Another Mortgage Trap

The housing boom America has experienced over the past decade created some very innovative mortgage options.

One of these was the "interest only" mortgage. It really caught on in California where it was reported that over half of all new mortgages were interest only. This type of mortgage is great when property values are skyrocketing. It's just as devastating if values stagnate or fall.

Dangerous as interest only mortgages can be, the LA Times reports on an even worse deal, the "pay option" mortgage loan. This type of mortgage allows the homeowner to decide, month by month, how much he'll pay. According to the Times, this option has landed homeowners such as Will Hertzberg in a financial mess of their own making:

"Like hundreds of thousands of other homeowners around the state, Hertzberg has a mortgage that lets him choose how much he pays each month.Like many of them, he always chooses to pay as little as possible.

"For the moment, this allows the 56-year-old Hertzberg to continue living in his tract home despite being only marginally employed. But his debt is swelling, and his mortgage company controls his fate.

"'I am rather screwed,' he said.

"A few years ago, as home prices began escalating sharply, lenders pushed loans that let the homeowner pay only the interest for an initial period.When even that was too onerous for some borrowers, they offered loans such as Hertzberg's, often called "pay option" loans.

"One of his options is to pay $2,513 a month. That would cover the principal and interest as if it were a traditional 30-year loan.

"A second possibility is to pay $2,279, which would cover only the interest.

"But each month he always takes the cheapest option: paying $1,106 and promising to make up the shortfall later.

"Essentially, option loans are bets that good things will happen. Maybe the mortgage holder will get a big raise, or sell a script to Hollywood, or inherit a chunk of change. When the borrower has to start paying off the loan in earnest in five years, the plan is that he or she will somehow be able to handle it.

"Alarmed regulators recently have attempted to force lenders to cut back on loans like Hertzberg's. Even some industry executives are beginning to wonder how these borrowers will handle their added debt, especially if housing prices stay flat or fall.

"If it turns out that many can't, it would be a major blow to the housing market. In the worst outcome, it could drag down the overall economy.

"Hertzberg could sell now, but his lender would charge him an $11,034 prepayment penalty — money he doesn't have. Yet if he stays, the housing market may tank, vaporizing what little equity he has left."

No question that people who go for these mortgage deals are the authors of their own misfortune. The reality, however, is that their actions impact on the overall housing market if and when they default.