Mortgage Loans

Know Your Mortgage Loans

You can greatly reduce your risk of defaulting on your mortgage payments and facing foreclosure by choosing the right loan.

The 30-year fixed rate home loan that used to account for most home financing has given way to an array of “exotic” interest-only loans and other non-traditional adjustable rate mortgages. These loans can be risky and come with complex terms and payment calculations that many borrowers don't fully understand.

Protect yourself. Learn about different mortgages, their terms, and their risks by participating in a homebuyer education course offered by a HUD-approved housing counseling agency before you commit to a loan.

If you are already in a mortgage with non-traditional or complicated terms, be sure you understand exactly how your interest rate, monthly payment, and loan principal balance could change over time. If you don’t plan for these adjustments, you could find yourself facing the possibility of foreclosure if you can no longer make the payments.

Here are a few popular mortgage types and what you should know about each one:

Adjustable Rate Mortgage (ARM). Any time you have a loan where the interest rate can rise and fall with prevailing rates, your future monthly payment amount is uncertain. Typically with an ARM, your payment will be based on a relatively low introductory rate. Depending on the terms of the loan, after several months or a few years, your payment will be adjusted (often upward) on a regular basis.

Negative amortization mortgage. Negative amortization is what happens when your mortgage payment is smaller than the interest due on the loan for that month. To make up the shortfall, the lender adds the difference to your loan balance.

Negative amortization loans start out with a reduced monthly payment. At some point, the lender must “recast” the loan (re-calculate the monthly payments so that the original loan balance plus all unpaid interest is amortized over the remaining years in the loan term). In other words, you must now pay off a bigger loan in a significantly shorter period (perhaps 20 or 25 years instead of the original 30)—and that requires a significantly larger payment. If your neg-am loan is also an ARM, and rates have risen since you took out the loan, you might experience even greater negative amortization than you expected.

Another risk with this type of loan is that if you try to sell your home after only a few years and it hasn’t appreciated substantially, you could find yourself “upside down,” owing the lender more than you could get for the property.

Interest-only mortgage. These ARMs allow homeowners to make smaller payments for a number of years at the beginning of the loan (typically 5 or 10) because the part of the payment which would ordinarily pay off the amount you borrowed (principal) is deferred.

Monthly payments increase when the lender recasts the loan to require monthly payments large enough to cover the interest and pay off the entire principal balance in the years remaining on the original loan term. If interest rates have also risen, the monthly payment will be even higher.

With an interest-only loan, you would not build up any equity unless it came from appreciation, or if you had decided to make additional payments toward the principal during those years when you were not required to. Equity is the homeowner’s financial share of the house.

Option ARM. These can be called payment option ARMs or flex-ARMs. As with any ARM, your payments would increase if interest rates go up.

Whether or not your payments eventually go even higher will depend on which payment option you choose for your loan: the minimum payment (typically resulting in negative amortization), an interest-only payment, a fully amortizing 30-year payment or a fully amortizing 15-year payment (choices may vary among lenders, and you can switch at certain times).

Option ARMs have a built in recalculation period, usually every five years. At that point, the lender will recalculate (recast) your payment. If you have a 30-year loan, your payment will be recalculated over a 25-year period. No payment cap applies to this adjustment—which means your monthly payment could go up dramatically.

 

This brochure was created by Consumer Action’s Housing Information Project. © 2007 Consumer Action. Rights Reserved.