Betting Everything on the House: 3 Risky Loans to Avoid

Falling prices, sluggish sales and risky loans that let borrowers pile up debt faster than they can pay it off could put more homeowners out of their houses this year than at any other time this decade.

Yet many homeowners — particularly in California, Florida and Colorado — are still purchasing or refinancing their mortgages with “exotic” loans that may keep their monthly payments low now, but when these gimmicky loans “reset” upward borrowers could lose their homes if they haven’t planned for an increased monthly mortgage payment. While these loans certainly can be used for good, too often consumers don’t fully understand the risks involved. Here are three popular, yet risky loans that the average consumer should think carefully about before jumping into:

1. Adjustable Rate Mortgages (ARMs)
With an adjustable rate mortgage, also called ARMs, borrowers lock in a lower interest rate for the first few years. The loan then readjusts periodically in tandem with often volatile short-term interest rates. The danger with ARMs is that the risk of readjusting upward is often too great to justify the minimal savings — especially if a borrower plans to hold onto the property for at least a couple years. For most borrowers, it’s better to lock in a fixed interest rate on a 30-year loan and never worry about interest rates rising.

2. Option Payment ARM Mortgages
Option Payment ARMs are some of the riskiest mortgages around. They offer borrowers a low initial interest rate and then allow them to choose the amount of monthly payments. Homeowners can opt to pay both the interest and principal on a fully amortized loan. Or they can make a payment that is so small it covers only the interest due on the mortgage. With this loan it can be very tempting to make just that minimum payment. In just a few months homeowners who aren’t fiscally disciplined could find themselves "upside down" with this type of loan, and owing more money than they borrowed.

3. Interest-Only Mortgages
The interest-only mortgage gives the homeowner an option to pay just the interest on the mortgage. As the name implies, borrowers don't pay down any principal for the first three, five, seven or 10 years of their loan. But after the initial "interest only" grace period expires, the monthly payments balloon to cover the remaining interest and all of the principal owed on that mortgage. People who take on these loans are more likely to go into foreclosure because their monthly payments can quickly balloon out of control. For more details, read "Could you handle an interest-only loan?"

Today, when borrowers apply for a loan, they have more choices than ever before.  But before homebuyers choose either a traditional fixed-rate mortgage or an adjustable-rate mortgage, they should make sure they understand their risks and how they work.  Buyers who intend to own a home for a short time, or can handle higher payments in the future, may consider ARMs.

But homebuyers who plan to be in their homes for years, or do not expect a significant increase in income by the time the monthly payments go up, should carefully consider the risks and advantages of adjustable-rate loans.

At RealtyTrac, we want you to know the facts. For more information on mortgages, read our Mortgage and Financing FAQ.