2/28 and 3/27 are Very Dangerous Mortgage Loans

(December 15th, 2007)

In 2004 - 2005, there was a boom in the number of 2/28 and 3/27 loans that were given out to sub-prime borrowers (borrowers with poor to bad credit histories). The effects of these loans are now surfacing with America facing a record number of foreclosures in 2008. These adjustible rate mortgages were the most common given to every 3 out of 5 sub prime borrowers. Now, very few lenders are offering these loans.

The ideology behind interest-only loans was to offer a 2-3 year introductory interest rate that was lower than most fixed-rate mortgage interest rates. By making on time payments for 2-3 years, these borrowers were promised that they will be able to increase their credit scores and thus refinance into a newwer mortgage loan with far lower interest rates. This was before their 2/28 or 3/27 ARM mortgages reset to a higher interest rate after 2-3 years. Shady mortgage brokers also promised borrowers that they will never have to deal with higher monthly payments, and that is not really a concern. But events have unfolded against the sub prime borrower.

Most sub prime borrowers are unable to refinance into a lower interest mortgage loan because they were unable to increase their credit scores whilst in their introductory 2-3 year periods. Plus, they did not build enough equity in their homes to be able to refinance their homes. This was particularly the case with borrowers who had no money down and borrowed upto 100% of the purchase price of the home.

How 2/28 Loans Work

Most 2/28 loans are tied to an Index called the 6 month LIBOR rate (London Interbank Offered Rate). The LIBOR rate is the rate at which European banks borrow and lend money to/from each other. Most ARM mortgages given to borrowers with good credit charged LIBOR + 2.75%. 2/28 loans will now reset to LIBOR + 6.25%. With current LIBOR rates hovering at around 4.6%, here's how the interest rate game works out:

That's a jump of almost 4% in interest rate! That means borrowers will have to pay hundreds or even thousands more dollars in their monthly mortgage payments. This obviously leads to thousands of sub prime borrowers defaulting on their loans. What's worse is that 2/28 loans reset once every 6 months with an increase of 3% interest the first time and 1% every time after that. Over the long run, interest rates on 2/28 ARM mortgages will just keep increasing, while many borrowers will have the same income. This obviously leads to a deficit in their household budgets, forcing them to default on their payments.

First American Real Estate Solutions, a division of First American Corp expects one in eight borrowers who took out 2/28 mortgages in 2004 - 2005 will default on their payments. This is because a typical household that borrowed $100,000 at 6% saw their monthly payments increase from $600 a month to $1100 a month after two resets have been done! In summary, because of the high risk of defaults from sub prime borrowers, most mortgage lenders have stopped lending out any type of ARM loans.

The Lowest Mortgage Interest Rate is Not Always the Best

That's right, the lowest mortgage interest rate you get may not always be the best option. This is because thousands of dollars can be charged on closing costs that diminish the value of the lower interest rate. Some mortgage loans charge as much as $7000 in closing costs including the fees to process your loan, appraisal value of the home you want to purchase, origination & discount points, lien check fees, etc. Other mortgage loans charge as low as $500 in closing costs. It is therefore best to shop for the lowest interest rate you can get (at your current credit history) at the lowest closing costs.

Also, a typical homeowner will refinance his mortgage loan in 7-10 years, therefore it is not worth it to take out a loan with high closing costs just to save a few quarter points in the interest rate. Here's an example we derived from comparison charts @ www.interest.com

From these two, which one would you choose? I would definitely choose Lender B because it sounds economically more feasible.

The monthly payment on Loan #1 would be about $990 per month. The monthly payment on Loan#2 would be slightly higher, at around $1030 per month. However, the $40 difference is worth it because it would take you 13.5 years to recover the $6500 closing costs. Here's how we derived this calculation:

$6500 / $40 / 12 months = 13.5 years

If you owned the house for only 7 years, you would pay $100 / year in extra interest costs for Lender B's loan while you would pay a whopping $928 per year for the loan borrowed from Lender A. We derived the $928 by using:

$6500 closing costs / 7 years = $928 per year