Thursday, March 8, 2007

New mortgage options

Not so long ago, most American home buyers saved up a down payment of 20 percent of the purchase price and paid off the rest with a fixed-rate mortgage. Many still do, but the trend in recent years has been toward lower-percentage down payments and more flexible mortgage terms. According to the National Association of Realtors, today 42 percent of first-time home buyers put no money down at all.

While this may make it possible for some people to purchase a home they would otherwise not be able to afford, no-down-payment mortgages and other new mortgage options need to be considered with caution.

The common feature of these new mortgages is the low payments they offer in the short term. However, in the long run they can end up being considerably more expensive than traditional loans. That's because in almost every case, those low monthly payments rise sharply after an initial period.

Option adjustable rate mortgages (ARMs) offer up to four choices each month, from a low minimum payment to a fully amortized amount (like a traditional fixed-rate mortgage), and their popularity has even surprised the experts. "Traditional banker that I am, I didn't think there would be much interest in this product," Anthony Hsieh, president of, told CNN recently. "But consumers have loved it."

Hsieh is careful to point out that option ARMs are not for everyone. "If you have seasonal income or are self-employed with monthly income that is inconsistent, this loan may be great for you," he says. "You can pay the minimum a few times per year and catch up in months when your income is higher." If you're not disciplined enough to do that, however, your debt can spiral out of control.

Interest-only and negative amortization mortgages are also growing in appeal. These differ from traditional mortgages in one very important way: they are not amortized. In other words, instead of paying a mix of interest and principal each month, you pay only interest. And in the case of a negative-amortization mortgage, you're not even paying all of the interest due.

These mortgages can make sense for homeowners experiencing a short drop in income -- such as a job loss or a partner going back to school for a year or two -- as long as their income will rise in the near future, at which point they should refinance to an amortized mortgage. Interest-only loans may also be a good choice for investors who only plan to hold a property for a short time before selling it.

Some borrowers, however, are choosing interest-only or negative amortization mortgages without understanding that they may be losing equity with every passing month. What's more, after a specified period the interest-only option disappears and the loan must be paid back on an accelerated schedule. If the borrowers can't meet these new, much higher payments, they could end up having to sell their home.

Piggyback loans are another option helping homeowners avoid the added expense of private mortgage insurance (PMI), which lenders usually charge on mortgages that exceed 80 percent of a home's value. If buyers can come up with a down payment of just 5 or 10 percent, they can often get a piggyback loan to cover the rest. This is a second mortgage, often structured as a home equity line of credit, which may be less expensive than PMI, in part because it's tax-deductible. Of course, it requires another monthly payment on top of the first mortgage.

As with any financial decision, it's important to understand the risks inherent in these non-traditional mortgages before deciding whether one of them is right for you. Here's a chart that explains the pros and cons of each:

Mortgage type Benefits Risks Who should consider it
Option ARM Flexibility; allows you to make smaller or larger payments according to your cash flow each month. The amount you owe grows (negative amortization) if you choose the minimum payment option too often. People with fluctuating incomes and the discipline to catch up on missed payments.
Interest-only mortgage Low monthly payments, because you're not paying down the principal. You build no equity in your home. Payments rise sharply after the interest-only period (usually 5 to 10 years). Homeowners experiencing a short-term drop in income but expecting a future rise. An investor who hopes to resell the property at a profit.
Negative-amortization mortgage Very low monthly payments, because you're not paying all the interest owed. The amount you owe grows every month and erodes any equity you have built in your home. Payments rise sharply after the initial period (usually one year). The same people who would consider an interest-only mortgage, but who want an even lower payment and a shorter loan term.
Piggyback mortgage Allows a home buyer to make a small down payment and still avoid private mortgage insurance. It often has no fixed payment schedule, so the balance may grow quickly if you make only the minimum payment. It may end up costing more than PMI if housing prices rise. Home buyers who do not have a 20-percent down payment but have sufficient income to make two mortgage payments.