With home prices at historic highs, lenders are coming up with new types of mortgages that make borrowing more affordable. Some of these can be great – and some can be dangerous, depending on your situation. With so many new options out there, you’ll want to be sure you understand all your legal obligations before you buy or refinance and sign on the dotted line.
Traditionally, there were two types of mortgages. Fixed-rate mortgages have an interest rate that stays the same for the life of the loan – usually 30 years. Adjustable-rate mortgages, called ARMs, typically have a lower interest rate at the beginning, but at certain intervals the interest rate changes to reflect market conditions.
The danger with ARMs is that the interest rate will go up and you’ll pay more in the long run. But they can be a smart idea, especially if you plan to move in a few years.
Here’s a look at some of the new products that lenders are offering:
Interest-Only Mortgages. These mortgages let you pay only the interest on the loan in the first few years, rather than paying the interest and part of the principal. The good news is that you get a lower initial monthly payment. The bad news is that you don’t build up any equity in the property in the first few years. If the property’s value goes down, you might end up with a mortgage loan greater than what your home is worth – which could mean big trouble if you have to sell, because you’ll suddenly have to come up with the difference.
Interest-only mortgages are usually ARMs, but recently some banks have begun offering fixed-rate interest-only mortgages.
Option Mortgages. These loans give you the option each month of paying the regular payment amount, or just the interest. Some also give you the option of making a “minimum payment” that is even lower than the amount of the interest.
This can be a great deal for a person who makes a lot of money but whose income fluctuates each month – for instance, a luxury car salesman who works on commission. But it’s also dangerous, because if you make only the “minimum payment,” the amount you don’t pay gets added to the balance of the loan. The result: The total amount you owe gets larger over time rather than smaller.
40-Year Mortgages. In the past, the longest term for a mortgage was typically 30 years. But more banks are now offering 40-year mortgages because, under a recent change in the law, it’s much easier for them to resell these mortgages.
A 40-year mortgage typically offers lower monthly payments, because the payments are stretched out over 10 more years. However, you’ll pay more in interest. With a $200,000 40-year mortgage at a fixed 5.75 percent rate, you’ll pay $92,000 more in interest over the life of the loan than you would with a 30-year loan at the same rate.
While most 40-year mortgages have a fixed rate, some banks are offering them with an adjustable rate.
Piggyback Loans. This is a traditional mortgage for 80 percent of the purchase price combined with a second mortgage (or home equity loan) for some portion of the remaining 20 percent. Normally, if you borrow more than 80 percent of the home’s value, you have to pay for private mortgage insurance, or PMI. With a piggyback loan, you can borrow more than 80 percent and avoid paying PMI. Plus, the interest on the second loan is tax-deductible.
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Balloon Mortgages. With a balloon mortgage, the interest rate and payments are calculated as though the loan were for 30 years, but the entire balance comes due after a shorter period, such as seven years. (This balance is called a “balloon payment.”) The idea is that after seven years, you’ll refinance the balance. Balloon mortgages are similar to ARMs in that you pay a fixed interest rate for a certain period and then pay a new rate when the period ends. The big difference is that ARMs typically limit how much the interest rate can go up each time there’s an adjustment. With a balloon mortgage, there’s no limit.
Graduated Payment Mortgages. This type of mortgage has a low monthly payment for the first year, and the payment slowly increases each year for five to 10 years, after which it becomes fixed. It’s similar to an ARM, except that you know in advance the amount that your payments will adjust each year.
Typically, the payments for the first few years are less than the amount of interest on the loan – which means that for a while, your mortgage balance will actually increase rather than decrease.
Accordion Loans. An accordion loan has a fixed interest rate, but not a fixed term. You know exactly how much you’ll pay each month, but you don’t know how long you’ll have to pay. If interest rates go up, the length of the mortgage is extended. If interest rates go down, the mortgage is paid off sooner.
Portable Mortgages. A portable mortgage is a mortgage that can be transferred from your existing house to a new house if you move. Usually you pay a slightly higher interest rate to make a mortgage portable. However, if you expect to move in a few years, a portable mortgage can save you the transaction costs of taking out a new mortgage when you move, and will protect you if interest rates go up sharply during that time.
Shared Appreciation Mortgages. These mortgages usually have a low interest rate and generally favorable terms. But they have a catch: When you sell the house, the lender is entitled to a portion of the appreciation (i.e., the difference between what you paid for the property and the amount for which you sell it). Shared appreciation mortgages may make sense if you think you’re buying near the top of the market, and you don’t plan to stay in the house for a long time. But they can be a terrible deal if you stay in the house for many years and its value increases substantially.
Low-Documentation Loans. Traditionally, mortgage borrowers are required to provide extensive documentation of their assets and income and the fact that they have the ability to repay the loan. To streamline the process, some lenders are skimping on their documentation requirements. That can make your life easier – but regardless of what the bank requires, you still need to be sure you’re not biting off more loan than you can handle.
Obviously, mortgage lending is a whole new world. Before you take out a loan, you’ll want to make sure you understand all the legal obligations you’re undertaking.
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