Your Mortgage : New Bills Restrict ‘High Cost Mortgages’

New bills pending in both the House and Senate would crack down on con-artist lenders who trick homeowners into signing up for double-digit mortgage rates and crushing fees at closing. But the same bills could also have a drastic side-effect: The outlawing of legitimate forms of mortgages--including bridge loans and balloon-payment loans--that thousands of homeowners around the country use successfully.

The companion bills (H.R. 3153 and S. 1275) are sponsored respectively by Rep. Joseph Kennedy II (D-Mass.), chairman of the House consumer credit subcommittee, and by Sen. Donald W. Reigle Jr. (D-Mich.), chairman of the Senate banking committee. Both measures grew out of hearings that documented “reverse redlining” by lenders who target vulnerable homeowners, and then rate-gouge them into foreclosure. The victims frequently are cash-strapped elderly persons or financially unsophisticated borrowers.

For example, one 72-year-old woman described to the Senate hearing how she was duped into a $150,000 “home improvement” loan by a door-to-door solicitor. The prepaid fees charged by the lender at closing exceeded $23,000. The payment due on the mortgage every month was larger than her entire gross monthly income.

To prevent abuses like this, the two bills would create a new category of home loan under the federal Truth-in-Lending statute--”High Cost Mortgages” (HCMs)--with tough new restrictions on all lenders who offer them. High cost mortgages are defined as any loan secured by a consumer’s principal dwelling in which either:

--The annual percentage rate exceeds one-year Treasury bills by more than 10 percentage points (a rate of about 13.5% at present), or

--Carries fees payable to the lender by the borrower that are higher than 8% of the loan amount, or $400, whichever is greater.

The bills would force lenders to warn applicants for such loans that they could lose their homes if they fall behind on payments. A new disclosure required to be delivered in writing no later than three days before settlement would tell applicants that they could still bail out of the deal, and might indeed be able to find better loan terms elsewhere.

The two bills would go far beyond disclosure, however. They would ban outright the use of balloon-payment plans on any loans that fell within the federal definition of an HCM. Balloon-payment loans involve deferral of portions of principal or interest until the final lump-sum payoff of the mortgage. Both Fannie Mae and Freddie Mac offer popular low-rate balloon mortgages in which monthly payments are computed according to a 30-year amortization schedule, but the lump-sum final (balloon) payoff is due five or seven years after closing. The 30-year amortization allows monthly principal and interest payments by the borrower to be significantly lower than they would be on a standard five- or seven-year amortization.

In practice, the balloon payment due from the homeowner at the end is usually paid off via refinancing into another loan, either from the original or a different lender. In the case of Fannie Mae’s and Freddie Mac’s balloon programs, borrowers can either choose to pay off the debt in full at year five or seven, or roll over the debt into a loan extension, which may carry a higher rate than the original.

Balloon payment programs often involve two other concepts the new bills would prohibit on high cost mortgages: “negative amortization” (deferral of interest by the lender), and “interest-only” payments (deferral of all principal until the final lump-sum payoff). Proponents of the bans say these payment methods are almost invariably employed in high-rate, high-fee loans that rip off unsuspecting borrowers.

But here’s the problem: The same concepts are also commonly found in mortgages for homeowners with temporary credit problems caused by loss of jobs, deaths of spouses, divorce or business failures by the self-employed. So, too, for bridge loans used by credit-worthy home buyers facing an “equity gap”: They need to close on a new house before they sell their existing home. Loans like these typically are short-term, feature balloon payments and have annual percentage rates that would fit the new federal definition of “high cost.” The borrowers involved tend to be aware of what they’re signing up for. They’d prefer to be paying lower rates, but given their financial situations, they’ve got little or no alternative in the conventional mortgage market.

Take the case of a Danville, Calif., businessman, who contacted a local mortgage broker for help last spring. The businessman, who asked that his name not be used in print, faced imminent foreclosure by a bank on his home after a series of business reverses. No conventional lender would extend him credit. The mortgage broker, however, arranged a 12-month, $270,000 balloon note carrying a rate of 13.75%. The interest-only repayment terms enabled the borrower to get his business affairs back in order and qualify for a new conventional mortgage, which he obtained in September.

The borrower’s “high cost” mortgage would have been illegal under the terms of the pending bills. So would large numbers of bridge loans used by home buyers and sellers, which typically are short-term but carry effective annual percentage rates in the mid-to-upper teens.

The upshot? Both bills are moving ahead in their respective legislative bodies. Proponents say that while they’re “sympathetic” to borrowers like the California businessman, they plan no immediate amendments.