Mortgage Poison
By Scott Ramella - July 2000
This month, I will tackle a subject that may upset some in the close knit mortgage community. I will detail three types of loans you should attempt to avoid at all costs and the reasons for doing so. Please note that there may be some circumstances where these loans are appropriate but for most of the people most of the time these are a bad deal for you as the borrower.
1) A Negative Amortization Loan
Never heard of one? Consider yourself lucky. A negative amortization loan is when the mortgage payments you make on a monthly basis don't even cover the monthly interest costs accrued by the mortgage. This leads to a negative amortization situation where the loan balance actually increases rather than decreasing with every mortgage payment you make. You will owe more on the home after making payments for a year than the balance you started with. This can be financially disastrous. Some adjustable loans that cap the payment increases but not the interest rate can possibly be a negative amortization loan. All lenders may not be forthcoming with this information, so if in doubt, ask. The only case I can see where someone would even consider a loan of this type is if you are buying a new home and you know for sure you will soon have a substantial increase in income to allow you to refi to more favorable terms. And I stress that it's a big "IF".
2) A Bridge Loan
A bridge loan does exactly what it's called. You can get a "bridge" loan on a property you are buying while still holding the mortgage on the property you are currently living in. A bridge loan can be very inviting to someone who wants to move into a house immediately but may not be able to sell their existing house first. Most lenders require proof of sale of your current home before they will fund your new mortgage. A bridge loan does not require this. I don't approve of bridge loans for several reasons. First, most people cannot afford to pay three mortgage payments (first mortgage on existing home, bridge loan, plus the first mortgage on your new home) at the same time. Secondly, most people can afford to place more money down if they sell their present home first, reducing both your PMI requirement and the mortgage payment itself. Third, the fact that you have this "enabler" type of equity loan may reduce the urgency to sell your first house. Fourth, bridge loans are not cheap and carry significant fees and higher rates than normal first mortgages. Finally, there is a chance you could lose both homes. Bridge loans are secured against both properties. If for any reason, such as a rapid drop in home values, you are unable to sell your home and can't make all three mortgage payments, the bank can foreclose and take both properties from you.
3) The 125% Equity Loans
There is only one reason these new 125% loans exist in my mind, and that is due to greed on the part of banks and mortgage lenders. This is a very controversial loan that has come into existence in the past few years. While all other mortgage loans are covered by the fact the home is worth more than the loan, a 125% equity loan exceeds by a great deal the appraised value of the subject property. I have even seen 135% and 150% mortgages advertised. This type of loan creates many serious problems:
A. Your loan can trap you in your house for a very long time. How do you pay off a $20,000 or $30,000 loan when you want to move or buy a new house? You owe much more than the home is worth, leaving a cash deficit when you sell your home. Your loan officer will probably never mention this to you. This is to say nothing of what happens if real estate values start to fall.
B. Although they may be sold as such, be aware that the IRS allows no tax deduction for any part of any mortgage that exceeds the home's value.
C. They have high interest rates, high closing costs, and high monthly payments. Even with perfect credit, don't expect to see an interest rate below 12% on a 125% mortgage. Some interest rates are as high as 18%.
D. They tend to encourage more consumer debt. Many people take out these type of loans to pay off high interest rate credit card debts. The problem is that these people, who never had to suffer the consequences of piling up too much debt in the first place, then go right back out and charge up their credit cards again. Only this time, they have no equity left to bail them out of their finacial crisis. Who ends up holding the bag for all these bankruptcies and foreclosures? You and I, as the taxpayers.
I would avoid these 3 mortgages like the plague, they are not part of any fiscally sound financial plans for you or your family. They are to be considered as last resorts only. These cures may end up being worse than the disease.
Scott Ramella (SRamella@aol.com) is a licensed mortgage broker for the State of Florida, has a bachelor's degree in Finance, and has been actively involved in the mortgage business since 1995 in several capacities.
**None of the opinions stated here are meant to be construed as the opinion, in whole or in part, of MortgageRatesUSA.com**