Payment Shock - Interest Only Mortgages

Fitch, who is considered by many industry insiders to be the mortgage experts warned of growing payment shock risk for sub-prime borrowers who currently have an interest only payment. The volume for interest only first and second mortgages has been breaking record year after year.

Many of theses interest-only mortgages originated only have a fixed rate for 2 or 3 years. Some many borrowers will see a significant increase in their monthly payment any day now.

"The payment increase for an IO at the rate reset is high even if rates do not rise, and is mostly due to the rate reset with only a small portion comprising principal amortization," said Suzanne Mistretta, Senior Director, Fitch Ratings. "Because sub-prime interest only mortgages have high margins and low initial rates, the payment increase from the rate reset could range from 40% to over 50%, and the high margins assure that the initial rate cap, which hovers around 3%, is reached."

Fitch continued to study the effect of the payment increase on the interest only mortgage. They analyzed how the borrowers' debt to income ratios were affected by the rise in monthly payments.

Fitch applies 2 frequencies of foreclosure factors, when rating residential mortgage backed securities that have sub-prime interest only mortgage loans that are fixed for 2,3,5, or 7 years. The first of the Foreclosure factors applies to all adjustable rate mortgages and addresses the payment shock risk faced by the borrower when the payment increases due to the rate reset. The second foreclosure factor, is if the adjustable rate mortgage has an interest-only period, is applied to address the larger payment increase faced by the interest only borrower and the impact on their debt to income ratio.

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