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The home loan buffet: buyers have more options, many enticing, some perilous for the unwary

Alan Greenspan caught the attention of consumers last month when he noted that adjustablerate mortgages could have saved home-owners billions of dollars over the past decade.

The observation sparked a flurry of counter pronouncements from consumer experts saying that old-fashioned, fixed-rate mortgages still make sense for many buyers.

Controversy aside, this much is clear: home buyers face a growing array of mortgage choices that can save them money or help them buy a more expensive property.

But potential perils also abound. And in Louisiana, plain vanilla fixed-rate mortgages still rule, especially in today's low-interest market.

"Close to 90 percent of our mortgages are fixed rate," said Karen Calamia, regional vice president for Bank One's home loan division in Louisiana and Florida.

Many of the "new" options aren't new at all. Adjustable-rate mortgages have been around for years. And some carry more risk than others. Interestonly mortgages and those with introductory "teaser" rates of 3 percent or less can backfire.

Those options are still rare in Louisiana, where affordable real estate prices and a higher aversion to risk make them less palatable to many people.

ARMs and balloons

The virtues of adjustable rate mortgages include lower payments--at least in the short term--and easier qualifying criteria. That means more buying power for consumers.

Also called a variable-rate loan, ARMs provide an initial interest rate that runs lower than traditional fixed-rate loans. After one to 10 years, the interest rate "adjusts" to become permanent.

The risk is that the adjustment will bump up the rate. The direction of the adjustment is determined by the current status of a published market index chosen when the loan is made.

ARMs are more attractive when interest rates rise; local bankers say they saw a flash of interest in them early this year when rates climbed briefly before resettling at current bargain levels. Locally, about 10 percent of buyers opt for ARMs, bankers say.

For many consumers, however, adjustable rate mortgages don't make sense. A later jump in payments could push borrowers into financial straits unless their incomes also rise. And with 15- and 30-year mortgages at 40-year lows, locking in a marginally lower rate for a short period may not make sense.

"A lot of people are unrealistic about what they can handle over the long haul," says Julie Garton-Good, an author and home-affordability expert.

Many consumers figure they can refinance their ARMs to head off the impact of rising interest rates. But doing that typically means thousands of dollars in refinancing fees, a prepayment penalty or in some cases both.

Adjustable-rate mortgages are a great deal for certain buyers, such as those who know they will be living in the home for only a few years. Medical interns or others who know their income will rise in a few years can also benefit, notes Norm Bour, a personal-finance expert and radio host in Southern California.

It's easier to get an ARM than a traditional mortgage because lenders use the lower rate in deciding whether someone qualifies for the loan.

Whether an ARM is a good deal in the long haul is often a function of the larger economy. ARMs are pegged to indexes whose rise and fall is impossible to accurately predict. Caps on how high an adjusted rate can rise do provide some protection for buyers.

Another choice is a "balloon" mortgage. While the monthly note is based on a 30-year payment schedule, the full amount of the loan comes due after five or seven years.

That makes sense when homeowners know they will live in a house for just a few years. That's because their monthly notes reflect a 30-year loan repayment schedule rather than the higher ones a five- or seven-year loan would carry. The initial rate on such loans is often even lower than for a typical ARM.

Buyers "reset" their balloon mortgages at a fixed market rate after the initial term runs out. For some borrowers, that rate could be higher than they originally expected.

Bye bye, PMI

Consumers seem more willing to consider ARMs for just a portion of, rather than the total amount, of their loan. Using an adjustable rate for a smaller chunk of debt also lessens a consumer's risk if rates eventually rise.

So-called piggyback loans help consumers avoid the private mortgage insurance, or PMI, they must pay until they have at least 20 percent equity in their property. PMI is meant to help protect banks from defaulting borrowers.

Piggyback loans, also called 80-10-10 or 80-20 loans, work like this: A buyer comes up with a 10 percent down payment. The lender makes a standard mortgage for 80 percent of the sales price. A second mortgage--often in the form of a home--equity line with tax-deductible, adjustable-rate interest--provides the remaining 10 percent of the money needed to avoid PMI.

"PMI is becoming less common," says Sharon Jenkins, who oversees Union Planters bank's mortgage program in Louisiana.

That's good news for borrowers, because PMI protects banks but does nothing for homeowners. PMI can cost homeowners thousands of dollars before they build up 20 percent equity.

Bigger gambles

Louisianans so far haven't developed much of a taste for riskier interest-only loans or those with introductory "teaser" rates.

Loans with ultra-low teaser rates can work well for consumers under certain circumstances. But buyers need to understand the danger of something called "negative amortization."

Negative amortization can leave a borrower with a loan worth more than the house--a nightmare if that's the situation when they are trying to sell it. It also can leave a buyer facing payment shock if the later note jumps too high for them to handle, Garton-Good says.

Here's how negative amortization works: An introductory interest rate of 2 percent or so lets a buyer make an eye-poppingly low payment for a few months. The amount the borrower pays is less than the combination of the lender's costs and interest that would otherwise be collected.

To compensate, the lender shifts any shortfall to the principal balance. That means the buyer will face a higher interest rate and a bigger balance when the introductory rate runs out, Bour says.

The potential benefit to consumers is the lower interest rate at the outset of the loan and easier qualifying. In markets where prices are skyrocketing, the loans pose less risk because rapid appreciation may outweigh any run-up in principal. It is a workable option for some, but not if payments based on a short-lived introductory rate is all a buyer can really afford, Bour says.

Interest-only loans are becoming more common in some U.S. markets, but remain fairly unusual in Louisiana. The loans give borrowers the option of paying only interest, but the amount of that payment rises and falls according to a specific index.

The benefit of such loans is a cheaper monthly payment; the downside is a borrower may not make headway on paying down the principal unless they opt to make extra payments earmarked for that purpose.

Buyers now enjoy an embarrassment of home-financing options, but always need to weigh the very real possibility of being overwhelmed by later payments.

"People can get way too leveraged," Garton-Good says.

SARA BONGIORNI covers economic development, banking and personal finance, Reach her at sbongiomi@businessreport.com.