Fitch Ratings announced it altered the risk factor for interest-only, subprime hybrid adjustable-rate mortgages because of high vulnerability to payment shock.

In analyzing the payment shock potential for 2005 subprime IO and non-IO ARMs, Fitch said the payment increase at the rate reset is much higher than the increase from IO payments to principal amortization — even if rates don’t increase.

‘If a borrower selects an IO to qualify for a larger loan, their debt-to-income ratio … will rise more than that of a non-IO product after the rate reset,” Fitch said. And if the DTI gets “too high to qualify for a new mortgage before the rate reset, they become vulnerable to payment shock risk.”

Due to the higher odds of default on IOs on two- and three-year subprime hybrid ARMs, the ratings agency said it will adjust the treatment of such mortgages within a month.

The performance of newer vintages may not be as strong as loans in the past few years because more borrowers could face a payment increase as home price appreciation slows, Fitch said, noting that subprime borrowers tend to use accumulated home equity to pay off additional debt to lower their DTI.

Thus, borrowers facing their first reset in 2007 and later may be more susceptible to payment shock risk than borrowers whose 2004 loans reset this year because home values rose since then.

 

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