Adjustable-Rate Mortgages: The Most Dangerous
It’s a familiar refrain in the current housing market: payment shock on adjustable-rate home loans is causing a countless number of owners to default.
In order to avoid this unwanted fate, it’s important to be well-versed in the two most dangerous types of adjustable-rate mortgages.
They are …
Interest-only mortgages
As the name implies, these loans, usually an ARM or a hybrid, allow a borrower to make interest-only payments during the first five years or so. After that, borrowers are expected to repay principal and interest in order to pay off the interest-only mortgage loan within the remaining 25 years of its term.
Borrowers can be in for a big payment shock once the interest-only period ends because they have to pay off the entire amount borrowed in only 25 years, compared to the typical 30. Rising interest rates will exaggerate that shock.
Typically this type of loan works best for a borrower who is certain he or she will be selling the home or mortgage refinancing within the interest-only period and is simply seeking to keep his or her house payment temporarily at its rock-bottom low.
If combined with a low down payment, these can be very risky loans for borrowers because they may not find it as easy to refinance out of this loan as they had anticipated, especially if the value of their home has not grown enough to give them a good equity stake.
Payment-option loans
They come by different names, usually incorporating the words option or choice. These home mortgage loans offer borrowers a choice of two or three payments each month, but their complexity grows right along with those choices.
The first two choices are fairly straightforward:
- You can pay the full amount of principal and interest owed that month, just as you would with a traditional mortgage.
- You can choose to pay even more and pay off a 30-year-loan on a 15-year schedule.
However, the other two choices can get borrowers in over their heads. In any given month, a borrower can opt to pay only the interest that is due that month, or the borrower can choose an even smaller minimum payment, an amount that covers none of the principal and only part of the interest that is owed.
To make things even more complicated, these loans often have mortgage rates that adjust as frequently as every month. And payment caps could allow your minimum payment to rise by as much as 7.5 percent in a given year.
Risk factors
If borrowers choose to make the minimum payment frequently, these loans can set the borrower up for a huge payment shock after just a few years. At the end of five years, or whenever the borrower’s outstanding adjustable-rate home loan balance has grown to 10 percent or 15 percent above their original loan amount, the loan will be recast.
What does this mean?
The lender will draw up a new payment schedule designed to get the loan paid off on time, and the minimum payments can grow dramatically. There are no caps on how high the payment can go at these recast periods. Only the most financially sophisticated borrowers (perhaps those few who already understand from personal experience how hedge funds and arbitrage work) should consider these very complicated mortgages.
SOURCE: Bankrate.com