NEW YORK (MONEY Magazine) -
Feeling nervous about real estate prices? Who can blame you? Even if you haven't bought or sold lately, the constant debate over whether or not there's a housing bubble is probably making you uneasy.
These prices are crazy, you think as you scan the local real estate listings. How can anyone afford to buy a house in this market?
That's a question a lot of home buyers are asking themselves these days, and a growing number are coming up with the same answer: Skip the 30-year fixed-rate mortgage and grab a riskier loan with a lower initial payment.
Interest-only, option-payment, 40-year fixed, piggy-back loan, low-doc loan: These weird mortgages come in an assortment of names and flavors, but they all have the same goal -- to help you afford an expensive home. How? More often than not by letting you put off paying down your mortgage.
A few years ago, so-called "nontraditional" mortgages were a mere sliver of the market (less than 3 percent by some estimates); a July survey by the mortgages Federal Reserve found that they now account for more than a quarter of new business at a third of the nation's largest home lenders.
That swift rise has industry observers worried.
"We're very concerned with how safe these products are," says Stu Feldstein, president of financial research firm SMR Research. "There's an awful lot of risk out there."
But who's at risk? Almost everyone. If you're a buyer, the risk is that you'll find yourself with a loan you won't be able to afford in a few years. But even if you're among the 75 percent of borrowers with a stodgy fixed-rate loan or the lucky 35 percent of homeowners with no mortgage at all, this loan lunacy could pose a danger to your home's value.
That's because experts fear that the rash of nontraditional loans has been driving up prices in many markets -- and could intensify the decline if prices soften.
"I think the creative mortgage structures have been the last puff on the real estate balloon," says Nick Buss, vice president of market research at PNC Finance. "Consumers were already stretched, and these products have stretched them just a little bit further."
The affordability puzzle
Taking out a risky mortgage is seldom the first choice for borrowers. A recent survey by the Consumer Federation of America found that an overwhelming majority of consumers prefer a fixed-rate loan.
Yet when faced with the prospect of having to put off owning a home, buyers have been looking for any way to get in, especially when it means (they hope) a chance to ride the double-digit gains that homeowners have been racking up.
The solution: Borrow 100 percent of the price. Take an adjustable rate. Pay just interest for a few years (or not even that much) and hope to sell for a profit or find a way to pay more later. Whatever it takes.
Banks, meanwhile, are looking for ways to continue to lend money as home prices rise. For both borrower and lender, the underlying assumption is that the market will continue to move in one direction -- up, up, up. In a few years, the thinking goes, borrowers can use their inflated equity to refinance into a safer loan.
Trouble is, there's simply no guarantee that housing prices will continue to climb. And if prices soften and interest rates rise, the abundance of adjustable-rate, interest- only, option-payment and similar loans could backfire in several ways.
For borrowers, the biggest risk is payment shock. Say you buy a $300,000 home, financing 100 percent of the price with an interest-only loan. In five years, if your rate rises just as your principal becomes due, your monthly payment could easily spike by 50 percent. With little or no equity to fall back on for a refinancing, you could be forced to sell quickly or even default on the loan. (What's worse, if your home is worth just 5 percent less, you'll have to come up with $15,000 to pay off your mortgage.)
An uptick in selling, in turn, would push up inventory on the local market, potentially causing prices to collapse.
At greatest risk, says David Lereah, chief economist with the National Association of Realtors, are markets where a majority of buyers are opting for nontraditional loans.
"There will be cases where lenders and borrowers will be caught with their financial pants down," he says.
Finally, the explosion in innovative mortgages could sting the housing market in one other way. As banks have heavily marketed these loans, critics say, they may have stretched themselves too thin by lending money to consumers who wouldn't have qualified a few years ago. If those borrowers default, banks may pull back, leaving the marginally qualified buyers -- the ones who have kept the market bubbling along -- frozen out.
Lenders counter that new credit scoring models have eliminated most of the risk of defaults. But Lereah notes that lenders have been testing their new scoring systems in an unusual time of low rates and economic growth.
