Editor’s note: Steven Krystofiak offers an insider’s take on what’s been unfolding in the subprime mortgage industry. Read Krystofiak’s previous articles, “What is a subprime loan? It depends on whom you ask“; “High-risk loans enable buyers to obtain, not afford homes“; and “Why home-ownership shortcuts will lead to longer recovery.”)
Many mortgage companies have consumers concentrate on the glitz and glamour of low monthly payments based on “option interest rates” of 1 percent or 1.95 percent, much like a magician trying to pull off a disappearing trick on stage.
These rates are used to calculate monthly payment, but while the consumer makes these low payments he or she is being charged something else — a higher rate.
The magician comes out and reveals a trick: In reality, and oftentimes completely unknown to the consumer, the monthly payment being charged is derived from an interest rate usually between 7.5-9 percent. This rate can be 2-3 percent higher than what that same consumer wishing to get a conservative 30-year fixed-rate loan at 6 percent would pay. The higher interest rate is a premium that allows the consumer to get into more debt by paying those low payments. The more debt the consumer gets into, the more profit the banks make.
Turning the borrowers’ focus on one payment while charging another interest rate is a sales pitch that is all smoke and mirrors. Mortgage brokers and loan originators have a huge incentive to sell these loans. And banks love buying them — more on that later.
A California lawmaker is trying to get rid of the smoke and deceptive advertising that goes along with these newly popular and sought-after “option” loans. Assemblymember Alberto Torrico from the San Francisco Bay Area earlier this year proposed bill AB 941, which would require advertisements to include a disclosure of “This advertised rate of ____ is not the actual interest rate. It is the payment rate. If the borrower chooses to pay this advertised rate, the principal balance of the loan will increase.” Best of all this disclosure will not be in fine print and, “not smaller than the prevailing font in the printed advertisement.”
If this bill becomes law it would be a great first step to inform consumers about the risks involved in these loans before they take the first step in calling a slick mortgage salesperson. This would remove the smoke being bellowed from the sneaky mortgage originator. The smoke currently allows originators to steer clients to potentially more profitable and riskier loans by concealing the important fact that the loan balance goes up and the 1 percent being flashed in front of borrowers’ eyes is not the interest rate being charged.
If this law passes, consumers would get proper disclosure before they call a mortgage originator and get excited imagining ways to spend their monthly “savings.” Currently, it is difficult for consumers to look beyond the short-term benefits and see a potentially harmful loan that could destroy their long-term financial goals once the salesperson gets a hold of them and promises a larger monthly cash flow and an artificially low monthly payment.
I said earlier that banks love buying and making these loans — this is because banks are in the business to offer more and more credit. That is why every month you get five credit card offers and five refinance offers; they want your debt. When the loan balance increases every month the banks acquire more debt from the consumer without the overhead and cost of getting it through other means. The premium with the interest rate 2-3 percent higher is also a motivating factor why banks originate billions of dollars of these loans.
The least obvious reason banks like to hold onto these loans is because of an accounting trick. Banks get to put on the asset side of their books the charged amount with the higher interest rate every month, even if they collect the minimum payment. But banks only have to pay taxes on minimum portion received. So the banks’ accounting books are growing at a faster rate for three reasons: acquiring more business (debt) every month, charging a higher interest rate, and not having to pay taxes on everything being put onto the books.
How do banks reward brokers and originators who get them these valuable loans? They offer larger commissions, but only as long as there is a prepayment penalty tacked on. Virtually all banks give commissions to brokers who make loans with high interest rates, but for years consumers have been able to see a bad deal with a high interest rate and go across the street for a lower interest rate loan.
The free market has allowed consumers to shop for the best terms because the interest rate and costs on a traditional loan are transparent. But now brokers can sell consumers on the low monthly payment with that 1 percent interest rate, which is not where the commission is derived. The commission on these loans comes from the higher interest rate being charged — the interest rate between 7.5-9 percent. Consumers often do not see, realize or even care in some cases about this higher interest rate even though it is what causes debt to pile on.
The motivation for all the smoke is the large commissions that banks offer. I have seen bank representatives brag about 3.5 percent commissions on option loans — that equates to a $14,000 commission on a $400,000 loan. The final paycheck could grow even higher if the broker decides to charge any fees directly to the consumer. In general, the bank requires a prepayment penalty to be added on for a broker to receive a commission. If there is no prepayment penalty, the bank might not offer any commission to the broker.
How popular are these loans? I will go into that in my next article, “Negatively amortized loans to cause much pain in 2008.” As the title foreshadows, these loans have become very popular.
Steven Krystofiak is a mortgage broker based in California. He is president of the Mortgage Broker Association for Responsible Lending, an advocacy group.