With mortgage delinquencies and foreclosures soaring, federal researchers have identified a key contributing factor: Large numbers of consumers simply do not understand their own mortgages - especially subprime loans that come with complex features and costly penalties.
As a result, too many people are ill prepared to handle jolting payment increases and rate reset deadlines.
In a study involving 819 recent prime and subprime mortgage customers in 12 locations around the country, the Federal Trade Commission found that using current "truth-in-lending" and "good faith estimate" disclosures:
Nearly nine out of 10 borrowers could not identify the correct amount of up-front charges connected with a loan.
Four out of five had trouble understanding why the stated interest rate on the loan note was different from the "annual percentage rate" (APR) highlighted in the truth-in-lending disclosure.
Two-thirds did not spot a potentially dangerous snare lurking in the loan - a substantial penalty if they refinanced within the first two years.
Nearly a quarter could not correctly identify the total amount of settlement costs.
In a separate series of intensive interviews conducted with 36 recent home buyers or refinancers that focused on their own prime or subprime mortgages, the researchers also found that "many borrowers were confused by the current (truth-in-lending and good faith estimate) mortgage cost disclosures" mandated by federal law. "Many borrowers also did not understand important costs and terms of their own recently obtained mortgages. Many had loans that were significantly more costly than they believed, or contained significant restrictions, such as prepayment penalties, of which they were unaware."
Equally troubling, borrowers often said they had no idea of their own loan costs or terms until they went to closing, "and some appeared to learn for the first time during the interview," according to the FTC researchers.
Some of those borrowers said they had spent considerable time shopping and comparing rates before choosing their mortgage. But they still had problems understanding the disclosures they were provided.
So where's the breakdown in the system? Are modern mortgages so complicated that they are beyond the grasp of even experienced consumers? Or are the federally mandated truth-in-lending and good faith estimate disclosures simply not doing the job? Are the disclosures themselves part of the problem?
FTC researchers Janis Pappalardo and James M. Lacko tested the latter hypothesis by developing a new, combined disclosure form that focused on the main functional categories of costs - and potential consumers snares - in mortgage originations and settlements.
The new disclosure is simpler to understand than the current disclosures in both language and graphic presentation. It starts with a box titled "Your Loan" - a three-line description of the type of mortgage (e.g., 10-year interest-only balloon), the loan amount and the term of the loan. The next section is a box called "Our Loan Charges," summarizing the lender's interest rate and all the up-front charges (lender fees plus all settlement costs), and the amount of any monthly billed charges, if any. The box also includes the APR, which is the cost of the loan, interest payments, and any other finance charges, expressed as an annualized rate.
Subsequent sections summarize "your loan payments," penalties and late fees, whatever taxes and insurance are included in the monthly payment, plus all key settlement charges grouped in functional categories from lender services, title-related services and government taxes and fees.
The researchers tried out the simpler, better-targeted disclosures on consumers participating in the study and found a big jump in understanding: Eighty percent of those using the new form could answer 70 percent or more of all questions about their mortgages correctly, compared to only 29 percent of those using the current truth-in-lending and good faith estimate disclosures. The performance was particularly stronger when the mortgage features were more complicated - with rate resets, variable payments and the like.
Bottom line: "Current mortgage disclosures fail to convey key mortgage costs and terms to many consumers, leaving them susceptible" to bad deals, overcharges, loan payments that explode on them, and "deceptive lending practices," according to the authors.
The FTC's findings are likely to be given serious consideration by the Federal Reserve and the Department of Housing and Urban Development, where projects are under way to streamline the entire set of mandatory disclosures consumers nationwide receive when they sign up for and close a home mortgage.
In the meantime, take this message to the application desk: Home loans are inherently complicated financial instruments. Demand that the loan officer walk you through every feature. And don't sign up for a debt obligation tied to your house until you understand all its mechanics, payment scenarios, downside risks and costs.