Study Warns of Payment Shock

The findings were outlined in the State of the Nation’s Housing: 2005 report from the Joint Center for Housing Studies of Harvard University.

While nearly half of all home purchase loans in 2004 were standard 30-year, fixed-rate mortgages, credit standards have eased over the past 15 years. Subprime lending has seen “meteoric” growth, and the share of zero and near-zero downpayment loans has grown from 3 percent in 1990 to about 16 to 17 percent. Meanwhile, low- or no-documentation, interest-only, and option-adjustable mortgages have all seen rapid growth in just the last few years.

“Housing affordability problems are climbing the income scale” stated Nicolas P. Retsinas, director of Harvard’s Joint Center for Housing Studies, in the report announcement.

Despite disappearing spreads between fully indexed adjustable- and fixed-rate mortgages — down from about two percent previously to almost zero in 2004 — the ARM share of originations doubled to 35% during the year in part due to lenders offering substantially lower teaser rates and home prices rising rapidly. About one-third of ARMs have adjustments after the first year.

Although lenders typically shield ARM borrowers from acute payment shock by capping annual adjustments at two percentage points, many borrowers could be in for a shock whether interest rates spike or not — with those in one-year discounted ARMs seeing their rates increase by 40 to 150 basis points this year.

The study noted that others vulnerable to payment shock are borrowers in interest-only loans, which have grown from a few percent three years ago to nearly one-quarter of originations last year. While these loans, like ARMs, can initially save a household hundreds in monthly payments, they also leave borrowers vulnerable to sharply higher payments when principal payments start to become due.

“With the number of borrowers vulnerable to payment shocks up, default rates predictably several times higher for subprime than prime loans, and house prices growing at such rapid rates, the housing market could deteriorate if the economy softens or if rates increase sharply” explained Retsinas.

The center said, however, that payment shocks for most owners are still several years out, and many will sell their homes or refinance before reaching that point.

If the economy continues to expand, short-term risks of price declines and rising defaults will likely remain low. But if it hits a soft spot, housing corrections may be more painful than they would otherwise have been, the announcement said.

“While the future looks bright for housing investment, there is little cause for optimism that the nation’s housing affordability challenges will diminish; in fact they are growing worse,” noted Eric Belksy, the center’s executive director, in the announcement.

Statistics from 2000 through 2003 alone, show that the number of households spending more than half of their income on housing increased by 2.5 million.

“Housing affordability is a chronic problem and narrowing the gap between what decent housing costs and what low-wage workers and retirees can afford will remain a major national challenge,” Belksy added.