Nontraditional Mortgage

What Is a Nontraditional Mortgage?

A nontraditional mortgage broadly describes mortgages that do not have standard conventional characteristics. These can refer to any type of mortgage that doesn't conform to a standard amortization schedule or have standard installment payments.

Nontraditional mortgages often come with higher interest rates because of the higher payment risks associated with the loan. Examples include balloon loans, hybrid ARMs, or interest-only mortgages.

Understanding Nontraditional Mortgages

A mortgage is a debt vehicle used to purchase a property—a home, land, or other types of real estate. The owner pays down a predetermined payment amount—a combination of principal and interest—over a certain period of time. This period is referred to as the amortization period. The mortgage is secured by the property, so if the mortgagor fails to fulfill their financial obligation, the lender can foreclose on the asset.

Traditional mortgages are simply structured, where a mortgagor borrows on a fixed or variable interest rate, making payments until the loan is completely paid off. They offer borrowers predictability, so there are no surprises in terms of the amount of the monthly payment or when the loan ends.

Nontraditional mortgages are different because they offer a variety of other options for borrowers. These products give borrowers more flexible repayment terms, allowing them to defer their payments—primarily the principal balance, but, in some cases, also interest. This lowers how much the borrower is initially responsible for before the full balance is due.

These types of mortgages often come with a higher risk. That's because there's a higher risk for default. Any of these mortgages require less asset and income requirements. There is a trade-off though—the lender can charge borrowers a higher interest rate. Nontraditional mortgages are usually extended to borrowers in nontraditional situations including subprime borrowers. Because they may not have another place from which to borrow, they're generally willing to accept a higher interest rate along with the flexibility they offer.

Types of Nontraditional Mortgages

Some of the market’s most common nontraditional mortgages include balloon mortgage loans, interest-only mortgages, and payment-option adjustable-rate mortgages (ARMs).

Balloon Mortgage Loans

In balloon-payment loans, both the principal and interest can be deferred until the maturity date. Once the mortgage reaches maturity, the borrower is required to make a lump-sum payoff. Balloon-payment loans can also be structured with interest-only payments. Balloon-payment mortgage loans are commonly used by developers. They generally come with higher interest rates and offer deferred payments.

Interest-Only Loans

Just like balloon-payment loans, interest-only loans are also commonly offered by developers. These loans require the borrower to make regular interest payments followed by a lump sum principal payment at maturity. In the case of building development, many developers use a take-out loan at maturity or refinance a balloon payment loan with collateral once it has been built.

Payment-Option Adjustable-Rate Mortgages

Payment-option adjustable-rate mortgages (ARMs) are one of the most flexible nontraditional loans offering numerous payment options for mortgage loan borrowers. These loans follow the adjustable-rate mortgage framework however they give borrowers the option to choose the type of payment they would like to make each month.

Payment-option ARMs require a fixed-rate interest payment for the first few months or years of the loan. After that, the loan will reset to a variable rate loan, usually charging a high margin to compensate lenders for some of the higher risks. In a payment-option ARM, the borrower can choose from several options offered by the lender when making their monthly installment payment. Payment options typically include a low fixed-rate option usually based on the introductory period rate—an interest-only payment—or a 15- or 30-year fully amortizing payment.

Payment option ARMs can be complicated for both borrowers and lenders since they involve negative amortization. With a payment-option ARM, any unpaid principal or interest below the standard payment amount is added to the borrower’s outstanding principal, increasing the amount of interest they are charged on subsequent payments.