5 Risky Mortgage Types To Avoid

By Amy Fontinelle AAA

If there's anything we've learned from the subprime meltdown of 2008 and crash of 1987, it's that we should all proceed with caution when borrowing money to purchase or refinance a home. The type of mortgage you choose can mean the difference between one day owning your home outright or finding yourself in the middle of a foreclosure or even a bankruptcy. In this article, we'll discuss the types of mortgages that people most commonly have trouble with and explain why they are a bad idea when matched with the wrong borrower.

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What Makes a Mortgage Risky?
Because of the housing crisis, many of us have come to believe that certain types of mortgages are inherently risky. However, mortgage experts will tell you that a risky mortgage is really a loan product that is not matched with the repayment ability of the borrower. (Take a look at the factors that caused this market to flare up and burn out, check out The Fuel That Fed The Subprime Meltdown.)

Keith T. Gumbinger, Vice President of HSH Associates, agrees, saying, "believe it or not, the products available [around 2009] weren't especially risky, for the right audience." The problem was that certain mortgage types were being matched with the wrong borrowers, and lenders were telling borrowers, "you can always refinance." This may have seemed true when home prices had been rising for years, but isn't true when home values are declining.

Housing market statistics shortly after the 2008-2009 crisis support these assertions. According to the Mortgage Bankers Association's National Delinquency Survey, in the second quarter of 2010, the types of loans with the highest percentage of foreclosure starts were subprime adjustable rate mortgages (ARM), which had a foreclosure start rate of 3.39%. ARMs, with their changing interest rates, are a particularly risky mortgage product for borrowers with less-than-ideal financial situations.

By comparison, the survey reported that VA loans had a foreclosure start rate of 0.70%, prime fixed loans 0.71%, FHA loans 1.02%, prime ARMs 1.96% and subprime fixed loans 2.3%. This data indicates that any type of mortgage can be a bad idea for a subprime borrower, and that even prime borrowers can get into trouble if they don't understand ARMs.

In fact, even fixed-rate mortgages can be detrimental to borrowers. Let's look at our first risky mortgage type.

1. 40-Year Fixed Rate Mortgages
Borrowers with fixed-rate mortgages may have a low rate of foreclosure, but that doesn't mean that fixed-rate mortgages are always a good idea. The 40-year fixed-rate mortgage is one such product because the longer you borrow money for, the more interest you pay.

Let's say you want to buy a $200,000 home with a 10% down payment. The amount you'll need to borrow is $180,000 ($200,000 minus $20,000).

At an interest rate of 5%, here are the monthly payments and the total amount you'll pay for the home under various terms if you keep the loan for its life:

Term Interest Rate Monthly Payment Lifetime Cost (including down payment) Principal(including down payment) Total Interest Paid
15 years 5.0% $1,423.43 $276,217.14 $200,000 $76,217.14
20 years 5.0% $1,187.92 $305,100.88 $200,000 $105,100.88
30 years 5.0% $966.28 $367,860.41 $200,000 $167,860.41
40 years 5.0% $867.95 $436,617.86 $200,000 $236,617.86
Figure 1: Interest and principal paid on a mortgage over various terms (years).

The chart above is a simplified comparison. In reality, the interest rate will be lowest for the 15-year loan and highest for the 40-year loan. Here's a more realistic comparison:

Term Interest Rate Monthly Payment Lifetime Cost(including down payment) Principal(including down payment) Total Interest Paid
15 years 4.5% $1,376.99 $267,858.83 $200,000 $67,858.83
20 years 5.0% $1,187.92 $305,100.88 $200,000 $105,100.88
30 years 5.2% $988.40 $375,823.85 $200,000 $175,823.85
40 years 5.8% $965.41 $483,394.67 $200,000 $283,394.67
Figure 2: Interest and principal paid on a mortgage over various terms (years) and interest rates.

As you can see in Figure 2 above, the 40-year mortgage is 0.6% higher in interest, and it will lower your monthly bill by just $23, from $988 to $965. However, it will cost you an extra $107,570.82 over the life of the loan. Most people cannot afford to throw away that kind of money. Taking out a 40-year mortgage increases your risk of not having enough for retirement, not being able to pay for your children's college education, or any number of other scenarios. At best, you're forgoing $107,570.82 that you could have spent on vacations, electronics, nice dinners and other fun expenditures. Who wants to do that?

2. Adjustable Rate Mortgages
Adjustable rate mortgages (ARMs) have a fixed interest rate for a short initial term that can range from six months to 10 years. This initial interest rate, called a teaser rate, is often lower than the interest rate on a 15- or 30-year fixed loan. After the initial term, the rate adjusts periodically - that might be once a year, once every six months or even once a month.

