What is an Exotic Mortgage
An exotic mortgage is a type of home loan that offers lower monthly payments in the first few years but is considered high-risk because of its difficult-to-understand terms and higher future payments. People often use exotic mortgages to buy more expensive homes than they otherwise could afford. Homeowners may also refinance into exotic mortgages to lower their monthly payments. Exotic mortgages, also called non-traditional mortgages, make up a small part of the mortgage market.
BREAKING DOWN Exotic Mortgage
With an exotic mortgage, payments can increase dramatically after the initial period to twice or more the initial payment. Their payment schedules can also cause borrowers to end up owing more than they originally borrowed.
Interest-only mortgages are one type of exotic mortgage. Instead of requiring the homeowner to pay both principal and interest, they only require interest payments for the first few years, which means a smaller monthly payment. These mortgages typically have adjustable interest rates, so the initial monthly payment can jump if the interest rate increases, in addition to spiking when the interest-only period ends and principal repayment is required.
Another type of exotic mortgage is the payment-option adjustable-rate mortgage. This loan allows homeowners to choose a different amount to pay each month. They can even choose to pay less than the interest owed.
Aside from the problems of unpredictable monthly payments after the introductory period and difficulty in understanding their terms, a major problem with exotic mortgages is that if homeowners originally took them out because they could only afford a very small monthly payment, they may not be able to afford the future payment increases. In a declining housing market where home prices are decreasing, homeowners cannot sell their homes or refinance to get out of their no-longer-affordable exotic mortgages. Their only choices are a short sale or foreclosure. This scenario occurred regularly during the 2008 housing crisis.
How Mortgage Loan Regulation Impacts Exotic Mortgages
Many of the exotic mortgages available during the boom years leading up to the housing crisis were made illegal by new regulations. Others simply fell out of favor as long-term mortgage rates fell to very low levels that made exotic loans less competitive for lower-income or subprime borrowers.
Despite tighter lending standards made under the Dodd-Frank Act and greater scrutiny of mortgage lenders, exotic mortgages are still being underwritten. They are available to borrowers in the form of adjustable-rate, interest-only and to a limited degree, stated income loans. Mortgage lenders are also piggyback second mortgages that allow borrowers to circumvent conforming loan limits.