Non-Traditional Mortgage Loans: Walking the Financial Tightrope

Record numbers of people have taken out non-traditional mortgages, loans with lower initial payments or other options designed to help buyers with limited resources overcome sky-high home prices.

But these loans - which in some cases are considered predatory by consumer advocates - come with higher risk. Not only risk to the individual buyer, but to the economy as a whole.

Comprising less than 1 percent of the home loan market in 2000, estimates are that as many as a third of all mortgages currently are non-traditional loans, according to the Washington Times.

Additionally, although industry experts say there is likely a correlation between high-risk mortgages and foreclosures, “statistics on how many homes foreclose because of high-risk mortgages is hard to track,” says Fannie Mae Foundation Director of Public Affairs Albert King.

Experts told a U.S. Senate subcommittee that delinquencies on adjustable rate mortgages increased 141 percent in 2006 from a year earlier. Some estimate that subprime borrowers are 25 percent more likely to default on their loan. Still, lenders are filling what they perceive as a need in the marketplace.

Home buyers have several costs involved in mortgages. A payment includes principal and interest and also includes taxes and insurance. Altogether, this is sometimes referred to as PITI.

For our purposes, discuss the principal — the amount borrowed — and the interest, the amount the lender charges for the loan. How a homeowner repays the loan with interest is what determines the true cost of a home. Buyers have many creative ways to finance a home, rather than the so-called traditional 30-year mortgage. Here are four options, from the “safest” to the riskiest.

1. 40- or even 50-year home loans lower the monthly payment by about $100-200. The trade-off is that it is slower (much slower) to earn equity.
2. Another choice is an interest-only mortgage, where consumers can pay nothing toward principal for a period of time. Typically, these loans work like an adjustable rate mortgage (ARM) with a three- to 10-year term that ends with a balloon mortgage payment.
3. Low- or no-documentation loans (no doc loans) available for self-employed home buyers relies only on the word of the consumer as to annual income. The home buyer is asked to sign an income declaration form and complete a loan application.
4. Finally, there is a loan that economists consider to be the riskiest, the option-ARM, a loan where the buyer has the option to pay only a portion of the interest monthly. The balance of the monthly interest charge is rolled back into the loan, increasing the principal.

Interest rates on option-ARMs generally start between 9-10 percent.

If homeowners cannot refinance before the introductory rate expires, they could find themselves paying up to 15 percent interest. If a buyer has an option-ARM loan and sees their interest rate go up two points within two years, they could see their mortgage payment up by 30 percent.

Gary Herman, president of Consolidated Credit Counseling Services.com, counsels people who fall victim to overwhelming debt because of risky mortgages.

“The initial rate these mortgage lender quotes is almost always a teaser. It’s never spelled out for the borrower what the final payment ‘could’ be if the interest rate keeps rising,” he said.

Herman says many people don’t know what it will cost them over the life of the loan. The majority of Herman’s clients have credit card debt and also a second mortgage loan.

“A client asked me to talk to a financial service for them about what their final payment could be and what they would actually pay for the loan. I called them up and asked them for the bottom line and to fax me the paperwork. The guy laughed at me and said that if they knew that they wouldn’t take the loan,” he said.

The upside? ARMs give consumers with credit problems and no savings a way to finance housing. But there are other choices. Fannie Mae offers a 40-year fixed mortgage, which helps consumers avoid some of that term-interest payment. It helps make the monthly payments more affordable.

Whatever you do, be careful with these risky options. There is little room for error, and you don’t want to end up strapped for cash when things go awry. You need that security blanket.