Mortgage Debt has Never Been so Risky. Get Some Advice First.

Financial Planning Association

A July study by LoanPerformance, a San Francisco-based mortgage loan research firm, shows that one out of every four new mortgages is now an interest-only loan — a loan that delays principal payments for three years or more to guarantee a borrower a lower monthly payment.

Skyrocketing real estate values, other forms of high-rate consumer debt and a trend toward get-rich-quick real estate investment is driving supply and demand for loans that allow lower monthly payments in exchange for slower or, in some cases, negative buildup of equity. Add what many believe is an increasingly overheated real estate market to the mix and some fear calamity that could devastate overextended borrowers down the line. In July, Federal Reserve Chairman Alan Greenspan told the House Financial Services Committee, "There's potential for individual disaster here."

Are these new mortgage loans ticking time bombs? It depends on your financial situation and how you use them. It's best to get some advice before you respond to these offers. Based on your situation, some of these loan options may actually be good choices. Your tax adviser or financial planner not only can help you understand these options, but he or she can assess your overall financial picture to see what's right for you in the first place.

Whether they come from your current lender or a late-night infomercial, here's an overview of several nontraditional loan options on the market and their potential risks and rewards:

Interest-Only Loans: This immensely popular loan option allows a borrower to pay only the interest on the mortgage in monthly payments for a fixed term. After the end of that term, usually five to seven years, the borrower can refinance, pay the balance in a lump sum, or start paying off the principal, in which case the payments can rise. They do work for some people — for instance, those who expect their income to jump considerably in the next few years. Some types of interest-only mortgages have been around for decades and used by wealthy borrowers who were sophisticated and disciplined enough to find profitable uses for money saved on monthly payments. But today's loan products are increasingly marketed to ordinary homebuyers and, in many cases, to "sub-prime" borrowers who in the past could not have qualified for standard loans. That's where the risk comes in.

Zero-Down Mortgages: An increasingly common option for borrowers with less-than-perfect credit, these loans allow borrowers to buy with no money down. It gets a borrower into a home, but any chances of acquiring equity in a home will have to come from rising market values, and that's not something every borrower can count on. It might be better to ask for a low-down payment alternative — such as FHA financing — that allows a borrower to have some small amount of equity at the start.

Piggyback Loans: Some borrowers who can't make a 20 percent down payment may consider an end run around private mortgage insurance by taking out a first and second mortgage concurrently. Typically, a piggyback loan works as follows: the most common type is an 80/10/10 where a first mortgage is taken out for 80 percent of the home's value, a down payment of 10 percent is made and another 10 percent is financed in a second trust at possibly a higher interest rate. Some lenders may allow a piggyback loan for less than a 10 percent down payment.

100-Plus Loans: Also known as loan-to-value (LTV) mortgages, lenders promote these mortgage loans of 100 percent or more of appraised market value as a way to draw in customers who can't make a down payment. An overly high appraisal value in a sliding market, a loss of home value, or even worse, a loss of a job can lead very quickly to rising debt and the possible loss of the home.

Negative Amortization Loans: Negative amortization means that a loan balance is increasing instead of decreasing. With a negative amortization loan, if a payment isn't enough to cover the interest and principal payment, the shortage is added to the loan balance, which means you never really start paying off the loan. Again, this may work for people in short-term housing situations in markets with rising rates, but those conditions are never guaranteed.

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October 2005— This column is produced by the Financial Planning Association®, the membership organization for the financial planning community. If you use all or part of this column, please credit FPA® and provide a link to FPA's Web site at www.FPAnet.org/Public.

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