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 one day finding yourself in the middle of a foreclosure. We'll look at 5 mortgages that people most commonly have trouble with.
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, 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.
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. Taking out a 40-year mortgage increases your risk of not having enough for retirement, not being able to pay for your children to go to college, or any number of other scenarios.
Adjustable Rate Mortgages
Adjustable rate mortgages (ARMs) have a fixed interest rate for a short initial term that can range from 6 months to 10 years. After the initial term, the rate adjusts periodically - that might be once a year, once every six months or even once a month. 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.
With an interest-only (IO) mortgage, the borrower pays only the interest on the mortgage for the first for 5 to 10 years, which gives them a lower monthly payment during this time. 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. However, 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.
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. Many people simply do not have the financial or emotional wherewithal to withstand the uncertainty that comes with interest-only ARMs.
Low Down Payment Loans
It seems low-risk to only put 3.5% down because you're not parting with a lot of cash. 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.
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.
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