Although it is clear that payments on IO loans will rise at the reset date, whether borrowers have the ability to meet the adjusted payments is a matter of concern.
Last week, Lehman Brothers noted that nominal changes in payments could be considerable in IO loans. However, an improving economic landscape, which will accompany higher rates, theoretically should lead to improvements in income levels as well.
Even with conservative assumptions, the "real" debt-to-income ratios change marginally, even on IO loans. Aside from this, loans with a 10-year amortization holiday (10-year IOs) have less changes in DTI compared to their five-year counterparts because of the de-linking of the rate-reset and the amortization effects, said Lehman.
Lehman looked at the main drivers of the magnitude of payment shock in hybrid ARMs and applied them to hybrid IOs. The payment change on a hybrid loan is a function of the initial rate as well as the rate after first reset, explained Lehman. Researchers argued that the lower the initial rate and the higher the rate at reset, the larger the jump in payment at reset. More significantly, the spike in payments on an IO loan is comparatively larger when the initial rate is lower. Furthermore, the payment spike at the end of the fixed-rate period is less in a 10-year IO compared to a five-year IO loan since the rate-reset and the amortization-related payment shocks are de-linked in a 10-year IO.
IO loans are loans with an amortization holiday (i.e., the borrower just makes interest payments) for some period, said Lehman. Although the most common term of an IO loan in jumbos is five years, Alt-A hybrids mainly have a 10-year IO period. Because of the amortization holiday, the IO loan has lower monthly payments in initial months and larger payments after the end of the IO period.
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