Rates Up, "New" Loan Features Back

GPM, 2:1, IO. As they say there is nothing new under the sun. For those of us who didn't grow up in a rising rate environment, or who aren’t mortgage history nerds, there may be some terms you start to hear that look “new” or “innovative”. Many of these loan features are not new but they do have to be handled differently today than they did 15 years ago (due to ATR and QM considerations). So what are these?

GPM - Graduated Payment Mortgages

2:1- Two One Buydowns

IO- Interest Only

In the end these types of products, generally, provide:

a) Borrower's with a lower starting payment

b) Lenders with a higher interest rate (more premium/profit)

c) both a & b

However, even if they end up near the same result (lower starting payment), how they get there is quite different. For instance, lets start with the easiest to conceptualize: IO. Normally when a borrower gets a standard 30 year fixed rate loan, they get an interest rate of X. Lets just say its a 500k loan amount with a rate where X=6%. This means the borrower will pay both interest and principal over 30 years at which point the loan will be fully paid off. The borrower in our example will pay around $3k/mo for P&I. If the borrower decides to take an interest only payment for 10 years, then that $3k payment drops to $2.5k. While this saves the borrower $60k over the 120 month interest only period, the payment will jump to ~$3.6k after 10 years, and unlike 15 years ago, the borrowers DTI (debt-to-income) ratio will reflect the $3.6k payment for ATR purposes. Thus, unlike 15 years ago despite the borrower having a lower payment with the IO, the lender doesn't get to use the IO to "help" the borrower qualify with a lower DTI, in reality the DTI for an IO loan is actually now HIGHER than with a fully amortizing payment (even at the same interest rate).

Buydown loans are similar in terms of making the borrowers payment lower for a period of time. The buydowns are usually characterized as 2:1 or 3:2:1 where the number of digits is how many years the buydown is in effect (2:1 meaning two years and 3:2:1 being 3 years) and the number themselves show how much lower the interest rate will be for that year. So for example, 2:1 buydown means for the first two years the borrower will pay less than the note rate on the loan. So a 6% loan would be 4% in year 1, 5% in year 2 and 6% from year 3 onwards. In order to get this, a borrower (builder/seller/etc.) pays points up front and those points are basically the amount of interest the borrower is saving in that period. Similarly to interest only loans, the lower starting payment might be attractive to a borrower, but in the end the highest payment is what's used to determine the DTI on the loan.

Graduated Payment Mortgages are similar to an IO and a buydown combined. However, these are much more complicated and can result in the borrower owing more on their home in the first few years than they initially borrowed. GPMs are structured for a period of time (say 5 years) and at a fixed payment increase (say 5%). So that means that the starting payment in year two will be 5% higher than in year one and so on until the 6th year when the payment will be enough to payoff the loan in equal installments over the 25 years left on the loan (30 year loan with a 5 year initial period). One difference with this type of loan is that it can (especially if the note rate is much higher than the payment increase or if the payment increase is a large number) lead to negative amortization (where the unpaid interest is added to the principal). For those who remember the subprime crisis, neg-am loans were a big problem when in the wrong hands. However, on these types of GPM loans, the loan balance doesn't grow substantially higher than the initial loan amount. For example, on a 500k loan with a 6% interest rate a 5 year initial period and a 5% payment increase, the max balance is ~$500,558 and before the 2nd year is over, the balance is back below the initial loan amount. Another good thing about QM rules and ATR is that the borrower can't be qualified (DTI) off the initial starting rate and must use the higher payment from year 6. This once again, just like IO loans, actually leads to a borrower getting a higher DTI than they would with a normal 30 year full-am loan. On these types of products, its important for the borrower to keep in mind that they may be charged a meaningfully higher interest rate by their lender, than if they just took a full-am loan (or possibly even an interest only loan).

As always, this is neither legal nor compliance advice, and the views expressed in this post are my own.