Home buyers in high-cost markets -- and the realty professionals who work with them -- should be prepared for potentially significant cutbacks in the availability of payment-option and interest-only mortgages, starting early next year. Both types of loans offer buyers reduced monthly payments that allow them to afford high-cost houses.

Federal financial regulators released their long-awaited proposed guidelines for banks, thrift institutions, credit unions and mortgage banking subsidiaries active in the booming "affordability" loan marketplace last week. If adopted after a 60-day public comment period, the new rules would pressure lenders to reserve their riskiest negative-amortization and payment-reset loans primarily for relatively sophisticated borrowers with high credit scores, low debt-to-income ratios, and high downpayments.

Affordability loans have been the mainstays of high-cost, high-appreciation real estate markets on the East and West coasts for the past year. Nearly half of all new loans in the Washington DC market during the first six months of 2005 carried interest-only or payment-option features, according to mortgage industry estimates. The percentage was even higher in some California metropolitan markets, according to Loan Performance LLC, a San Francisco-based mortgage analytics firm.

The proposed new guidance from the Federal Reserve Board, the Comptroller of the Currency, the Office of Thrift Supervision, the National Credit Union Administration and the Federal Deposit Insurance Corp., would require commercial banks, savings banks, credit unions and their mortgage banking subsidiaries to follow far stricter underwriting and loss-mitigation standards in 2006 or face potentially stiff administrative penalties.

The central thrust of the guidance is for mortgage lenders to treat interest-only, payment-option and reduced documentation loans as products that carry significantly higher risks compared with conventional, plain-vanilla mortgages. In particular, the proposals target "layering of risks" in certain loan programs, where negative amortization features are combined with low credit score thresholds, high household debt-to-income ratios, and "stated income" underwriting where borrower income and assets are not verified.

Payment-option plans triggered special concern by the regulators. These mortgages typically carry 30-year terms but allow up to five years of reduced payments and negative amortization as one of several optional plans. Negative amortization -- literally the build-up of principal debt rather than reduction -- can add 10 to 15 percent or more onto a home buyer's debt in the first five years of a payment-option loan, according to Comptroller of the Currency John C. Dugan. A $300,000 mortgage, for example, might morph into a $330,000 loan balance after an extended period of negative amortization.

Regulators fear that with home price appreciation slowing markedly in some markets, payment option programs could leave purchasers "upside down" -- owing more on their houses than the market value of the properties themselves. To deal with the added risks of affordability loan products, the regulators' proposal calls on banks and mortgage subsidiaries to make sure their customers can handle monthly payment "resets" in the coming years, and that their underwriting should reflect the fact that "nontraditional mortgage loans often are inappropriate for borrowers with high LTVs (loan-to-value ratios), high DTIs (debt-to-income ratios) and low credit scores."

The regulators also strongly cautioned against use of "no-doc"and "stated income" features in connection with payment-option and interest-only loans. The higher the risk of the loan program, they said, "the more comprehensive" must be the lender's income verification and documentation standards.

Other features targeted by the regulators for special concern:

• So-called "piggyback" plans that provide second liens or home equity credit lines in conjunction with interest-only or payment-option loans. Though these programs can reduce the equity needed for a buyer to close on a new house, the regulators fear that they greatly increase the potential for defaults in softening markets.

• Deep "teaser" or low introductory rates that create a greater likelihood of "negative amortization, payment shock and earlier recasting of borrowers' monthly payments."

• Interest-only and payment option loans extended to borrowers with subprime credit characteristics or existing credit problems. Ditto for loans to non-occupant investors.

The regulators are expected to put the final guidance into the field—affecting most major lenders around the country—sometime in the first half of 2006.