Revolutionary Loan on Horizon May Aid Younger Home Buyers
A new kind of mortgage, offering initial monthly payments only half the size of those on current loans, may be introduced as early as this spring. The Federal Reserve Board issued a letter Friday that, in effect, removes the last major legal barrier facing the new loan.
The new loan, called the price level adjusted mortgage, or PLAM, could revolutionize the mortgage market if it catches on. For some prospective home buyers--particularly younger ones who may have trouble qualifying with today’s rising interest rates--it may be worth a good hard look.
The loan is radically different from conventional adjustable- or fixed-rate mortgages in that monthly payments are tied to changes in inflation, not interest rates.
Thus, payments on a PLAM loan will be more closely tied to growth of your earnings over time. They start out very low and work their way up along with rises in the consumer price index.
So while a conventional fixed-rate loan of $100,000 at today’s going rate of 11% may result in a monthly payment of $952, the PLAM loan may start out at a monthly payment of only $477--allowing far more borrowers to qualify.
If the consumer price index goes up 5% a year, then the monthly payment on a PLAM loan will go up 5%, adjusting once or twice a year just like adjustable-rate mortgages. What actually happens is that the loan principal grows at the rate of inflation--through a process called “negative amortization” in lender lingo.
So if you start out with a $100,000 loan, a 5% inflation rate will boost the loan amount to $105,000. If for any reason there is deflation--possibly in a severe recession--the loan amount will fall accordingly.
The interest rate remains the same, however, through the 30-year life of the loan. PLAM interest rates are expected to be about 4%, which is the so-called real interest rate after inflation is factored out of normal interest rates.
“This loan will allow more people to qualify. Even those who can qualify (with current fixed- or adjustable-rate loans) may prefer the PLAM because they like its pattern of payments better,” says Susan E. Woodward, chief economist and deputy assistant secretary at the Department of Housing and Urban Development, which has developed the new mortgage along with some private lenders.
“For the typical home borrower, it makes a lot of sense,” she says.
The new loan, however, does have some drawbacks.
First, in the initial years of the loan, you won’t be able to reap as much profit from rising home prices as you would through conventional mortgages. That’s because your $100,000 initial mortgage may require about $128,000 to pay off after five years, assuming 5% annual inflation. Hopefully, your home will be worth at least that much when you sell it then--but that’s not guaranteed.
Second, monthly payments will be much larger than conventional fixed- or adjustable-rate loans in the later years. For example, on a PLAM loan that starts at $100,000, the monthly payment by the 30th year will be about $3,200, assuming an average annual inflation rate of 6.5%, Woodward says. By the loan’s nature, there can be no annual “caps” that limit rises in payments, as are included in conventional adjustable-rate mortgages.
As such, a PLAM loan would be inappropriate for you if you are living on a fixed income, or expect to be soon. “If you will only earn $1,000 a month for the rest of your life, then it is risky to take out a mortgage tied to inflation,” Woodward admits.
But PLAM proponents say the first drawback--not building equity fast initially--isn’t so bad when you consider how much lower the initial payments are.
“Sure, you will have less equity in early years,” Woodward says. “But that stands to reason because you have a smaller payment.”
Money saved in the early years from those lower payments presumably can be invested in other things, making up the difference, she argues. Also, home prices--particularly in strong markets like California’s--typically shoot up faster than inflation. So you still may be able to profit from price rises.
And while payments in later years will be larger, you also will be accumulating equity faster then, Woodward says. Presumably, your income also will be larger then too, rising with inflation.
At any rate, most homeowners--particularly mobile Californians--don’t own their homes as long as 30 years anyway. And PLAM loans can be refinanced without prepayment penalties, Woodward argues.
Another PLAM advantage: Payments will not fluctuate to the degree that current adjustable-rate mortgages do, because the inflation rate is not as volatile as interest rates, contends Gerald Detwiler, branch manager in San Diego for CityFed Mortgage Co., a nationwide mortgage banking firm.
For example, when the rate on an adjustable-rate mortgage goes to 9% from 7%, the monthly payment can go up by about 20%. But it is unlikely that inflation will ever go up that much.
Will the new loan catch on? Some realtors and lenders don’t think so, contending that big California savings and loans and other major home lenders will balk at offering them. That’s because the new loan will compete directly with conventional adjustable-rate loans that form the foundation of S&L;’s lending business.
And many home buyers may not understand the new loan, or be leery of its high later payments and the slow buildup of equity. In some markets, such as Houston and other areas depressed by the fall in oil prices, home prices actually fell while overall inflation continued to grow.
But many mortgage brokers and other lenders will like the new loan, Woodward says. The mortgages can be easily packaged and sold in the secondary mortgage market to big institutional investors such as pension funds. These new loans are ideal for pension funds that often are looking for investments to serve as inflation hedges, she says.
And the new loan could win many consumers if rates on conventional mortgages are high. “The higher interest rates are, the bigger the benefit from this new instrument,” Woodward says.
When will you be able to get the new loan?
HUD’s Woodward thinks versions of the loan, backed by the Federal Housing Administration, could hit the market as early as May, thanks to a letter issued by the Federal Reserve on Friday. The Fed, in effect, said it plans to exempt the new loan from Regulation Z, which requires that adjustable-rate loans carry annual rate caps and disclose to borrowers “worst-case” scenarios for payments.
But some private officials are not so optimistic, saying it may still be a year or more before the loan becomes widely available. For example, before many lenders will offer the loans outside of FHA backing, they need a ruling from the Internal Revenue Service on how loans will be taxed to them. And it may take a while before the exemption from Regulation Z becomes codified.
Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.
