Exotic Mortgage

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 can be risky because of its often difficult-to-understand terms and higher future payments. People sometimes use exotic mortgages to buy more expensive homes than they could otherwise afford. Homeowners may also refinance into exotic mortgages to lower their monthly payments. Also called non-traditional mortgages, exotic mortgages were once more popular but make up only a small part of the mortgage market today.

Types of Exotic Mortgages

Exotic mortgages come in several varieties, all of which provide lower initial payments than regular mortgages do but at greater risk to the borrower. They include:

Interest-only mortgages

Interest-only mortgages are one type of exotic mortgage. Instead of the borrower paying both interest and a portion of principal each month, as is the case with traditional mortgages, they require only interest payments for the first few years. That allows for a smaller monthly payment at the outset.

These mortgages typically have adjustable interest rates, so the initial monthly payment can jump if the interest rate increases. It can also spike when the interest-only period ends and the borrower must start repaying the principal. As a result, the borrower's monthly payments could become unaffordable.

Payment-option adjustable-rate mortgages (ARMs)

Another type of exotic mortgage is a payment-option adjustable-rate mortgage, also known as an option ARM. With this type of loan, the homeowner can choose a different amount to pay each month—the regular full payment, an interest-only payment, or a payment that is even less than the interest they owe.

In theory, this type of loan could be good for someone whose income fluctuates significantly from month to month. The danger is that any interest they don't pay is simply added to the principal they owe so that they ultimately end up paying interest on the interest.

Balloon mortgage

A balloon mortgage starts with low—or even no—monthly payments, but at a certain agreed-upon point, the borrower must make a large lump-sum payment to the lender. Typically, the balloon payment comes at the end of the mortgage and pays off any remaining debt in full. The danger here, of course, is that when the balloon payment comes due, the homeowner won't be able to come up with the cash.

Pros and Cons of Exotic Mortgages

The advantage of an exotic mortgage is that it can allow a borrower to purchase a home that they couldn't afford with a traditional mortgage.

The tradeoff is that they are taking on a considerable amount of risk in return for those lower monthly payments. With either an interest-only or payment-option mortgage, their monthly payments will increase at some point, possibly dramatically and unaffordably. With a balloon mortgage, they will need to come up with a significant amount of cash when their balloon payment comes due.

If all goes well, everything may work out fine. However, a job loss, an unexpected financial emergency, or a decline in housing prices could make it impossible for the borrower to hold up their end of the bargain. In that case, the lender could foreclose on the property, and the borrower could lose their home. This scenario occurred regularly during the 2008 housing crisis.

In the aftermath of the housing crisis, some kinds of exotic mortgages were made illegal. Others simply fell out of favor as mortgage rates dropped to historically low levels, making exotic loans less competitive. But some remain available and they could see a resurgence in a future housing market.