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5 Risky Mortgage Types To Avoid

By admin On March 16, 2011 Under VA Credit Requirements, VA Loans, VA Purchaes Loans, VA Refinance Loans

If there’s anything we’ve learned from the subprime meltdown of 2008 and crash of 1987, it’s that we should all proceed with caution when borrowing money to purchase or refinance a home. Let’s face it, not everybody can be a homeowner.  Some people are just not cut out to handle it.  Whether it is lack of education or just a lifestyle of overspending and not managing bill properly, sometime renting might be better.  Granted the type of mortgage you choose can mean the difference between one day owning your home outright or finding yourself in the middle of a foreclosure or even a bankruptcy. For some they just fail to plan ahead or are just thinking about the current moment.

What Makes a Mortgage Risky?
Because of the housing crisis, many of us have falsely come to believe that certain types of mortgages are inherently risky. However, mortgage experts will tell you that a risky mortgage is really a loan product that is not matched with the repayment ability of the borrower.  Take for example a borrower taking out a two year adjustable rate mortgage.  Why did they take this type of loan.  Well it had a lower payment that the 30 year fixed.  Sound simple, right.  When you ask them what they will do in 2 years when it adjust, they usually replied that they would just refinance.  Did they magically think there would be a lower rate for them in two years?  Now the lenders were to blame for this also.  Many sold borrowers on the “don’t worry, we’ll refinance you in two years” story but ultimately it was the borrower who said yes to the snake oil salesman.  Then what happened?  They defaulted on a payment they could or would not make.
According to the Mortgage Bankers Association’s National Delinquency Survey, in the second quarter of 2010, the types of loans with the highest percentage of foreclosure starts were subprime adjustable rate mortgages (ARM), which had a foreclosure start rate of 3.39%. ARMs, with their changing interest rates, are a particularly risky mortgage product for borrowers with less-than-ideal financial situations.

By comparison, the survey reported that VA loans had a foreclosure start rate of 0.70%, prime fixed loans 0.71%, FHA loans 1.02%, prime ARMs 1.96% and subprime fixed loans 2.3%. This data indicates that any type of mortgage can be a bad idea for a subprime borrower, and that even prime borrowers can get into trouble if they don’t understand ARMs.

So now you are saying everyone should just take a fixed rate mortgage, right?  Wrong, even fixed-rate mortgages can be detrimental to borrowers. Let’s look at our first risky mortgage type.

1. 40-Year Fixed Rate Mortgages
Welcome to the 40 year mortgage.  I’m sure some would take a 50 year one if they could.  Borrowers with fixed-rate mortgages may have a low rate of foreclosure, but that doesn’t mean that fixed-rate mortgages are always a good idea. The 40-year fixed-rate mortgage is one such product because the longer you borrow money for, the more interest you pay, duh.

Let’s say you want to buy a $200,000 home with a 10% down payment. The amount you’ll need to borrow is $180,000 ($200,000 minus $20,000).

At an interest rate of 5%, here are the monthly payments and the total amount you’ll pay for the home under various terms if you keep the loan for its life:

Term Interest Rate Monthly Payment Lifetime Cost (including down payment) Principal(including down payment) Total Interest Paid
15 years 5.0% $1,423.43 $276,217.14 $200,000 $76,217.14
20 years 5.0% $1,187.92 $305,100.88 $200,000 $105,100.88
30 years 5.0% $966.28 $367,860.41 $200,000 $167,860.41
40 years 5.0% $867.95 $436,617.86 $200,000 $236,617.86
Figure 1: Interest and principal paid on a mortgage over various terms (years).

The chart above is a simplified comparison. In reality, the interest rate will be lowest for the 15-year loan and highest for the 40-year loan. Here’s a more realistic comparison:

Term Interest Rate Monthly Payment Lifetime Cost(including down payment) Principal(including down payment) Total Interest Paid
15 years 4.5% $1,376.99 $267,858.83 $200,000 $67,858.83
20 years 5.0% $1,187.92 $305,100.88 $200,000 $105,100.88
30 years 5.2% $988.40 $375,823.85 $200,000 $175,823.85
40 years 5.8% $965.41 $483,394.67 $200,000 $283,394.67
Figure 2: Interest and principal paid on a mortgage over various terms (years) and interest rates.

As you can see in Figure 2 above, the 40-year mortgage is 0.6% higher in interest, and it will lower your monthly bill by just $23, from $988 to $965. However, it will cost you an extra $107,570.82 over the life of the loan.  Hmm, couldn’t you use that money for you kids college or better yet how about a new car.   Most people cannot afford to throw away that kind of money.   But this is not always a bad loan.  Most people stay in their current homes around 7 years so the extra interest is really not that big a deal.  This loan isn’t a bad option for those that get corporate relocation deals every few years.

