Shopping for a Mortgage?
DO
YOUR
HOMEWORK
FIRST
Specialty Mortgages:
What are the Risks
and Advantages?
UNDERSTANDING SPECIALTY MORTGAGES
In many housing markets, home prices have risen to very high levels,
making it harder to afford a home—especially for first-time
homebuyers. The traditional fixed-rate mortgage and standard
adjustable-rate mortgage may not be the best options for everyone. A
growing number of homebuyers are deciding to use one of several new
types of specialty mortgages that let them “stretch” their income so
they can qualify for a larger loan. But before you choose one of
these mortgages, make sure you understand their risks and how they
work.
Specialty mortgages often begin with a low introductory interest
rate or payment plan—a “teaser”—but the monthly mortgage payments
are likely to increase a lot in the future. Some are “low
documentation” mortgages that come with easier standards for
qualifying, but also higher interest rates or higher fees. Some
lenders will lend you 100% or more of the home’s value, but these
mortgages also present a big financial risk if the value of the
house goes down.
It’s in your best interest to learn the “ins and outs” of these
packages before deciding if the loan you’re considering is right for
you.
Specialty Mortgages Can—
•
Pose a greater risk that you won’t be able to afford the mortgage
payment in the future, compared to fixed rate mortgages and
traditional adjustable rate mortgages.
•
Have monthly payments that can increase by as much
as 50% or more
when the introductory period ends.
•
Cause your loan balance (the amount you still owe) to get larger
each month instead of smaller.
COMMON TYPES
OF SPECIALTY MORTGAGES
Today, when you apply for a loan, you have more choices than ever
before. Here are a few examples:
Interest-Only Mortgages:
Your monthly mortgage payment only covers the interest you owe on
the loan for the first 5 to 10 years of the loan, and you pay
nothing to reduce the total amount you borrowed (this is called the
“principal”). After the interest-only period, you start paying
higher monthly payments that cover both the interest and principal
that must be repaid over the remaining term of the loan.
Negative Amortization Mortgages:
Your monthly payment is less than the amount of interest you owe on
the loan. The unpaid interest gets added to the loan’s principal
amount, causing the total amount you owe to increase each month
instead of getting smaller.
Option Payment ARM Mortgages:
You have the option to make different types of monthly payments with
this mortgage. For example, you may make—
•
A minimum payment that is less than the amount needed to cover the
interest and increases the total amount of your loan,
•
An interest-only payment, or
•
Payments calculated to pay off the loan over either 30 years or 15
years.
40-Year Mortgages:
You pay off your loan over 40 years, instead of the usual 30 years.
While this reduces your monthly payment and helps you qualify to buy
a home, you pay off the balance of your loan much more slowly and
pay much more interest. This is only a short list of specialty
mortgages. Today’s marketplace includes many variations on these
types.
WHAT ARE THE
MAJOR RISKS OF SPECIALTY MORTGAGES?
1. Payment Shock.
One major risk is that
your monthly payment may increase by a large amount,
resulting in “payment shock.” Even a change of 1% or 2% in interest
rates can result in a very big jump in your monthly mortgage
payment. For example, if the interest rate on your mortgage changes
from 4% to 6%, your monthly payment could rise by as much as 50%
(from $1,000 to $1,500). If your income has not increased enough,
you may not be able to afford the new larger monthly mortgage
payment. And if that happens, you could lose your home.
Example:
How Payment Shock Can Occur
Assume you buy a home for $300,000, put 10% down, and choose a 5.75%
interest-only adjustable rate mortgage.
The mortgage requires interest-only payments for 5 years. After
that, the interest adjusts every year based on rates in effect at
that point.
•
Initial monthly payment:
$1,294.
•
Monthly payment after 5 years with
no
increase in mortgage interest rates (amount increases because
payments begin to include principal in addition to interest):
$1,699.
•
Monthly payment after 5 years with a 3% increase in interest rate to
8.75%:
$2,220.
2. Higher Debt Over Time.
Another risk that comes with specialty mortgages involves your
“equity”—the amount your house is worth after you subtract the
amount you still owe to the lender. Consumers who choose some types
of specialty mortgages will build equity in their home much more
slowly than with traditional loans. In fact, with some specialty
mortgages,
the amount you owe on your home could increase rather than decrease
over time.
WHO IS BEST
SUITED FOR A SPECIALTY MORTGAGE?
Specialty mortgages are designed for homebuyers in special
circumstances. The lower initial monthly payments may make sense for
buyers who intend to own a home for a short time or who can handle
high payments in the future. If you are a homebuyer who plans to be
in your home for years, or who does not expect a significant
increase in income by the time the monthly payments go up, you
should very carefully consider the risks and advantages of a
specialty mortgage.
QUESTIONS TO
CONSIDER BEFORE CHOOSING A SPECIALTY MORTGAGE
•
How much can my monthly payments increase and how soon can these
increases happen?
•
Do I expect my income to increase or do I expect to move before my
payments go up?
•
Will I be able to afford the mortgage when the payments increase?
•
Am I paying down my loan balance each month, or is it staying the
same or even increasing?
•
Will I have to pay a penalty if I refinance my mortgage or sell my
house?
•
What is my goal in buying this property? Am I considering a riskier
mortgage to buy a more expensive house than I can realistically
afford?
Be sure you work with a REALTOR®
and lender who are willing to discuss different options and address
your questions and concerns!
HELPFUL
STEPS TO TAKE BEFORE FINANCING A HOME
•
Check your credit status.
As of September 2005 (or earlier, depending on where you live), you
have the right to receive a free credit report once a year from each
of the 3 major credit bureaus—Equifax, Experian and TransUnion. For
completeness, it is best to review reports from each one of them.
Contact information is included under “Additional Resources.”
•
Work with your REALTOR®
and lender to determine how much you can afford to pay for a home.
•
Ask your lender for your credit score.
This score, which is calculated based on your credit history and
other factors, determines how lenders view your creditworthiness and
determine the loan terms to offer.
Scoring rules vary widely, but generally a score of 650 or higher
means that you qualify for the most favorable loan terms.
•
Shop around.
Different lenders charge different rates and fees and have different
options. Be sure to compare to get the best deal. Your REALTOR®
can recommend reliable lenders.
•
Be sure you understand the risks of your mortgage and know whether
you can handle possible payment increases.
This information provided Courtesy of:
National Association of REALTORS®
500 New Jersey Avenue, NW
Washington, DC 20001
Center for Responsible Lending
910 17th Street NW, Suite 500
Washington, DC 20006
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