One of the biggest lessons the world learned from the crash of 1987 and the subprime meltdown of 2008 is 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 owning your home outright one day in the future or finding yourself in the middle of a foreclosure or even bankruptcy right in the middle of your loan term.
Is there a way you can avoid falling into the latter? You can certainly do so by choosing the right mortgage loan—one that won't be too risky for you. In this article, we discuss the types of mortgages that people commonly have trouble keeping up with, and we explain why they are a bad idea when they're matched with the wrong borrower.
- Mortgages tend to be risky when they're matched with the wrong type of borrower.
- You'll end up throwing more money out the window in interest with a 40-year fixed-rate mortgage—even at a lower rate.
- Adjustable-rate mortgage interest rates may rise, meaning you'll pay more in interest when they reset.
- Not only are interest-only mortgage rates higher than others, but you'll also have to pay the principal down by a certain date.
- Interest-only adjustable-rate mortgages combine two risky products into an equally risky one.
What Makes a Mortgage Risky?
Many of us have come to believe that certain types of mortgages are inherently risky mainly because of what happened during the housing crisis. But most mortgage experts will tell you that isn't necessarily true. In fact, some of the mortgages available on the market weren't especially risky for the right consumers. A risky mortgage is really a loan product that doesn't correspond to the borrower's ability to repay it.
During the recession in 2008, certain mortgage types were being matched with the wrong borrowers, and lenders were reeling them in with the prospect of refinancing. This may have been true when home prices were rising. But it isn't the case when values drop. With their changing interest rates, ARMs are a particularly risky mortgage product for borrowers with less-than-ideal financial situations.
Any type of mortgage can be a bad idea for the subprime borrowers and prime borrowers and they are not immune to trouble if they don't understand ARMs. In fact, borrowers who aren't financially suited to them may even find some fixed-rate mortgages problematic as we see in the first risky mortgage type below.
40-Year Fixed-Rate Mortgages
Borrowers with fixed-rate mortgages may have a low rate of foreclosure, but that doesn't mean these mortgages are always a good idea. That's because you end up paying more in the long run. How does that work? It's simple. The longer your borrowing period, the more interest you end up paying.
Here's a hypothetical situation to demonstrate. 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|
So if you don't refinance and keep the loan as is, you'll pay $236,617.86 in interest alone by the end of the 40-year period. This is, of course, a very simple comparison. The interest rate will probably be lower for the 15-year loan and the highest for the 40-year loan. Here is a more realistic comparison using interest rates based on the term of the loan:
|Term||Interest Rate||Monthly Payment||Lifetime Cost(including down payment)||Principal(including down payment)||Total Interest Paid|
As you can see in the second chart, the 40-year mortgage is 0.6% higher in interest, lowering 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 can't afford to throw away that kind of money.
Taking out a 40-year mortgage increases your risk of not having enough for retirement or not being able to pay for your children's college education—let alone any other scenario. At best, you're forgoing $107,570.82 that you could have spent on vacations, electronics, nice dinners, and other expenditures. Who wants to do that?
Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages (ARMs) have a fixed interest rate for a short initial term ranging 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. This may be once a year, once every six months, or even once a month.
Loans with a fixed rate shorter than their terms are prone to interest rate risk. This means if interest rates rise, your monthly payments become more expensive under an ARM. In some cases, that is an expense that you can't afford.
This degree of unpredictability that accompanies ARMs is a problem for many people, especially those on a fixed income or who don't expect their incomes to rise. ARMs become even riskier with jumbo mortgages because the higher your principal, the more a change in interest rate will affect your monthly payment.
Keep in mind, though, that adjustable interest rates don't just rise. They can also drop, which can decrease your monthly payment. ARMs, therefore, may be a good option if you expect interest rates to fall in the future. Of course, you can't predict the future.
If you take out an interest-only mortgage, you can push down paying the principal balance to a later date, meaning you're only responsible to pay the interest on the mortgage for the first for five to 10 years, This allows you to pay a lower monthly mortgage payment during this time.
In many cases, interest-only mortgages require a lump sum payment for the principal balance by a certain date.
If you have an irregular income source or know your income will see a significant increase in the future, an interest-only mortgage may be a good idea for you. Or perhaps you're a real estate investor who wants to reduce your carrying costs and only own the home for only a short period of time.
Of course, there is a downside. The interest rate on an interest-only mortgage tends to be higher than the rate you would pay on a conventional fixed-rate mortgage because people default on these loans more often.
Why You Might Not Want an Interest-Only Mortgage
If you're not financially sophisticated, these 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. 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 decline, putting you underwater.
- Borrowers with interest-only loans for the life of the loan pay significantly more interest than they would 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.
Any of these problems could cause you to lose the home in a worst-case scenario if you're not a viable candidate for an interest-only mortgage. If you're in the clear and none of these apply, the loan could simply cost you much more than you really need to pay to be a homeowner.
There's also another interest-only product on the market—the interest-only adjustable-rate mortgage. Like a regular ARM, the interest rate can rise or fall based on market interest rates. Essentially, the interest-only ARM takes two potentially risky mortgage types and combines them into a single risky product.
Here's an example of how this product works. The borrower only pays the interest at a fixed rate for the first five years. The borrower continues their interest-only payments for the next five years, but the interest rate adjusts annually based on market interest rates. This means the interest rate can rise or fall. For the remainder of the loan term—say, for 20 years—the borrower repays a fixed amount of principal each month plus interest each month at an interest rate that changes annually.
Many people don't have the financial or emotional wherewithal to withstand the uncertainty of interest-only ARMs.
Low Down Payment Loans
Putting down only 3.5% because you're not willing to part with a lot of cash may seem like a minimal risk. And that may be true. In fact, VA loans and Federal Housing Administration loans (FHA loans)—which have down respective payment requirements of 0% and 3.5%—have some of the lowest foreclosure start rates. But 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 small 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 genuinely high-risk, like the interest-only ARM, are no longer on the market, there are still plenty of ways to end up with a lousy mortgage if you sign up for a product that isn't right for you.