2. Adjustable Rate Mortgages
Adjustable rate mortgages (ARMs) have a fixed interest rate for a short initial term that can range from six months to 10 years. This initial interest rate, called a teaser rate, is often lower than the interest rate on a 15- or 30-year fixed loan. After the initial term, the rate adjusts periodically – that might be once a year, once every six months or even once a month.

Interest rate risk is the risk that if interest rates increase, the monthly payments under an ARM will become more expensive, and in some cases that is an expense that the homeowner can’t afford.

The element of unpredictability that comes with ARMs is a problem for many people, especially if they are on a fixed income or don’t expect their incomes to rise.

ARMs become even riskier if you have a jumbo mortgage, simply because the higher your principal, the more a change in interest rate is going to affect your monthly payment.

It’s also important to note that an adjustable interest rate can adjust downward, decreasing the monthly payment. This means that ARMs can be a good choice if you expect interest rates to decrease in the future. Of course, you can’t predict the future.

The key to an adjustable rate mortgage is the “Margin”.  This is the markup over the index or as I like to call it the “Bank Profit”.  If you loan is tied to say a 1 yr T-Bill and that index is around say 2% and your loan has a margin of say 9% then you are going to end up with a nice rate of 11%.  This was how subprime worked.  Borrowers were doomed the day they signed the loan papers because while they may have had low teaser rates, they had HUGE margins.  That why they always went up.  Bottom line, small margin good – big margin bad.

3. Interest-Only Mortgages
With an interest-only (IO) mortgage, the borrower pays only the interest on the mortgage for the first for five to 10 years, allowing for a lower monthly mortgage payment during this time. This makes interest-only mortgages attractive to some real estate investors who will own a home for only a short period of time and want to reduce their carrying costs.

IO mortgages can also be good for people who earn an irregular income and people who have significant potential for income increases in the future, but only if they are disciplined enough to make higher payments when they can afford to do so.

The downside is that the interest rate on an IO mortgage tends to be higher than the rate you would pay on a conventional fixed-rate mortgage because people default on interest-only loans more often.

Furthermore, if you are not a financially sophisticated borrower, interest-only mortgages can be extremely risky for any one or more of the following reasons:

  • You can’t afford the significantly higher monthly payments when the interest-only period ends. At this point, you’ll still be paying interest, but you’ll also be repaying the principal over a shorter period than you would with a fixed-rate loan.
  • You can’t refinance because you have little to no home equity.
  • You can’t sell because you have little to no home equity and home prices have declined, putting you underwater.
  • Borrowers who keep the interest-only loan for the life of the loan will pay significantly more interest than they would have with a conventional mortgage.
  • Depending on how the loan is structured, you may face a large balloon payment of principal at the end of the loan term.

Borrowers flocked to these loans in the heydays.  They loved the lower payments and had the assumption that they could just refinance somewhere down the road.  They got a bigger house than their friend for the same payment.  These borrowers were very short sighted and most were just living in the moment.

4. Interest-Only ARMs
With some interest-only loans, called interest-only ARMs, the interest rate is not fixed, but can go up or down based on market interest rates. Essentially, the interest-only ARM takes two potentially risky mortgage types and combines them into a single product.

Here’s an example of how this product can work. The borrower pays interest only, at a fixed rate, for the first five years. Then, for the next five years, the borrower continues to pay interest only, but the interest rate adjusts annually based on market interest rates, meaning that the borrower’s interest rate can either go up or down. Then, for the remainder of the loan term, say, 20 years, the borrower will repay a fixed amount of principal each month plus interest each month at an interest rate that changes annually.

Many people simply do not have the financial or emotional wherewithal to withstand the uncertainty that comes with interest-only ARMs.

The same hold true here as it does with the other ARM.  You want a low margin or you will get hosed in the future.  Again many borrowers took these loans because they simply offered a lower payment.

5. Pick a Pay or PayOption ARM
For most borrowers these were the stupidest loans out there for them but people in high cost areas flocked to them like a news reporter at a Washington scandal.  These loans offered the borrower the ability to make a 15 year payment, 30 year payment, Interest Only payment or my favorite, a payment that doesn’t even cover the interest (minimum Payment).  Of course most people to the minimum.  Heck why pay more, who cares.  Just refinance later.

If you made the minimum payment then the remaining amount to cover the interest was added to your loan balance.   How nice of your lender to do this for you.  These were a train wreck waiting to happen and we all know how it ended.  Can you say Washington Mutual.  Boom!

The Bottom Line
While most of the loans that some mortgage lenders might consider to be truly high-risk, like the interest-only ARM, are no longer on the market, there are still plenty of ways to end up with a bad mortgage if you sign up for a product that really isn’t right for you.

As a Borrower, it’s real simple, if you don’t understand what you are signing then “Don’t Sign”.  Don’t believe anything that is not in the documents.  No promises to refinance you later, no don’t worry’s.  Stick with the fact in the documents.

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