During the Great Recession, the U.S. economy took a major hit because of mortgage foreclosures. Borrowers all over the nation had trouble paying their mortgages. During that time, borrowers were trying to refinance their mortgages, and even high-end homeowners were having trouble with foreclosures. Homeownership became a calamity for many Americans.
So, why were so many citizens having trouble with their mortgages? There were several reasons, including "liar loans" and underwater homes. These problems are not just in the past, either. Here are six common mortgage mistakes that can occur not only during periods of economic strife but anytime at all.
- Adjustable-rate mortgages offer a low initial rate that results in lower payments; however, the interest rate resets after a set period of time.
- Putting no down payment on a mortgage can make it more likely that the borrower’s house ends up “underwater.”
- Reverse mortgages have high upfront costs, are riddled with numerous fees, and result in losing the equity in your home.
- Longer time frames for mortgages result in less equity in the home and more interest paid—making it difficult for the owner to move.
- Exotic mortgage products can result in buyers building negative equity.
1. Adjustable-Rate Mortgages
Adjustable-rate mortgages (ARMs) can seem like a homeowner's dream. These mortgages start borrowers off with a low-interest rate for the first two to five years. They allow you to buy a larger house than you can typically qualify for and have lower, more affordable payments.
After two to five years, the interest rate resets to the market rate, which is generally higher. This isn't an issue if borrowers can take the equity out of their homes and refinance to a lower rate once it resets. Alternatively, if the buyer didn't stay in the home for long, it may already have been sold when the rate would have changed.
This type of mortgage can be a good choice for someone whose job requires frequent relocation. But it doesn't always work out that way. When housing prices drop, borrowers tend to find that they cannot refinance their existing loans. This leaves many borrowers facing high mortgage payments two to three times their original payments.
Shopping around with different lenders, offering complete and truthful information on your mortgage application, and addressing credit problems as they occur are the best steps you can take to get a fair and practical mortgage.
2. No Down Payment
One trigger of the subprime crisis was that many companies offered borrowers no-down-payment loans. Here's why that became a problem. The purpose of a down payment is twofold. First, it increases the amount of equity you have in your home while reducing the amount of money you owe. Second, a down payment makes sure that you have some skin in the game.
Borrowers who make large down payments are more likely to try everything possible to make their mortgage payments, as they do not want to lose their investment.
On the other hand, many borrowers who put little to nothing down on their homes and find themselves upside down on their mortgage end up walking away because they owe more money than the home is worth. The more a borrower owes, the more likely they will walk away, putting the mortgage in foreclosure.
3. Liar Loans
The term “liar loans” may sound disreputable, but such loans were prevalent during the real estate boom before the subprime meltdown in 2007. Mortgage lenders were quick to hand them out, and borrowers quickly accepted them. A liar loan requires little to no documentation and no verification. The loan is based on the borrower’s stated income, stated assets, and stated expenses. They are so named because borrowers have a tendency to lie, inflating their income so that they can buy a larger house. Some individuals who received a liar loan did not even have a job. The trouble starts once the buyer gets in the home.
As the mortgage payments have to be paid with actual income—not stated income—the borrower cannot consistently make mortgage payments. They fall behind on the payments and end up facing bankruptcy and foreclosure.
4. Reverse Mortgages
If you watch television, you have probably seen a reverse mortgage advertised as the solution to all of your income problems. A reverse mortgage is a loan available to homeowners age 62 and up that uses the equity out of their home to provide an income stream. The available equity is paid out to borrowers in a steady stream of payments or as a lump sum such as an annuity.
There are many drawbacks to getting a reverse mortgage. There are high upfront costs. Origination fees, mortgage insurance, title insurance, appraisal fees, attorney fees, and miscellaneous fees quickly eat up equity. While the borrower still retains the home's title and therefore "owns" the home, the reverse mortgage could have significant implications for their children.
However, this depends on how the loan was set up; the most common reverse mortgage is a home equity conversion mortgage (HECM). This means that if the borrower's children want to keep the home, they need to pay off the rest of the loan or 95% of the home's appraised value.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
5. Longer Amortization
You may have thought that 30 years was the longest time frame you could get on a mortgage, but some mortgage companies are now offering loans that run as long as 40 years. What’s more, 35- and 40-year mortgages are slowly rising in popularity. Why? They allow individuals to buy a larger house for much lower payments.
A 40-year mortgage may make sense for a 20-year-old who plans to stay in the home for the next 20 years, but it doesn’t make sense for other people. The interest rate on a 40-year mortgage will be slightly higher than a 30-year. This amounts to a lot more interest over 40 years because banks will not give borrowers 10 extra years to pay off their mortgage without making it up on the back end.
Borrowers will also have less equity in their homes. The bulk of payments for the first 10 to 20 years will primarily pay down interest, making it nearly impossible for the borrower to move. This also makes retirement harder if you’re making payments into your 70s.
6. Exotic Mortgage Products
Other types of mortgages developed before the Great Recession also led to foreclosure. Lenders came up with exotic products that made the dream of homeownership a reality. Some homeowners did not understand what they were getting themselves into. Two examples:
- Interest-only loans can lower payments by 20% to 30%. These loans let borrowers live in a home for a few years and only make interest payments.
- Name-your-payment loans allow borrowers to decide exactly how much they want to pay on their mortgage each month.
The catch for both products is that a big balloon principal payment comes due after a certain period. All of these products are known as negative amortization products. Instead of building up equity, borrowers are building negative equity. They are increasing the amount they owe every month until their debt comes crashing down like a pile of bricks. Exotic mortgage products have led to many borrowers being underwater on their loans.
What Is the Longest Mortgage Term?
The standard length of most mortgages is 15 or 30 years. There are 40-year mortgages available, but they don't come highly recommended.
What Is a Liar Loan?
The term "liar loan" is a colloquial term for loans that are given out without appropriate documentation, but rather on what the borrower tells the lender. These loans were popular in 2007 before the real estate bubble burst.
Should I Take Out a Reverse Mortgage?
A reverse mortgage can only be taken out if you are a homeowner age 62 or older and you have enough equity in your home to warrant one. If this is all correct, you may be able to receive steady payments or a lump sum based on your home's equity in the form of a reverse mortgage. However, there are risks to taking out a reverse mortgage and if you are planning to pass on the family home to your children, take note they will be responsible for paying off the reverse mortgage if they inherit. If you can't make the reverse mortgage payments, you could lose your home.
The Bottom Line
The road to homeownership is riddled with many traps, especially if you stray from conventional or federally backed loans. If you can avoid problems that can present themselves when you apply for a mortgage, you are more likely to say out of financial trouble. When it comes to a home loan, perhaps a good adage to keep in mind is that if something seems too good to be true, it probably is.