that it makes little sense to make principal payments. There is a growing realization that "investing" principal payments in your house is an illiquid and zero rate of return proposition. The property will appreciate (or depreciate) in value whether or not principal payments are made - the house doesn't know the difference and it has no bearing on the property's value.
The bottom line is that non-traditional mortgages are an inventive money management tool that can be used to a borrower's advantage if the borrower uses them as part of a sound financial planning strategy. Are there individuals out there who will get into financial trouble because they don't fully understand how their mortgage works? Of course, there's risk in every financial decision. As the Mortgage Banker's Association says, "Borrowers need to be vigilant to be sure that they are prudently managing the incremental risk that these innovative new products represent." But these new products aren't responsible for home appreciation, bubble or otherwise.
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