3 Types of Mortgages to Steer Clear Of

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Getting one of these loans could cost you.

Key points

• There are many different kinds of mortgages.
• Some loans can come at a high cost.
• You should steer clear of these mortgage types, including ARMs and subprime loans.

Most people who buy a home need a mortgage to do it. And you have many options when you try to secure a home loan. This can include conventional loans with no government guarantee, as well as loans backed by a government agency such as the Federal Housing Administration (FHA) or Veterans Administration (VA). 

While there are pros and cons to most different loan types, it’s usually a good idea to avoid these three mortgage types in particular.

1. Adjustable-rate mortgages

An adjustable-rate mortgage, or ARM for short, may seem like an attractive loan option. When you apply for a mortgage, you may see that an ARM has a lower rate than a fixed-rate loan and thus comes with a smaller monthly payment. 

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

After that initial lock-in period is over, though, the rate begins adjusting. It is tied to a financial index that it moves with and there’s always a chance it could move up. In some cases, it could increase by a lot. 

The risk of an ARM should be obvious — payments could end up becoming unaffordable over time as your rate rises. Both monthly payments could go up and so could the total borrowing costs you get stuck paying 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 staying at an affordable level. A fixed-rate loan that provides more predictable payments is a much better option.

2. Interest-only mortgages

With most mortgage loans, your monthly payment goes toward covering interest but also toward reducing the principal balance (that’s the outstanding amount you owe). That’s not the case with an interest-only mortgage.

With this type of loan, you only pay the interest on your mortgage for some set period of time. Obviously, your payment each month will be lower because of this. Of course, this isn’t sustainable forever, though, since you’d never pay down the debt this way.  

Typically, interest-only mortgages either must be paid off on a set date by a lump sum payment or your payments eventually go up to start covering the principal. Either way, you could run into financial trouble if you can’t afford the lump sum payment or future higher costs. 

This type of loan can seem attractive if you are struggling to afford a house and you assume your income will go up so you can make higher payments later, or if you plan to refinance into a cheaper loan later. But you cannot guarantee you’ll earn more in the future or be able to get a new loan when your old one has 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 one, then you can’t really afford the home at all and you should either buy a cheaper one or wait.

3. Subprime loans

Finally, you’ll want to steer clear of subprime loans. These are high-rate loans offered to people with poor credit or other financial credentials that could disqualify them from a standard mortgage. 

Subprime loans generally have high interest rates and other unfavorable terms such as big origination fees. There are better options out there, like government-guaranteed mortgages. Or you could wait to improve your credit or otherwise work toward becoming a borrower that can qualify for a cheaper conventional loan. 

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