2 Types of Mortgages to Steer Clear Of

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Some types of mortgages present a really big risk. Read on to learn two mortgage types in particular you should avoid at all costs. 

If you’re buying a home, chances are you aren’t going to be able to pay cash for it. You will probably need a mortgage to help you afford it. And there’s nothing wrong with that as most home buyers get loans because the costs of purchasing are so high.

While mortgages can be a type of “good” debt since you end up with a valuable asset (a house), there are some mortgages that are really risky and should be avoided at all costs. Here are two types of home loans you will definitely want to steer clear of.

1. Interest-only mortgages

Interest-only mortgages are home loans that allow you to pay only interest for a limited period of time, such as five years or seven years. These loans are often set to be paid off in full over 30 years, just like a traditional mortgage would be. But the big difference is, since you’re only paying interest for the first few years, your payment will have to jump up later so you can pay your balance off in full.

Here’s what this could look like.

Say you borrow $300,000 at 5% for 30 years and the first seven years are interest-only. Initially, your payments on the interest-only loan would be $1,250 per month but would go up to $1,831 at the end of the seven-year period. By contrast, if you took out a traditional fixed-rate loan, your monthly payments would be $1,610 for the life of the loan. With the interest-only mortgage, you’d also pay $310,416 in interest over time compared with $279,767 for the fixed-rate loan.

So, while you would get a lower starting payment, it would become much more expensive later to repay your loan. It would also be costlier to pay off your debt over time. It doesn’t really make sense to commit your future self to making higher payments when you can instead get a loan that gives you predictable payments and ultimately costs you less.

2. Balloon loans

A balloon mortgage allows you to make payments for a period of time that is below the amount you would pay with a standard mortgage.

Typically, what happens is you take a loan for a short period of time such as five or seven years. However, your payment amount will be calculated as if you were taking a much longer period (such as 30 years) to pay off your loan in full. Depending on the terms of the loan, you may pay only the interest due or may pay both principal and interest but be offered a lower rate than you’d pay with a standard fixed-rate loan.

At the end of your balloon period, however, you would have to make a lump-sum payment for the entire remaining amount due. And that would be a huge amount.

Say, for example, you borrowed $300,000 at 5% on a balloon loan with a 30-year amortization period (which means each payment would be calculated to be enough that your loan would be fully repaid after three decades) and your balloon payment was due after 10 years. Your monthly payment would be $1,610.46 and your balloon payment would be $245,637.40. Your total interest costs would be $137,282.14.

The huge risk of these kinds of loans is that you won’t have the money to make the balloon payment.

Rather than taking a chance of this happening, it’s best to just opt for a fixed-rate loan from a reputable mortgage lender without any of these quirky features that can make your payment cheaper upfront but cost you in the end. It’s worth paying a higher starting payment to avoid the stress of either rising payments or a huge bill coming due in just a few years’ time.

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