Debt Free

For most of you your mortgage will be your largest personal debt. It can be a bit scary the first time, even if large financial transactions really get you going. These days it seems like there are about ten thousand mortgage products out there all vying for your attention. Obviously they all can't be the best, no matter what the guy on the radio says. How do you wade through the crap you're bombarded with and actually choose the mortgage product that's the best for for you and your situation?

In the good old days, there were two basic types of mortgages, fixed and adjustable. Fixed, as the name implies, has a fixed interest rate for the entire term of the loan. Usually fixed mortgages are for either a 15 or 30 year term. These days some 40, and even 50 year mortgages are starting to leak out of that land of the wacky, California, due to the proliferation of 40 year old, 3 bedroom ranch houses with $750,000 price tags. The problem with these super long term mortgages is that you'll pay a huge amount of total interest on your property due to the extremely long term. After all, you'll be paying interest for 40 or 50 years.

Adjustable mortgages, also known as ARMs, have an interest rate that changes during the term of the loan and is typically lower at the beginning, then adjusts up after a set number of years. The advantage of an adjustable mortgage is that it will let you have a lower house payment early in the mortgage. Later, the payment will adjust upward. In theory, two or three things will have occurred by then. Either your income will have gone up, or the value of your home will have increased, possibly both. There is also the possibility you'll have sold the home and moved on. Adjustable rate mortgages account for around 22% of mortgages these days.

The mortgages will be described using a numerical figure such as 5/1 or 3/1. That's not a fraction, but describes the number of years before the mortgage adjusts initially, and how often it will adjust thereafter. A 5/1 ARM would adjust after 5 years, then every year after that. The rate is tied to an index, such as the London Interbank Offered Rate (LIBOR), or the Fed Prime rate. You'll usually pay the index plus a set percentage, such as 2%. Usually the consumer is protected from radical rate increases with caps that limit the amount the rate can increase in any given period. There is also a lifetime cap that limits how much the bank can ultimately adjust your mortgage. Typically, if you're still living in the home, the mortgage is refinanced before it actually adjusts upward, and the higher payments are avoided. This is possible because the property has appreciated, so the mortgage holder has equity in the home.

A type of ARM that's become popular lately is the option ARM, also called a “payment option loan”. The option ARM, as the name suggests, gives the homeowner an option on the payments every month. These are a favorite of the radio advertising set because they sound so attractive. “Hey, pay what ever you want, we don't care. We're so easy.” They're so easy because these types of products make them so much money. Normally, option ARMs will allow the homeowner to pay either the payment for a 15 or 30 year fixed, the ARM the customer originally signed up for, or an interest only payment. The problem with these mortgages is negative amortization. That's right, you're going backwards.

Keep this up and eventually you'll reach what's called the “Recast Cap”. At this point, you're out of options, too bad. The recast cap is typically set at 110% to 125% of the original loan balance. When your mortgage reaches the point where you owe that much of the original loan, the payment adjust automatically to the point where it needs to be to pay the fully amortized loan balance. Talk about sticker shock! Too many people get themselves into trouble when they aren't able to make these new, larger payments. You could be headed for foreclosure if you can't make the payment or your home's value hasn't reached the point where you can sell it and pay off the loan.

Interest only mortgages have increased in popularity to keep payments to reasonable levels. If you can't afford a payment where you're reducing the principal, it stands to reason the payment will be lower. As with the payment option loan, you'll have a problem at some point, because the lender will want their money back. Really. Depending upon the structure of the mortgage, you'll have from 5 to 10 years to pay interest only, thereafter you'll have to actually pay the principal. These work if your planning to live in the home for a few years and then sell it. Wait, that works if the real estate values in your area are rising. If they're rising you can pay only the interest portion of your mortgage to keep your payment low, and still have equity in the home when it comes time to sell.

Where this all can go astray is if the real estate values actually stay stagnant, or heaven forbid, fall. Then you'll be sitting on a home that you can't sell unless you pony up some dough, possibly a hefty chunk of it. Anyone can find themselves in this predicament if their homes value falls far enough, because you only chip away at a little of the loan's principal for the first 10 years of a 30 year mortgage anyway.

In many cases, either to afford a home at all in many metro areas (Boston, NY, Seattle, San Francisco, LA, etc.) or to afford a home they think they should have, people are getting themselves into trouble by getting into mortgage products that don't address the principal. If you're in a stable employment situation and your home's value appreciates, you can come out okay. If you have a little bump in the road, however, it can all come tumbling down. That can happen with any mortgage, but the risks are greater with the creative options. Weigh your options carefully, and don't let your love of a home make you do something that could cause you to lose it, when maybe you should have gotten something a step down the ladder.