Does the mortgage have any traps that could snare you? The Loan Estimate is designed to alert you to risky loan features.
Is the loan an ARM?
Most adjustable-rate mortgages are fine. Having an adjustable rate doesn't necessarily mean the loan is a trap. But if it is an adjustable-rate mortgage, or ARM, you need to know, because the monthly payments potentially could rise in the future.
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If the loan is an ARM, the Loan Estimate tells you in 2 places:
- On Page 1, in the "Loan Terms" section, if the word "yes" appears next to the interest rate, it is an ARM.
- On Page 2, if the bottom-right corner has a filled-in section called "Adjustable-Interest Rate (AIR) Table," the loan is an ARM.
For more information, read "Is it an adjustable-rate mortgage?"
Is there a prepayment penalty?
If the loan has a prepayment penalty, the word "yes" appears next to "Prepayment Penalty" in the "Loan Terms" section on Page 1 of the Loan Estimate. The maximum amount of the penalty is described, too.
A prepayment penalty is a fine levied on the borrower for paying off the loan early. It's a way to discourage borrowers from refinancing out of mortgages with high interest rates.
Prepayment penalties are rare now because regulators frown upon them. The penalties were a regular feature of subprime loans in the early 2000s. A study concluded that prepayment penalties increased foreclosure risk by 20%.
Is there a balloon payment?
If the loan has a balloon payment, the word "yes" appears next to "Balloon Payment" in the "Loan Terms" section on Page 1 of the Loan Estimate. The size of the balloon payment is described next to the "yes," and it's also enumerated in the "Projected Payments" section directly below.
When a mortgage has a balloon payment, it has a large payment due at the end of the term. An example would be a mortgage for which the monthly payments are on a 30-year timetable, but the loan expires after 7 years. As the borrower, you benefit by having lower monthly payments. But the downside is that, at the end of the 7-year term, a payment is due of tens or hundreds of thousands of dollars. Either you have to pay off the loan in a lump sum, sell the property or find refinancing.
Balloon mortgages are rare. Most of them are for homes in rural areas, and the lenders are small institutions.
Is it an exotic mortgage?
Exotic mortgages enjoyed popularity during the housing boom of the early 2000s:
- Interest-only loans, in which the borrower paid interest, but not principal, for the first few years.
- Pay-option ARMs, which were adjustable-rate mortgages that, each month, gave borrowers the option of paying only the interest or interest plus some principal.
- Step-payment loans, in which the monthly payments increase annually. In the 1st year or 2 of this type of loan, the monthly payments typically don't even pay all the interest due, so the loan balance goes up, even though payments are being made. This phenomenon is called negative amortization.
Exotic mortgages are rare. But if the loan has 1 or more of these features, the Loan Estimate will alert you in 1 or 2 places:
- On Page 1, in the "Loan Terms" section, next to "Loan Amount," the word "yes" may appear under the heading "Can this amount increase after closing?" Keep in mind what this means: The amount you owe can go up, even after you make the minimum monthly payments. Read that again if it didn't sink in.
- Details of the adjustable-payment features are found at the bottom-left corner of Page 2, in the section labeled "Adjustable Payment (AP) Table."
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