New mortgages put interest risk on borrower

Colon Terrell Jr. of Charlotte, North Carolina wanted to buy a house. But he couldn't afford a mortgage. A traditional fixed-rate $60,000, 30-year mortgage at interest rates of 14 3/ 4 percent would have meant monthly payments of about $850. It was more than he could handle.

A few years ago, that would have been the end of Mr. Terrell's hopes for a mortgage. Not anymore.

Colon Terrell went to Wachovia Mortgage Company in Winston-Salem, North Carolina (now famous for pioneering alternative mortgage plans) and negotiated a variable rate mortgage.

Today he has his house. The interest on his loan is 12 3/8 percent. His monthly mortgage payments are only $725 a month, and they're guaranteed to stay that way for the first five years of the mortgage.

However, even as his payments remain the same, the interest on his loan is being adjusted every three months according to the ups and downs of the US Treasury Department's 90-day bank notes. The additional interest is being accrued, and while his payments are fixed, his indebtedness is growing.

Mr. Terrell realizes that his payments are not keeping pace with interest rates. In fact, he says, "I'm probably going in the hole a little bit."

When the first five years are up, his payments will be adjusted -- with a maximum increase of 25 percent. However, Mr. Terrell figures that at 25 percent , "The most they can increase it is $180. My income had better increase more than that if inflation continues."

Anyway, he explains, "I don't anticipate keeping the house 30 years. . .. Frankly, my intentions are that if rates get back to some reasonable degree, I'll refinance the thing."

The real attraction, Mr. Terrell says, "was a lower rate fixed payment." His only alternative, he points out, was the more expensive fixed rate mortgage.

In the future, however, Americans can expect to see a whole range of alternatives.

Last month the Federal Home Loan Bank Board approved regulations that would allow federally chartered savings and loans to write mortgages with variable interest rates -- rates which will slide up and down with the credit market. Variable rate mortgages have been permitted in the past, but never before has the lender had the freedom permitted by the AML.

Will that freedom prove beneficial to all the mortgage-seekers in Colon Terrell Jr.'s shoes?

Consumer groups answer that question with an emphatic "No." They envision borrowers burdened by mortgages which grow as fast as inflation and eventually begin to nibble away at equity. Ellen Broadman, an attorney for Consumer's Union, calls the new regulations "irresponsible," saying that they "subject consumers to extraordinary risks" while permitting the lenders "to do whatever they want."

Nonsense, say lending institutions. Borrowers will actually benefit from the move. Competition among leaders will increase, and the result will be very favorable mortgage terms. More funds will become available for mortgages. And anyway, successful mortgage payments are as important to the lenders' economic well-being as they are to the borrowers'.

But the truth is that nobody yet knows what the impact of the AML will be. Only time and the future ups and downs of the economy will tell for sure.

What is known now, however, is that federally chartered savings and loan associations will be able to write mortgages with only the following restrictions:

* The rise and fall of the interest on the loan must be pegged to some "independent" index over which the thrift industry has no control. (The index would most likely be something like the cost of funds index, or the mortgage loan index, both published by the federal government. Treasury bills, although inclined to do more see-sawing, might also be used.)

* The size of the monthly payment could be adjusted as often as every 30 days , as long as 30 days advance notice is given.

Of course, not every mortgage written will necessarily take advantage of the new provisions.

For the moment, only federally-chartered savings and loans are directly affected by the move. However, it is widely expected that state savings and loans will either increase pressure on their regulatory bodies to give them equal freedom, or apply to switch to a federal charter. John H. Dalton, a member of the Federal Home Loan Bank Board, says the board has already received several applications.

But even should a majority of savings and loans begin working under the new provisions, there would still be pressure on the lender to come up with mortgages that borrowers can live with. Presumably competition among lending institutions will prevent the development of mortgages with prohibitive terms -- at least that's the way the FHLBB sees it. "The marketplace will protect the consumer," claims John Dalton.

What appears most likely now is that a variety of mortgage types -- including the old-style fixed mortgage -- will flourish. However, the fixed mortgage may lose some appeal when placed side-by-side with the variable rates mortgages. Because there is no "inflation-risk percentage" built into the variable rate mortgages, both the interest rates they carry and their premium charges are offered at discounted prices.

Early indications are that the "typical" variable rate mortgage will include the following features:

* A monthly payment that will remain fixed for a specified length of time, perhaps three to five years.

* An adjustment every six months that could change the interest rate on the loan. Thus, although the payment itself wouldn't change, the proportion of the payment going toward interest would.

* A provision allowing the lender to make up for growing interest rates through negative amortization -- which means increasing the amount of principal owed.

This last feature has consumer groups particularly concerned. If interest rates go up while a mortgage payment remains the same, the borrower will find his debt gradually increasing. The lender, under the new regulations, will have the right to either make the payments larger or to stretch them out over more time, until the full amount is paid.

James Boyle, director of governmental affairs for the Consumer Federation of America, says of negative amortization, "There's a very real possibility that you could pay on your mortgage for 10 years and end up owing more on it than you did when you began."

His feeling is that, "Basically, [consumers] are playing Russian roulette when they enter one of these mortgages."

The FHLBB counters by pointing out that if interest rates do go up, chances are that property values will be increasing just as fast. Thus, even if the borrower's debt is growing, so is the value of what he is purchasing.

Mark Ladenson, professor of economics at Michigan State University agrees with consumer groups that, "It is certainly correct that the variable rate mortgage is not as good a deal for the consumer as the fixed rate."

However, his sympathies are divided. He also points out that, "Inflation and volatile interest rates have just made the old system untenable."

In his view, there is no real solution short of a return to a "stable economic environment." Without that return, he believes, it is simply a matter of choosing the lesser of two evils. Either variable rate mortgages will become the norm, or the amount of money being made available for mortgages will slow to a trickle.