"Any loan that has a fixed interest rate for a period shorter than the term of the loan is running a huge interest rate risk," says California real estate broker Greg Cook of the First Time Home Buyer Network.

Interest rate risk is the risk that if interest rates increase, the monthly payments under an ARM will become more expensive, and in some cases that is an expense that the homeowner can't afford.

The element of unpredictability that comes with ARMs is a problem for many people, especially if they are on a fixed income or don't expect their incomes to rise.

ARMs become even riskier if you have a jumbo mortgage, simply because the higher your principal, the more a change in interest rate is going to affect your monthly payment.

That being said, Mary Tootikian, an experienced mortgage processor and underwriter and the author of the book "Stunned in America," points out that "Historically, people do not stay in their homes or their mortgages for more than five to seven years. Therefore, why pay a higher rate [for a] 30-year fixed loan when a lower rate mortgage will do?"

It's also important to note that an adjustable interest rate can adjust downward, decreasing the monthly payment. This means that ARMs can be a good choice if you expect interest rates to decrease in the future. Of course, you can't predict the future. (Both of types of mortgages have advantages and disadvantages depending on your financial needs and prospects. For more insight, read Mortgages: Fixed-Rate Versus Adjustable-Rate.)

3. Interest-Only Mortgages
With an interest-only (IO) mortgage, the borrower pays only the interest on the mortgage for the first for five to 10 years, allowing for a lower monthly mortgage payment during this time. This makes interest-only mortgages attractive to some real estate investors who will own a home for only a short period of time and want to reduce their carrying costs.

IO mortgages can also be good for people who earn an irregular income and people who have significant potential for income increases in the future, but only if they are disciplined enough to make higher payments when they can afford to do so.

The downside is that the interest rate on an IO mortgage tends to be higher than the rate you would pay on a conventional fixed-rate mortgage because people default on interest-only loans more often. (These loans can be beneficial, but for many borrowers, they present a financial trap. Learn more in Interest-Only Mortgages: Home Free Or Homeless?)

Furthermore, if you are not a financially sophisticated borrower, interest-only mortgages can be extremely risky for any one or more of the following reasons:

  • You can't afford the significantly higher monthly payments when the interest-only period ends. At this point, you'll still be paying interest, but you'll also be repaying the principal over a shorter period than you would with a fixed-rate loan.
  • You can't refinance because you have little to no home equity.
  • You can't sell because you have little to no home equity and home prices have declined, putting you underwater.
  • Borrowers who keep the interest-only loan for the life of the loan will pay significantly more interest than they would have with a conventional mortgage.
  • Depending on how the loan is structured, you may face a large balloon payment of principal at the end of the loan term.

If you are a borrower who is not a good candidate for an IO loan, any of these problems could cause you to lose the home in a worst-case scenario. In a slightly less-bad scenario, the IO loan could simply cost you much more than you really need to pay to be a homeowner.

4. Interest-Only ARMs
With some interest-only loans, called interest-only ARMs, the interest rate is not fixed, but can go up or down based on market interest rates. Essentially, the interest-only ARM takes two potentially risky mortgage types and combines them into a single product.

Here's an example of how this product can work. The borrower pays interest only, at a fixed rate, for the first five years. Then, for the next five years, the borrower continues to pay interest only, but the interest rate adjusts annually based on market interest rates, meaning that the borrower's interest rate can either go up or down. Then, for the remainder of the loan term, say, 20 years, the borrower will repay a fixed amount of principal each month plus interest each month at an interest rate that changes annually.

Many people simply do not have the financial or emotional wherewithal to withstand the uncertainty that comes with interest-only ARMs. (For more check out Payment Option ARMs: A Ticking Time Bomb?)

5. Low Down Payment Loans
It seems low-risk to only put 3.5% down because you're not parting with a lot of cash. And in fact, VA loans and Federal Housing Administration (FHA) loans, which have down payment requirements of 0% and 3.5%, respectively, have some of the lowest foreclosure start rates. The problem with making a low down payment is that if home prices drop, you can get stuck in a situation where you can't sell or refinance.

If you have enough money in the bank, you can buy yourself out of your mortgage, but most people who make low down payments on their homes don't have significant cash reserves.

The Bottom Line
While most of the loans that some mortgage lenders might consider to be truly high-risk, like the interest-only ARM, are no longer on the market, there are still plenty of ways to end up with a bad mortgage if you sign up for a product that really isn't right for you. (Also see Self Employed? 5 Steps To Scoring A Mortgage.)

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