By Diana Hill, Online Trading Academy Real Estate Investor Instructor
In the last three years, there has been a lot of media coverage regarding Non-conventional loans. These are the risky loans that started being put into the MBS around the year 2000. Then in late 2006 and early 2007, as home prices began to plunge and alarm was spreading across mortgage backed securities desks all over Wall Street, they started to back away from the riskiest mortgages.
What are Non-Conventional loans? It's a broad term describing loans that do not take the traditional form; in short, they would not be loans that would be accepted by either Fannie or Freddie. Non-Conventional financing includes loans such as Interest Only Mortgages (IO), Option Adjustable Rate Mortgages (Option ARM's), Subprime Mortgages and Alt-A Mortgages. Let's take a look at each one of these loans individually.
Interest Only Mortgages (IO)
These loans have two options, one is the interest-only option where the borrower CAN choose to pay an interest only payment. This interest-only payment is usually only available for between three and ten years. After the interest-only payment option is exhausted, the borrower's payment will increase to principal and interest fully amortized. This loan is a good investment vehicle for those that know how to handle it and can use it to get the best results.
Option Adjustable Rate Mortgage (Option ARM)
This is the type of loan on which the interest rate adjusts monthly and the payment resets annually, with borrowers offered options on how small or large a payment they can make. The options include a principal and interest payment, an interest-only payment and a minimum payment that is usually less than the interest only payment. The minimum payment option results in a growing loan balance which is called "negative amortization."
The selling point of this loan is the low minimum payment in year one. The low initial payment entices some borrowers into buying more costly homes than they would otherwise be able to afford.
For those borrowers that elect the minimum payment option, the major risk becomes the "payment shock," a sudden and sharp increase in the payment for which the borrower was unprepared.
Subprime Mortgage
This is the type of loan that is normally made to borrowers with low credit ratings. As a result of the borrower's low credit rating (below 600), a conventional loan is not available in a lender's view. The borrower is viewed as having a larger-than-average risk of defaulting on the loan. Lending institutions charge higher interest on subprime loans in order to compensate themselves for carrying more risk.
Alt-A
This is a classification of loan where the risk profile falls between prime and subprime. The borrowers that typically use these loans have clean credit histories, but they will generally have some issue that increases its risky profile. These issues can include higher loan to value (LTV), debt to income ratios or inadequate documentation of the borrower's income. These loans are attractive to lenders because the rates they can charge are higher than rates on conventional loans, but the borrowers tend to be less risky.
Although these non-traditional loans are certainly harder to find these days than they were three years ago, some of them are still available and can be utilized if managed correctly. But the real reason I want you to understand them is so when you look at a chart like the one below, you can understand it and see where the opportunity might exist.
In the year 2007, we witnessed the crash and burn of the subprime loan product. Even our large institutional lenders have felt the effects. And certainly the smaller lenders, whose portfolio consisted of 100% subprime loans, were dramatically affected and the majority of them had to close their doors.
Figure 1
So what's next? What happens when the Option ARMs hit their peak of resets in 2011? While none of us really know, we also don't know how unemployment, interest rates, or the intervention of governments will affect these resets. But I do know that there will be opportunity and I hope you'll be ready to take advantage of it.
- Diana Hill dhill@tradingacademy.com
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