Exotic mortgages lower payments, but raise risk
By Greg
McBride, CFA • Bankrate.com
Interest-only. Negative amortization.
Adjustable rates. Mortgages increasingly have elements that could
prove risky to many home buyers. Some mortgages may have several
dangerous elements wrapped into one. I recently saw an advertisement
for one such loan. What loan features should make borrowers wary,
and why might they cause problems down the road?
Affordability issues lead borrowers to choose adjustable rate mortgages
that offer lower initial rates than the traditional fixed-rate mortgage.
But there is a trade-off as borrowers face uncertainty as to how that
rate may adjust as the loan ages. Adjustable rates pose the risk of
higher monthly payments as interest rates rise. In the worst cases,
borrowers find themselves unable to make the higher monthly payments
and can fall behind on their mortgages or other debts. Rates adjust
at varying intervals, depending upon the mortgage product selected.
For example, many of the hybrid ARMs offer a fixed rate for an initial
period of years, then change on an annual basis thereafter. But many
other ARMs can change at more frequent intervals. Some, such as a
loan I saw advertised, are adjustable on a monthly basis and can change
just one month into the loan.
One loan feature designed to make mortgage payments more affordable,
particularly for home buyers in high-cost areas or without a large
down payment, is a 40-year mortgage term. Stretching the repayment
term from 30 years to 40 years reduces the principal component of
each monthly payment. While this may be the difference between affordable
or unaffordable for some buyers, the downside is the slower accumulation
of home equity.
Some loans may have even more flexible monthly payment terms. Known
as Option ARMs, these mortgages permit borrowers to make a monthly
payment determined by one of four different methods. Monthly payments
can be made according to a traditional fully-amortizing loan where
payments consist of interest and principal; an accelerated 15-year
fully-amortizing schedule; an interest-only payment, or a minimum
payment that may not cover all of the interest. Borrowers have the
option each month of which payment they will make. These loans are
popular among borrowers with widely variable income derived largely
from bonuses or exclusively from commissions.
ARMs often come with caps that limit how much the rate can adjust
in any one year or cumulatively over the life of the loan. Common
caps are expressed as 2/5 or 2/6, where annual adjustments are limited
to two percentage points, with a lifetime cap of five or six percentage
points. However, some ARMs may contain rate-adjustment and monthly-payment
caps that cushion the impact of sudden rate adjustments, but result
in deferred interest. This deferred interest is known by another
name -- negative amortization. In short, this means that the monthly
payments are not sufficient to cover the interest due for that month
and the unpaid interest is then added to the loan balance. The borrower
actually sees the loan balance grow instead of decline, by virtue
of the deferred interest.
Imagine taking a mortgage loan where the interest rate was adjustable
every month from the outset, the loan balance is amortized over
a 40-year period, the borrower has the option of making interest-only
or minimum payments, and monthly payment and rate adjustment caps
could result in the unpaid interest being added to the existing
balance. Such a loan is better suited for wealthy borrowers with
strong, but variable, monthly cash flows who are buying expensive
homes and desire some flexibility in the amount of money to be poured
into the home every month. But the advertisement also cites an example
of how low the monthly payment is for a $200,000 loan. Of course,
the most-favorable loan terms require a 20-percent down payment,
so first-time buyers who do not have either the accumulated equity
from a previous home or the significant cash savings to make a hefty
down payment can expect to pay a higher-than-advertised interest
rate.
This loan has too many risk factors to be marketed
at what may be median home buyers in many markets. A mortgage with
just one of those risk components is enough reason to stop and think.
A loan with all of those components should make most borrowers run
the other way.
Greg McBride is a financial analyst
for Bankrate.com.
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