The prevalence of high-risk mortgages in the housing market was one of the major causes of the 2008 financial crisis. While lending practices and laws have changed in the past ten years to help protect consumers, there are still ways for home buyers shopping for a loan to put themselves at risk. The type of loan you choose could mean the difference between a steady course to owning your home outright and going through foreclosure or bankruptcy. Everyone’s personal situation is unique, so make sure you deal with a qualified and trustworthy expert who lays out the long-term figures and risks for each type of mortgage product. Below is a list of typically risky loans that the average borrower might want to avoid.
40-Year Fixed Mortgage
The 15- and 30-year fixed mortgages are most popular in the fixed-rate loan category. Putting it simply, the longer the term, the more interest you pay. The difference in interest paid can be staggering when you consider all the things you could do with that extra money, such as put it toward your retirement lifestyle or pay for children’s college. Let’s compare buying a $200,000 home with ten percent as a down payment at a 30-year fixed rate of 5.2% versus a 40-year fixed rate at 5.8% (because longer-term loans will typically be charged a higher interest rate). At the end of the life of the loan, you’ll have paid about $175,800 in interest for the 30-year fixed versus about $283,400 for the 40-year fixed. That’s a difference of $107,600!
Adjustable Rate Mortgage (ARMs)
An ARM offers a “teaser” rate that is usually lower than the typical 15- and 30-year fixed rates, but it only lasts for a period around 5 to 7 years. After that period of time, the rate becomes variable and could be higher or lower than the original rate. The unpredictability of the rate makes this option risky for those who need to stay within a certain range of monthly expenses.
Interest-Only Mortgage
Borrowers only pay interest on the loan (no principal) for a set period of time with an interest-only mortgage and then an adjustable rate thereafter. This type of loan was commonly sold in the years leading up to the 2008 financial crisis and was considered quite toxic. Interest-only loans are still available, but typically with much greater restrictions (higher credit score and some down payment needed). Even so, the option can be risky in these ways:
∙ Difficult to refinance if needed since you have little or no equity in the home.
∙ Difficult to sell your home if prices decline since you have little or no equity in the home and you owe more than the home is worth.
∙ You will owe a much larger amount after the initial 5- to 10-year no-interest period that could have been spread out over those earlier years.
Low Down Payment Loans
Many people with low cash reserves choose low down payment loans (some as low as 0% and 3.5%) as a way to afford buying a house. While this can be a great way for some to get a home, it does come with a high risk if home values drop. When prices fall below the amount of the loan, it becomes nearly impossible to sell or refinance.
The bottom line is that you need a mortgage that is right for your situation. Research thoroughly and make sure you know the amount you will pay over the life of the loan and how specific adjustment in rates could affect what you owe.