"In a rising rate market, they're going to discover that some people are riskier than they'd thought," he predicts.
Financial regulators, meanwhile, are beginning to share that concern. Several, including the Federal Deposit Insurance Corporation and the Office of Thrift Supervision, recently met to discuss underwriting guidelines for nontraditional loans.
Big loan losses or tougher regulation, the effect on the market is the same: fewer loans and fewer buyers. Boom over.
What's a home buyer to do?
With real estate prices in the stratosphere and lenders dangling crazy credit, the onus is on you to make sure you don't end up with more home than you can afford.
"When you go to buy a house, you know it's up to you to make sure the plumbing works and the neighborhood schools are good. Now financing has been added to the list of buyer-beware items," says SMR's Feldstein.
If you're in the market for a new home, follow these steps.
Embrace a fixed-rate mortgage
At current interest rates, buyers should be flocking to fixed-rate loans. The 6 percent average rate on a 30-year fixed mortgage is still near historical lows, says Keith Gumbinger of financial data provider HSH Associates. His advice: "Go for as much fixed rate as you can afford."
Of course, once you've got your heart set on a certain home at a certain price, it's hard to ignore the siren call of a low-payment mortgage that lets you buy.
So start talking to lenders before you look for a home, not after you've fallen in love with one. If you've given yourself a loan limit, you'll have a better chance of resisting that unattainable love.
Construct the worst-case scenario
If you do decide to take an interest-only or option-payment ARM, consider what could go wrong. If interest rates increase by three percentage points, what will your monthly payment look like? If housing prices fall by 10 percent in your area, will you find yourself underwater if you need to sell?
Reset your expectations
Face it, nobody needs to buy a 4,000-square-foot house or live in a particular neighborhood. Don't change your mortgage to suit the home you want to buy; change the home to suit the type of mortgage you can afford.
Or consider renting (temporarily). Yes, real estate is a great long-term investment. But in some markets around the country, you'll pay less to rent than you would pay for a fixed-rate mortgage for the same house.
Buying a home with no money down and a high-risk mortgage is simply speculating on the future of the local market -- and no market is immune from the occasional downturn.
Just how crazy are crazy mortgages? Check these out:
- How it works: In the first three to 10 years, your payments cover only interest, not principal.
- The risk: When the interest-only term is up, your payments could increase so much that you can't afford your mortgage.
- Right for you if...You plan to move before the term ends, or you can count on earning more money soon.
Option- or flexpayment ARM
- How it works: You choose what to pay every month: the standard principal and interest, only interest or a minimum that's less than what's needed to cover the interest.
- The risk: If you make minimum payments, the rest of that month's interest is tacked on to the loan balance , so you could easily end up owing more than your home is worth.
- Right for you if...You need the flexibility to make smaller monthly payments once in a while -- but only once in a while.
40-year fixed mortgage
- How it works: You pay the loan off over 40 years instead of the usual 15 or 30.
- The risk: You will pay more interest over the term of the loan. Plus, it takes a loooong time to build equity.
- Right for you if...You can't afford a shorter-term loan but don't want to take on a lot of interest-rate risk.
- How it works: By taking out two loans (a traditional mortgage and a home-equity loan or line of credit for the 20 percent down payment) you can avoid private mortgage insurance.
- The risk: If the price of your house drops, you have no equity cushion, leaving you at risk of owing more than your home is worth.
- Right for you if...You have money saved for a down payment but fall a little short of 20 percent.
No-doc or low-doc loan mortgage:
- How it works: This loan lets you borrow without proving you meet the usual income requirements and, in some cases, without documenting your income at all. Most lenders expect you to have a credit score of at least 620.
- The risk: Borrowing more than you can afford. Plus, depending on your credit score and how much documentation you provide, the rate may be one-half to three points higher than an equivalent full-doc loan.
- Right for you if...You don't earn enough to qualify for a normal loan (say, if you're starting a business), but you know you won't have trouble making the mortgage payments.
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