5 Risky Mortgage Types to Avoid

One of the biggest lessons the world learned from the subprime meltdown of 2008 is that we should 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 or finding yourself in the middle of a foreclosure or even bankruptcy a few years into 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.

Key Takeaways

  • Any mortgage is risky if it is matched with the wrong type of borrower.
  • You'll end up spending more with a 40-year fixed-rate mortgage, even at a lower rate.
  • Adjustable-rate mortgage interest rates can go up, meaning you'll pay more when they reset.
  • Interest-only mortgage rates are higher than others and you'll have to pay the principal down by a certain date.
  • Interest-only adjustable-rate mortgages combine two risky products into 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. 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.

In 2008, certain mortgage types were being matched with the wrong borrowers, and lenders were reeling them in with the prospect of refinancing soon. This may have even worked when home prices were rising, but not when home values started to drop.

With their changing interest rates, adjustable-rate mortgages (ARMs) are a particularly risky choice for borrowers with less-than-ideal financial situations.

In fact, some fixed-rate mortgages can also be problematic under the wrong circumstances.

40-Year Fixed-Rate Mortgages

Borrowers with fixed-rate mortgages don't live with uncertainty, but that doesn't mean these mortgages are always a good idea. That's because you end up paying more in the long run. The longer your borrowing period, the more interest you end up paying.

Here's a hypothetical situation. 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)

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 a simplified comparison. The interest rate will probably be lower for the 15-year loan and the highest for the 40-year loan.

Below 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
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 the second chart, the 40-year mortgage is 0.6% higher in interest than the 30-year mortgage. That lowers your monthly bill by only $22.99 a month, from $988.40 to $965.41 However, it will cost you a whopping $107,570.82 more over the life of the loan.

That's a big chunk of money that could go to fund your retirement or to pay for your children's college education. At best, you're forgoing money that you could have spent on vacations, home improvements, and any other expenditures.

Adjustable-Rate Mortgages (ARMs)

Adjustable-rate mortgages (ARMs) have a fixed interest rate for an initial term ranging from six months to 10 years. This initial interest rate, sometimes 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. If interest rates rise, your monthly payments increase. Depending on your circumstances at the time, that could be an extra expense that you can't afford.

This degree of unpredictability is a problem for many people, especially those who have a fixed income and those 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 can fall as well as rise. ARMs can be a good option if you expect interest rates to fall in the future.

Interest-Only Mortgages

If you take out an interest-only mortgage, you are pushing out the payment on the principal of the loan to a later date. Your monthly payment covers only the interest on the mortgage for the first five to 10 years.

The attraction is the lower monthly payment for those early years.

In many cases, interest-only mortgages require a lump sum payment for the principal balance by a certain date.

If you are very sure that your income will significantly 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 intend to 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

An interest-only mortgage can be extremely risky for one or more of the following reasons:

  • You may not be able to 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 may not be able to refinance if you have little to no home equity.
  • You may not be able to sell if you have little to no home equity and home prices decline, putting you underwater on the mortgage.
  • 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 balloon payment at the end of the loan term.

Any of these problems could cause you to lose the home in a worst-case scenario. Even if none of these problems apply, the loan could cost you much more than you really need to pay to be a homeowner.

Interest-Only ARMs

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 works. The borrower only pays the interest at a fixed rate for the first five years. The borrower continues interest-only payments for the next five years, but the interest rate adjusts up or down annually based on market interest rates. For the remainder of the loan term—say, for 20 years—the borrower repays a fixed amount of principal plus interest each month at an interest rate that changes annually.

Many people don't have the financial or emotional resilience 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 lower risk. And that can be true.

Veterans Administration loans and Federal Housing Administration loans (FHA loans), which offer down payment options of 0% and 3.5% respectively—have some of the lowest foreclosure 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 the home. You owe more than it's worth on the market.

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 to do that.

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.

Article Sources
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  1. Reuters. "Subprime crisis exposes mortgage scams."

  2. U.S. Department of Veterans Affairs. "Purchase Loan."

  3. U.S. Department of Housing and Urban Development. "Let FHA Loans Help You."

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