Over the past couple of years, there has been a significant increase in the number of non-traditional mortgage loans. These mortgages have made houses affordable for many people who are simply not able to go the traditional route of a fully amortized loan.
Non-traditional mortgages, however, often carry added risks, especially when they allow you to defer repayment of the principal. In the worst-case scenario, homeowners can find themselves unable to make their monthly payments, or living in a house that is worth less than their outstanding principal.
If you are considering a non-traditional mortgage, it’s important to be aware of their inherent pitfalls:
Risk #1: Payment shock
Option ARMs, one of the most popular non-traditional mortgages, allow you to choose how much you pay each month. They can be a good choice for people with a fluctuating income, but they require self-discipline. That’s because option ARMs are periodically “recast,” or adjusted to the fully amortized rate, to make sure the homeowner doesn’t fall too far behind. If you pay the minimum each month, your payments will skyrocket when the loan is recast.
Payment shock can also occur with interest-only mortgages. When the interest-only period ends and payments become amortized, the monthly bill will rise substantially. If you cannot make these higher payments, you may be at risk of defaulting on the loan.
Risk #2: Building no equity
Interest-only and negative amortization mortgages are attractive to people looking for the lowest monthly payment possible. But nothing is free. The payments are so low because during the interest-only term (which can last five to ten years) they do nothing to reduce the loan’s principal. While these mortgages can help you accomplish a short-term goal -- for example, staying in your house while enduring a year or two of reduced income -- you won’t move any closer to owning your home.
Risk #3: Rising interest rates
When interest rates go up, anyone with an adjustable-rate mortgage will face higher monthly payments. However, homeowners with non-traditional loans face a greater danger, because they are piling this risk on top of the others.
Most non-traditional mortgages are designed to keep payments low in the beginning, with the understanding that payments will increase later in the term. If the overall market also goes up during this period, homeowners face a double whammy.
Let’s say you take out an interest-only mortgage that converts to a fully amortized loan after five years. This will cause your payments to increase in five years even if market rates don’t change. If mortgage rates go up during those five years, your new payments will rise even higher and may become unaffordable.
Risk #4: A downturn in the housing market
No one can predict where the real estate market will go in the future, but house prices can’t continue to rise at the rate they’ve been increasing in recent years. When housing prices climb, the risks of non-traditional mortgages are lessened, since the market is building in a cushion automatically. But a drop in house prices compounds all of the risks.
For example, if you pay only the interest on your mortgage for five years and the market drops 10 to 15 percent, you may find yourself owing more than the house is worth when the time comes to refinance.
Still, a non-traditional mortgage can be just the ticket you need to carry you through a period of reduced cash flow. Just be sure to “stress test” any loan you’re considering to make sure you’ll be able to afford the monthly payments, no matter what. Flexible mortgage terms can work to your advantage provided you have the self-discipline to not get in over your head.