The Federal Reserve will issue new lending rules to "restrict exotic mortgages" for people with poor credit ratings, according to a report in Tuesday's New York Times. What's so exotic about an exotic mortgage?
Its nontraditional repayment plan. Under a conventional mortgage, a borrower pays back part of the loaned money each month, along with interest. A borrower who takes out an "exotic" or "alternative" loan, by contrast, can put off paying back the principal. With an interest-only plan, or "IO," the borrower doesn't start chipping away at the principal for what is typically between three and 10 years. With a payment option adjustable rate mortgage, the borrower can choose different plans from month to month. One option is interest-only; another, called "minimum payment," cuts the borrower even more slack—he or she doesn't even have to pay the full interest every month. Another example of an exotic mortgage is the "teaser," a specific type of ARM. To entice customers, lending agencies set a low initial interest rate, then reset the interest to a much higher rate at the first agreed-upon adjustment date.
In contrast, the "subprime mortgages" that keep getting mentioned in the news refer more broadly to high-interest loans issued to borrowers with low credit scores. (The high interest rate compensates for the fact that customers with damaged credit are more likely to default.) A borrower with bad credit can take out a high-interest loan on a traditional, fixed-rate repayment scheme or experiment with an "exotic" plan.
Exotic loans are easier to keep up with in the short-term, but they carry significant risks for borrowers down the road. For example, someone on an IO plan may have his payments double or even triple once the interest-only period ends. A minimum payment plan can result in "negative amortization," whereby unpaid interest is added to the principal—and the aspiring homeowner ends up owing more for his mortgage than he originally borrowed.
Exotic loans do make sense for certain borrowers. For example, a Wall Street banker who has a relatively modest salary but expects a large bonus at Christmas may take out a pay-option ARM, start out by making interest-only payments, and then address the principal after the holidays.
In Tuesday's article on the Fed clampdown, the New York Times defines an exotic mortgage as an "Alt-A" loan, but that's not strictly correct. An Alt-A, or alternative documentation, loan holds borrowers with a good credit score to a lower approval standard than a traditional loan. (Applicants may not need to provide proof of income, for example.) So while an Alt-A is nontraditional and in that loose sense "exotic," an exotic loan isn't necessarily an Alt-A.
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Explainer thanks Douglas W. Elmendorf andRobert E. Litan of the Brookings Institution, and Daniel Gross.