Balloon Reset, 2-Step Loans Need Attention

WASHINGTON —  If you’re one of the hundreds of thousands of American home buyers or refinancers who took out a popular cut-rate mortgage earlier in the 1990s, carrying the name “balloon reset” or “two-step,” get ready to make a key financial decision.

The first wave of an estimated 800,000-plus Freddie Mac and Fannie Mae five-year and seven-year mortgages that originated nationwide from 1991 onward are hitting their rate-adjustment or payoff points. And in some cases, say mortgage industry experts, borrowers are unaware of the special mechanics of their loans and of what they need to do to keep them on the books.

For some borrowers, that lack of understanding could be disastrous: They could be legally required to pay off their loans this year, or to find a quick replacement, even though they thought they had a 30-year mortgage.

Here’s what’s happening: In the early 1990s, the two behemoths of the mortgage market--Freddie Mac (Federal Home Loan Mortgage Corp.) and Fannie Mae (Federal National Mortgage Assn.)--rolled out innovative loans with starting rates about half a percentage point below the then-prevailing 9 1/2% for fixed-rate 30-year mortgages.

Freddie Mac’s loan was called a “balloon reset.” It allowed borrowers to choose an initial five- or seven-year term with a fixed discount rate. At the end of the initial period, borrowers might qualify for a “reset,” a fixed rate for the remaining 25-year term of the loan. Alternatively, the borrower could pay off the entire principal debt in a lump-sum “balloon” payment by refinancing for some other type of mortgage.

Fannie Mae offered two cut-rate options: a new “two-step” adjustable rate loan with the first--and only--adjustment scheduled five or seven years down the road, and a seven-year balloon requiring a rate adjustment or payoff at the end of that term.

Although borrowers might not have focused on the fine print at the time, the balloon loans carry special requirements at the five- or seven-year mark to avoid triggering a lump-sum payoff. If a homeowner wants to keep a Freddie Mac balloon reset mortgage on the books, he or she has to meet several criteria:

* The past year’s payment history must be squeaky clean, with no payments 30 days or more late.

* No home equity lines of credit, second mortgages or other liens against the property are allowed.

* The home must still be occupied and owned by the original borrower.

* The borrower must make a written request to the lender to reset the rate and extend the loan within an extremely narrow time window--between 45 and 60 days before the balloon payoff date.

Borrowers who fail to qualify on just one of these requirements could find their loans deemed due and payable in full at the five- or seven-year maturity date. Freddie Mac has financed about 500,000 discount-rate balloon loans during the first half of the decade. The only problem, according to Freddie Mac officials, is that as the earliest batches of the five-year balloons reach or near maturity, some borrowers seem to have forgotten that they don’t have a standard-issue, 30-year mortgage.

“People think that they can just keep making the [monthly] mortgage payments, but that’s not the case,” says Freddie Mac vice president Cam Melchiorre. “This is a different type of animal.”

Borrowers with maturing five-year balloons need to respond promptly when their loan servicer writes to them asking whether they wish to reset the rate, says Melchiorre.

The current reset rate is about 8.625%--representing a slight decrease in monthly payments for 1991-vintage borrowers. But those consumers could lose the lower reset rate and expose themselves to the costs and hassles of refinancing if they don’t get in touch with servicers on time.

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Fannie Mae’s “two-step” borrowers face a different situation. Their five-year loans function like true adjustable-rate mortgages, not balloons. There is no lump-sum payoff requirement. There are no special criteria to meet. On the termination date of the initial five-year period, their rates automatically adjust to a new rate, fixed for the next 25 years.

Like Freddie’s reset rate, Fannie Mae’s two-step adjustment provides the borrower with a new long-term rate that probably represents a slight decrease from the initial rate. But in both cases, the new rate is about half a percentage point higher than the best-available rate a shopper could find in the 30-year mortgage marketplace.

Which means that five-year two-step borrowers need to confront the same basic question facing Freddie’s reset borrowers: Should they refinance elsewhere or stick with the revised rate on the loan they’ve got? Either way, though, they must be alert to the crucial deadline built into the Fannie or Freddie loan.

To be safe, pull out your mortgage documents and check. You may be one of the thousands whose mortgage clocks are ticking toward a rate-adjustment deadline you forgot.

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Distributed by the Washington Post Writers Group.