The past few years have seen an enormous number of foreclosures. The common wisdom has been that a leading cause of default was payment shock, a swift and sizable increase in adjustable monthly payments.
Now, however, Paul S. Willen, a senior economist with the Federal Reserve Bank of Boston, says payment shock is little more than an urban myth.
“Contrary to popular belief,” explained Willen before a congressional committee, “payment shocks played little role in the crisis and, in fact, most borrowers who lost their homes in the last five years had long-term fixed-rate mortgages.”
Why is the payment shock issue important to VA borrowers?
Exploring the Shock
Some borrowers do not consider adjustable-rate mortgages (ARMs) because they worry that monthly costs can suddenly rise. However, with VA mortgages there’s a 1 percent annual cap on interest rates and a 5 percent lifetime cap. Moreover, there are no prepayment penalties or other strange “gotcha” clauses. With ARMs borrowers are able to get an initial start rate for several years that’s usually below the interest level for fixed-rate mortgages.
But let’s consider the argument made by Willen.
Willen says he “studied 2.6 million foreclosures and, for 88 percent of them, the payment when the borrower defaulted was the same or lower than the initial payment. In other words, in only 12 percent of foreclosures — less than 1 out of 8 — did the borrower suﬀer any payment shock at all prior to defaulting. Why didn’t payments go up? It turns out that almost 60 percent of the borrowers who lost their homes had fixed-rate mortgages.”
The catch is that a careful look at Willen’s figures presents a different picture. Here’s why: First, if payment shock caused 12 percent of all the foreclosures studied then we’re talking about an additional 312,000 borrowers who lost their homes because of higher payments. That’s a very large number.
Second, not all loans with adjustable payments are equally risky. VA, FHA and conventional mortgages all have annual and lifetime interest caps. For instance, with VA loans the limits are 1 percent annually and 5 percent over the life of the loan, what lenders usually describe as a 1/5 cap.
The catch is that the so-called “non-traditional” and “affordability” adjustable loan products introduced in 2002, 2003 and 2004 had three caps. An option ARM might have a 2 percent annual cap, a 6 percent lifetime cap and a 6 percent cap for the first re-set — a 2/6/6 cap. This means once the start period ended the interest rate could instantly rise by as much as 6 percent.
No less important, the interest rate for option ARMs could be raised before the end of the start period if the mortgage balance rose to more than 110 to 125 percent of the original loan amount, depending on the loan agreement. An increasing principal balance was possible because option ARM borrowers were allowed to make initial monthly payments that were less than the interest cost. Monthly interest not paid was then added to the loan balance.
Did this happen? You bet.
VA Loans Safe
Fitch Ratings found that 94 percent of option ARM borrowers paid the monthly minimum — that is, less than even the interest cost for the loan. When the loans then re-cast — when the rate was first changed — the typical payment rose 63 percent. A $1,000 monthly payment would instantly increase to $1,630. That’s payment shock.
Not only was payment shock real, it was also known. In 2005, the Office of the Comptroller of the Currency said “in the case of a typical $360,000 payment option mortgage that starts at 6 percent interest, monthly payments could increase by 50 percent in the sixth year if interest rates do not change. If rates jump two percentage points, to 8 percent, monthly payments could double.”
Asked Comptroller John C. Dugan: “Are lenders really prepared to deal with the consequences — including litigation risk — of providing such products in markets where real estate prices soften or decline, or where interest rates substantially increase?”
Payment shock — say a swift monthly cost hike of 50 percent or more — is real, but it’s not an “ARM” issue and it’s certainly not a problem with VA loans. It’s a problem with the “non-traditional” loan products marketed by the private sector, products at the heart of the mortgage meltdown.
Photo courtesy of Images_of_Money