Testimony at Senate Banking Committee hearing reveals that homeowners don't fully understand the risks associated with exotic mortgage products.
U.S. banking regulators have promised that guidance to lenders on exotic mortgages should be released within a few weeks.
The usage of exotic loans -- such as interest only and option ARMs -- has risen from less than 2% in 2000 to over 33% in 2006. Industry data shows that almost 50% of all exotic loans sold were originated in California.
Exotic loans have been shown to be more prevalent in housing markets with large price increases, according to the Federal Deposit Insurance Corp. (FDIC).
"The greater availability of flexible mortgage structures probably allowed price increases to outstrip growth in incomes to a greater extent than would otherwise have been the case," said Sandra Thompson, acting director of supervision and consumer protection at the FDIC.
Several regulators have testified that defaults and foreclosures remain fairly low on nontraditional loans, but that could change with a slowing economy, rising interest rates and house price appreciation slowing.
Mortgage industry representatives say that they are not responsible for a consumer's financing decisions.
"I strongly believe that the market's success in making these nontraditional products available is a positive development, not a cause for alarm," said Robert Broeksmit of the Mortgage Bankers Association.
Critics argue that many borrowers simply do not understand the loan product they have choosen. They will be unable to afford the payments on down the road. Under some circumstances, the monthly payment on many exotic mortgage products could double or triple over time.
"This risk is heightened as interest rates rise and home appreciation slows," explained Thompson.
A Federal Reserve study reports that a large percentage of borrowers do not understand the terms of exotic loan products. Many underestimate how much their payment could go up.
For example, almost 75% of borrowers who have payment-option ARMs are only making a minimum payment. Because of this, one-in-five buyers currently owe more than their home is worth.
