3 types of mortgages to avoid

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Obtaining one of these loans could cost you dearly.


Key points

  • There are many types of mortgage loans.
  • Some loans can have a high cost.
  • You should avoid these types of mortgages, including ARMs and subprime loans.

Most people who buy a home need a mortgage to do so. And you have many options when trying to get a home loan. This can include conventional loans without a government guarantee, as well as loans guaranteed by a government agency such as the Federal Housing Administration (FHA) or the Veterans Administration (VA).

Although there are pros and cons to most different types of loans, it’s generally best to avoid these three types of mortgages in particular.

1. Adjustable rate mortgages

An adjustable rate mortgage, or ARM for short, can seem like an attractive loan option. When applying for a mortgage, you may find that an ARM has a lower rate than a fixed rate loan and therefore comes with a lower monthly payment.

There is a big catch, however. As you can probably guess from the name, the fare is adjustable. It will be guaranteed for a limited time, which could be 5 years if you get an ARM 5/1 or three years if you get an ARM 3/1. There are several different options for how long the initial rate will be guaranteed, each listed in the loan name.

Once this initial lock-in period is over, the rate begins to adjust. It is linked to a financial index with which it evolves and there is always a chance that it could increase. In some cases, it could increase a lot.

The risk of an ARM should be obvious – payments could end up becoming unaffordable over time as your rate increases. Both monthly payments could increase, as would the total borrowing costs you are obligated to pay over the life of the loan.

It’s often not worth taking a chance on an ARM since you don’t want to bet your house on rates remaining at an affordable level. A fixed rate loan that offers more predictable payments is a much better option.

2. Interest Only Mortgages

With most mortgages, your monthly payment is used to cover interest, but also to reduce the principal balance (i.e. the outstanding amount you owe). This is not the case with an interest only mortgage.

With this type of loan, you only pay interest on your mortgage for a set period of time. Obviously, your payment each month will be lower because of this. Of course, that’s not sustainable forever, because you’ll never pay off the debt that way.

Typically, interest-only mortgages must be paid off on a set date with a lump sum payment or your payments eventually increase to start covering the principal. Either way, you could face financial hardship if you can’t afford the lump sum payment or higher future costs.

This type of loan may seem attractive if you’re struggling to afford a home and assume your income will increase so you can make higher payments later, or if you’re considering refinancing a cheaper loan later. But you cannot guarantee that you will earn more in the future or that you will be able to get a new loan when the old one needs to be repaid. As a result, you risk foreclosure.

If you can’t afford to buy a house with a standard mortgage now, rather than an interest-only mortgage, then you really can’t afford to buy the house and you should either buy a cheaper one, either wait.

3. Subprime loans

Finally, you will want to avoid subprime loans. These are high-rate loans offered to people with poor credit or other financial credentials that might disqualify them from a standard mortgage.

Subprime loans usually have high interest rates and other unfavorable terms such as large origination fees. There are better options, such as government-backed mortgages. Or you can wait to improve your credit or work otherwise to become a borrower who can qualify for a cheaper conventional loan.

The good news is that all of these loans are easily avoidable if you know what to look for. Just say no, or you might end up regretting your home purchase.

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