• Many more mortgages are nontraditional now than in the past.monetary street image by Yuriy Poznukhov from Fotolia.com
  
  Mortgage lending was once a conservatively managed business that had low delinquency and loss rates. However, an increased use of nontraditional mortgage products---including interest-only or payment option adjustable-rate mortgages---brought risk into the business, according to the Federal Deposit Insurance Corporation (FDIC). In the past, nontraditional mortgage products were only offered by a few lending institutions. Those lenders used stable underwriting practices to screen borrowers. As more lenders offered nontraditional mortgages, underwriting loosened and there was more concern over the risks associated with those mortgages.
  
  

Risk Layering

• Lenders began offering nontraditional mortgage loans to a broader range of people. They also relaxed their underwriting standards. That meant many loans were issued with reduced documentation. In other words, the lender did not verify the borrower's income and assets. That meant the lender did not know if the borrower was financially able to pay back the loan. In addition, lenders issued many nontraditional mortgages simultaneously with a second mortgage, which further increased the risk. That type of risk layering in combination with expanding the marketing of nontraditional mortgages to more people resulted in an increased risk of loss to financial institutions.
  
  

Interest Rates

• Some nontraditional mortgage loans come with low introductory interest rates. Those introductory interest rates are set below the fully indexed interest rate as a way to market payment option adjustable rate mortgages to more people. However, the low payments in initial months mean that people are not paying much of the principal in the early months of the mortgage loan. In addition, there is a probability of payment shock when interest rates on the monthly payment reset, especially if the ARM resets earlier than expected. The borrower can end up with a negative amortization as aresult. In other words, he ends up owing more on the loan.
  
  

Investor Loans

• Nontraditional mortgage loans for non-owner-occupied, investor-owned properties pose a particular risk. Lenders should only make nontraditional loans for those properties if the borrower has the ability to pay the loan over the life of the loan. The borrower should require documentation that the borrower has enough cash reserves to pay the mortgage even if the property is not rented for periods of time, in order to reduce risks associated with this type of loan, according to the Federal Reserve.
  
  

Not Qualifying Buyers

• Some lenders made subprime loans to borrowers who did not have adequate income to repay their loans. The Federal Reserve says that lenders failing to properly qualify borrowers for nontraditional loans pose risks to both the lender and the borrower. There is a possibility of a nontraditional loan posing severe payment shock for a borrower if the borrow has a high loan-to-value (LTV) ratio, high debt-to-income (DTI) ratios and low credit score, according to the Federal Reserve. That is because payment of principal or interest is deferred during the early stages of the loan. More stringent underwriting requirements can reduce that risk by ensuring the borrower has the ability to repay the loan by its final maturity date.