Paying for ‘the wrong choices’

Every day, Will Hertzberg owns a little less of his three-bedroom house in Corona, Calif.

Like hundreds of thousands of other homeowners around the state, Hertzberg has a mortgage that lets him choose how much he pays each month.

Like many of them, he always chooses to pay as little as possible.

For the moment, this allows the 56-year-old Hertzberg to continue living in his tract home despite being only marginally employed. But his debt is swelling, and his mortgage company controls his fate.

“I am rather screwed,” he said.

Alarmed regulators recently have attempted to force lenders to cut back on loans such as Hertzberg’s. Even some industry executives are beginning to wonder how these borrowers will handle their added debt, especially if housing prices stay flat or fall.

If it turns out that many can’t, it would be a major blow to the housing market. In the worst outcome, it could drag down the overall economy.

Hertzberg could sell now, but his lender would charge him an $11,034 prepayment penalty – money he doesn’t have. Yet if he stays, the housing market may tank, vaporizing what little equity he has left.

“I made choices, and they happened to be the wrong choices,” said Hertzberg.

The real estate boom of the last few years has made it very easy to become overextended.

Earlier generations bought houses knowing they had no choice but to keep paying at the same rate for three decades. Their reward: the ability to sleep well, knowing their payments wouldn’t abruptly adjust upward.

As interest rates rose in the early 1980s, many borrowers couldn’t afford these traditional loans. Lenders responded with adjustable mortgages that offered lower introductory rates.

A few years ago, as home prices began escalating sharply, lenders pushed loans that let the homeowner pay only the interest for an initial period.

When even that was too onerous for some borrowers, they offered loans such as Hertzberg’s, often called “pay option” loans.

One of his options is to pay $2,513 a month. That would cover the principal and interest as if it were a traditional 30-year loan.

A second possibility is to pay $2,279, which would cover only the interest.

But each month he always takes the cheapest option: paying $1,106 and promising to make up the shortfall later.

Essentially, option loans are bets that good things will happen. Maybe the mortgage holder will get a big raise, or sell a script to Hollywood, or inherit a chunk of change. When the borrower has to start paying off the loan in earnest in five years, the plan is that he or she will somehow be able to handle it.

At a minimum, the borrower is betting the housing market will be better in a few years than it is today. If the house goes up in value, it will be possible to refinance and the day of reckoning can be put off once again.

In the first eight months of 2006, even as the real estate market began to weaken amid fears of a downturn, pay-option loans increased. Even now, 1 in 3 California loan applicants are choosing them.

Hertzberg bought his house 11 years ago for $129,995, immediately after his second divorce. Since then, the area has boomed.

Comparable homes in his neighborhood fetch more than $400,000. With fresh paint and a few repairs, Hertzberg could probably sell his place for $275,000 more than he paid.

He would see little of that, however, because he’s already seen so much. Over the years he has taken out $190,000 in cash through refinancings.

Hertzberg’s home equity paid off his credit cards, financed trips around the world that allowed him to indulge his passion for photography, bought a $32,000 Toyota Avalon and enabled some lousy investments. He bought dot-com stocks and lost money. To recoup those losses, he bought commodities – and lost money faster.

“Free money always has the unfortunate effect of making people go overboard,” said Hertzberg, whose living room is strewn with financial publications including American Cash Flow Journal and Donald Trump’s “How to Get Rich.” “You’d be surprised how fast $190,000 can go.”

The money wasn’t really free, of course. It just seemed that way, the result of a radical shift during the last decade in how people view their homes.

“Homeownership has become like auto leasing, where the price of the car doesn’t matter,” said Rick Soukoulis, chief executive of LoanCity, a San Jose, Calif., lender that funded $7 billion in mortgages in 2005. “All that matters is the size of your monthly payment.”

Lenders say these new loans are all about payment choice, but Hertzberg is far from the only borrower who invariably chooses the smallest payment option. Washington Mutual Inc., which has one of the nation’s largest portfolios of pay-option loans, said 47 percent of its borrowers in this category last December took the minimum option.

Hertberg’s day of reckoning is arriving early. By paying the minimum, Hertzberg has increased the size of his loan in a little over a year from $320,000 to $332,616. His lender, Countrywide Financial Corp., recently sent him a letter warning that when his loan hits 115 percent of its original size he’ll run out of credit with the company.

That will happen in about two years if he continues to take the smallest payment option. Then his minimum payment will automatically go up 150 percent, to $2,848 a month.

“If I could afford that,” he said, “I wouldn’t have needed this loan in the first place.”

Countrywide sees little risk of widespread foreclosures, saying its pay-option customers have good credit scores, indicating a high degree of financial stability. But at a company investment conference in September, Chairman Angelo Mozilo seemed to indicate that these borrowers might be naively optimistic.

“The average age of our borrowers is about 38 years old,” Mozilo said. “They have never in their adult lives seen values going down. The concept is alien to them.”