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Risky Mortgages You Probably Should Avoid

07/24/2018 Jerrica Kowcheck

LOAN TYPES RESOURCES

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At the most basic level mortgages are investments, and anyone who pays the least bit of attention to the stock market understands that some investments invite much more risk than others. There are several types of mortgages that commonly carry more risk than conventional loans; below we’ll examine why they should be avoided.

If you want to gamble on a risky mortgage, you should make sure you understand all the variables involved. It’s your own future that you’re betting on, after all.

When High-Risk Mortgages Go Bad

The housing crash of 2008 demonstrated how not to buy and sell real estate. Subprime loans and other risky mortgages resulted in many homeowners finding their properties to be underwater (i.e. worth less than their mortgage and balance) once the bubble popped. As a result, nearly four million homes were foreclosed on between 2008 and 2012.

The reason behind all those foreclosures? Risky mortgages were being approved for people who clearly couldn’t afford them due to, among other factors, a lack of transparency in the mortgage investment market. The risky mortgages you’ll learn about here can quickly expose you to the same peril as those four million souls who lost their homes.

To ensure you know what you’re getting into, we compiled this list of the riskier mortgage types, and the reasons why you may not want to take a chance no matter how good the terms seem.

Interest-Only Mortgage

An interest-only mortgage sounds great on the surface. You buy a home, and for the first five to seven years, you only pay the interest—never the principal. That means your payments are much lower, and it gives you plenty of time to save up for the higher mortgage payments later.

In reality, you’re only kicking the can farther down the road and hoping you can catch up with it in the end.

Once your “interest-only” period expires, you’ll not only be paying the principal but the interest as well. Your payments have now potentially doubled—or even tripled—leading to payment shock.

Many people opt for an interest-only loan because they intend to pay toward the principal during the interest-only period, thus paying the home off sooner on their own terms. But life has a way of intervening, and those “extra” payments may well be spent on other bills, emergencies, or even luxuries like vacations.

By not paying more than is technically due, the principal remains exactly the same. Homeowners are only paying toward the interest, which means that they end up paying far more for the home in the long run. And if income or circumstances change before they begin paying toward the principal, they may find they can no longer afford the home at all.

In certain circumstances, however, an interest-only loan may make sense. For instance, buyers who intend to sell the home quickly (usually within 10 years), who expect their income to increase significantly before the interest-only period expires, or who need lower initial payments may find this type of mortgage beneficial.

Reverse Mortgage

A reverse mortgage (sometimes known as a Home Equity Conversion Mortgage, or HECM) allows homeowners 62 and older to borrow against the equity in their home. This money can be used for anything, and as long as they remain in the home and pay the required taxes and insurance, there are no monthly payments whatsoever. The loan only comes due when they die or move out.

Sounds like a good deal, right? Use the money to see the world, don’t worry about making house payments until you’re ready to sell the home, then use the proceeds to pay off the mortgage and call it good.

Unfortunately, there are several catches to this type of loan. Fees are much higher than with traditional mortgages, and although they’re wrapped into the loan itself, these fees still increase the total amount owed.

With a reverse mortgage, no payments are due while you live in the home; however, interest still accrues, driving up the amount you owe. The longer you stay in the home, the more interest you’ll pay.

And while all the extra cash sounds good, especially for low-income seniors, these are exactly the people a reverse mortgage can really hurt. State and federal aid agencies such as Medicaid and other needs-based programs include the cash from a reverse mortgage when determining whether to provide you with benefits. You may have your aid significantly reduced or find that you no longer qualify at all.

A reverse mortgage is best suited to those who have plenty of equity in their home and a solid financial plan for the future.

Balloon Mortgage

The traditional length of a mortgage is 30 years. A balloon mortgage, however, structures the loan payments like a traditional mortgage, but with the balance becoming due after a much shorter period of time, often as little as five to seven years.

This, of course, leaves the homeowner with a giant “balloon” payment at the end of the term. Many people use this type of mortgage as an interim solution, intending on taking advantage of the lower interest rates before refinancing or selling the home, or as a stopgap measure to temporary financial difficulties that are expected to be resolved before the balloon payment is due.

Balloon mortgages make it all too easy to be left holding the bag when the final payment comes due and there’s no cash on hand. If you can’t sell the home in a timely manner or obtain another mortgage to refinance the home, you may face foreclosure.

Many borrowers take out a balloon mortgage without fully understanding the potential consequences, often to their detriment. Balloon mortgages have gained such a bad reputation that many are outlawed, and they’re frequently used as an example of predatory lending.

For those who expect a large increase in income or those who plan to increase their credit scores significantly to (hopefully) refinance for better terms, a balloon mortgage may be a viable option. However, potential borrowers are advised to tread carefully.

Are ARM Loans Risky?

The short answer is, no. Adjustable-rate mortgages (ARMs) gained a bad reputation after the Great Recession, particularly since many of the aforementioned limited verification loans were packaged as ARMs. However, ARMs are not as risky as the other loans covered above, and may be the best choice for borrowers in particular situations.

An ARM calculates the interest you’ll pay on your loan according to the current market interest-rate index. In other words, when the market index goes up, your monthly payments increase; when it goes down, they decrease. However, most ARMs have caps in place to protect the borrower, limiting how high your interest can go over the life of the loan, as well as how often the interest rate can be changed.

Adjustable-rate mortgages, while chancy for some, are often the best choice for people who plan to sell the home or refinance before the initial fixed-rate period ends. An ARM may also be a good option those who anticipate a steady income increase, such as a successful small business-owner, that will help them keep pace with potentially rising payments.

Find more information about interest caps and other ARM topics here.

Red Flags for Risky Mortgages

We’ve included some of the most well-known types of risky home loans, but the fact of the matter is any mortgage may be risky if it involves a company with unscrupulous lending practices. Here are some of the red flags for you to watch out for as you navigate the home loan process.

  1. Too good to be true. The old adage applies to homebuying as much as any other venture. If it seems like you’re getting the deal of a lifetime, there’s probably a catch.
  2. Pushy loan officer. If you feel like your loan officer is pressuring you to accept a deal you’re uncomfortable with, that is a huge red flag. A loan officer has a fiduciary duty to find a mortgage that suits your needs, and one who tries to get you to commit to more house than you need may be violating that duty.
  3. Signing blank forms. If you are ever asked to sign a blank form, or even a document with incomplete information, you should immediately be suspicious and probably walk away from the deal. This tactic is often used in scams against homeowners and buyers.
  4. We don’t need a down payment. There are plenty of means of obtaining down payment assistance, so if a lender says they do not require a down payment or are making a special exception for you, they may be trying to scam you. Talk with another lender or your real estate agent to get the truth.

Learn how to protect yourself from mortgage scams and other unethical practices.

Choose a Mortgage That Works for You

Every situation is different, and what’s risky for one person might be just the right fit for someone else. The ideal choice is to explore all of your options, stay away from questionable lenders and loans, and make the best selection based on your individual financial situation and long-term plans.

Do you have questions or need more information? PennyMac is here to help. Contact a PennyMac Loan Officer today and let us put you on the path toward homeownership!