Risky mortgages need better explanation, GAO warns

WASHINGTON — Federal regulators need to do a better job of explaining to people the workings and potential risks of interest-only and other nontraditional mortgages, congressional investigators said Wednesday.

Nontraditional home loans that once were mostly the domain of the wealthy, especially interest-only mortgages and option adjustable-rate mortgages, have exploded in popularity in recent years as people stretched to buy high-priced homes during the housing boom.

“Although lenders and certain brokers are required to provide borrowers with written disclosures at loan application and closing, federal standards on these disclosures do not currently require specific information on (alternative mortgage products) that could better help borrowers understand key terms and risks,” the Congress’ Government Accountability Office said in a report released Wednesday.

Borrowers and lenders with such mortgages could get clobbered if housing prices drop or if interest rates were to shoot up.

Interest-only mortgages require that the homeowner initially pay only the interest on the loan for a set period. Option ARMs give the homeowner flexibility to decide how much to pay each month. One of the options is a minimum payment that covers only a portion of the monthly interest.

These mortgages are appealing to people who need cash for other expenses. But it also exposes them to far greater risk — if housing prices drop, their loan could be worth more than their property. If interest rates rise, their loan will become expensive to pay off.

The GAO said that from 2003 to 2005, nontraditional mortgages comprising mostly interest-only and payment-option ARMs grew from less than 10 percent of all residential mortgage originations to about 30 percent. They were highly concentrated on the East and West coasts, especially California, the GAO said.

Federal banking regulators last year issued some guidance to lenders about handling nontraditional mortgages and providing would-be borrowers with information about them. Further guidance is expected.

Regulators also are working on a revamping a booklet, expected to be published later this year, that will provide consumers with additional information on interest-only and option ARMs, Sandra Braunstein, director of the Federal Reserve’s division of consumer and community affairs, told a Senate hearing on Wednesday.

Sandra Thompson, acting director of the Federal Deposit Insurance Corp.’s division of supervision and consumer protection, suggested improvements are needed. “Consumer disclosures are neither adequate for consumers to fully understand the risks associated with these complex loan products, nor provided at the points in time when it is most needed,” she said.