Rising Mortgage Rates Mean the Return of ‘Creative Financing’

With mortgage rates and home prices rising through the roof, attractive and affordable mortgages are becoming harder to come by these days--bad news for many prospective home buyers as they enter the traditional peak spring buying season.

Accordingly, lenders and mortgage brokers are wheeling out “creative financing” alternatives that could make it easier to qualify for loans and get lower initial payments.

These alternatives come amid signs that conventional adjustable rate mortgages--a mainstay of the housing finance market in recent years--are becoming less attractive. Lenders are raising introductory “teaser” rates on ARMs, or shortening the periods that they last. Many lenders are now pricing their teaser rates at or above 9%--compared to as low as 7% a few months ago. And some lenders are offering teasers for as short as three months, instead of the customary six months or one year.

Some mortgage bankers and other lenders are even cutting back on the number of ARMs they are willing to offer, particularly the type whose rates are tied to the so-called 11th District cost of funds index. That index measures what certain savings institutions in this region pay for deposits and other lendable funds, but it hasn’t risen fast enough to keep up with rising rates in the rest of the economy, squeezing lenders and investors who hold mortgages tied to the index.

Accordingly, institutional investors who buy mortgages packaged into securities are less willing to buy those ARMs at current rates.

There are even scattered reports of lenders withdrawing commitments to fund ARMs for prospective home buyers after loan papers had already been written up.

Meanwhile, evidence is growing of a temporary shift back to fixed-rate loans. The Federal National Mortgage Assn. (better known as Fannie Mae) reported in its weekly survey of lenders this week that the volume of applications for fixed-rate mortgages rose 49% in February over January, versus only an 11% rise for ARMs.

A major reason for the shift: Rates on some ARMs--once adjusted upward after the first year--will be at 11% or 11.5%, the same as current rates on 30-year fixed-rate loans. Many borrowers thus are opting for the stability of fixed rates, says Dennis Campbell, Fannie Mae’s senior vice president for marketing.

“We are seeing greater interest in fixed-rate loans,” reports Gary Anderson, president of Directors Mortgage Loan Corp. in Riverside and president of the California Mortgage Bankers Assn.

Prospective buyers also are beginning to show more interest in creative financing options. Many of these are merely variations on loan alternatives first offered in the late 1970s or early ‘80s, when rates also shot up. These options include:

- Graduated payment mortgages, also called buy-down loans, Equal (for easy qualify) loans, “predictable ARMs” or other monikers.

These essentially are fixed-rate loans that offer lower rates in the first few years in exchange for slightly higher rates the rest of the loan term. Key advantages: You can usually qualify for the loan at the lower initial rate, but you have the stability of a fixed rate later on.

There are almost as many variations of these as there are lenders. One program, offered by CompuFund of Pleasanton, Calif., currently starts you out at 9%, 2.5 percentage points below a comparable fixed-rate loan. It adjusts upward by 1 point each 6 months, until it reaches 12%, where it stays for the remainder of the loan term.

Other variations involve lenders applying initial loan fees toward lowering initial payments, or builders raising the price of the home to compensate for lower initial rates, says Judith Naiman, national transaction executive at the Federal Home Loan Mortgage Corp., better known as Freddie Mac. Some also involve “negative amortization,” a process where your payments are lower than what is needed to cover all interest due, with the difference added to your loan balance.

These loans might be attractive if you plan to live in your home for only a few years. And should fixed rates go down considerably, you can always refinance these mortgages.

- Three- or five-year ARMs. If you don’t like the volatility of most ARMs, these loans might be for you. They are more stable because, instead of being tied to the 11th District cost of funds index, or an index based on one-year Treasury bills, they are pegged to three- or five-year Treasury notes. Accordingly, they remain fixed for the first three or five years and then adjust only once every three or five years. And usually there is no negative amortization.

Disadvantage: The initial rates are higher than on other ARMs and only slightly below rates on conventional fixed-rate mortgages.

Other variations include the “3/1 ARM,” which offers an initial fixed interest period of three years, followed by annual adjustments after that based on the one-year Treasury bill index.

- Interest-only loans. These offer lower monthly payments in the first few years because you are only paying interest, not principal. And you can qualify at lower initial rates.

Key drawbacks: You are likely to face higher payments in later years. And you may need to refinance after a few years, running the risk that rates may have risen considerably higher.

- Forty-year loans. Home Savings and other lenders are offering these loans, usually adjustable rate, that allow lower monthly payments than conventional 30-year mortgages in exchange for a 40-year term. The lower payments could help you qualify for a slightly more expensive home. Drawbacks: You pay much more interest over the long term, and the monthly payments are not that much lower.

Also, the higher the interest rate is, the less advantage you gain in a lower monthly payment, Freddie Mac’s Naiman says.

Of course, there are other options as well. Shared appreciation mortgages, for example, offer you a lower monthly payment in exchange for the lender taking rights to part of any gain in the value of your home. These loans are complicated and could lead to disputes over, for example, who gets what share of home improvements you make.

Convertible loans allow you the option of converting from an ARM to a fixed-rate loan, or vice versa, within the first few years. You can switch for a lot less cost than if you refinanced into an entirely new loan. But you may pay more up front, either in higher fees or a slightly higher rate. There are almost as many variations of convertible loans as there are lenders offering them.

Also, in this rising rate market, be sure to inquire whether the seller’s existing loan is assumable. Also, sellers may be more inclined to offer financing themselves, or pay part of the fees charged for new loans.

Sellers also may consider giving you a lease option, where you rent for a while with the option to buy at a later point. Part or all of your rental payments could be applied toward the purchase.

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.