As Interest Rates Rise, Here Are The Loan Types To Avoid
As the fed announces increasing interest rates for the first time since 2018, most new investors do not have a bunch of excess capital lying around to purchase a property without some type of mortgage loan. While there are still many valid mortgage terms out there to meet the unique needs of the current borrowing community, there are some loan types that should be avoided at all cost. Below we will discuss some of the worst home loan types you should avoid as well as provide you with a few reasons why these are not as good as they sometimes sound.
Balloon mortgages may be structured in slightly different ways, but at their core they are all basically the same. After a small period of time passes, a large lump sum payment comes do. With a balloon mortgage, you’ll normally make payments for around a 5-7 year term. After that you’ll owe the entire remaining balance of your mortgage loan, which can often mean a payment of several hundred thousand dollars. Some balloon mortgages don’t charge monthly payments. Other times, the monthly payment is based on what you’d owe if you were paying your loan off over a longer period of time. Regardless, whatever terms these balloon mortgage offers, there will always be a large lump-sum payment.
A lot of borrowers sometimes will take out balloon mortgages because they offer lower interest rates or reduced monthly payments. Generally, they hope to refinance their loan before the lump-sum payment is due. Refinancing isn’t always possible, however, and if you can’t pay off your entire loan, the property could go into foreclosure and you could lose the property. This risk with these loans far outweigh the pro’s and this is why you should avoid balloon mortgages at all costs.
As interest rates continue to rise, understandably some may feel the need to consider more untraditional loans in hopes of offsetting the increased costs. Interest-only mortgages are structured so that you only pay for the interest on the loan and no principal. This means a lower monthly payment, however, the problem with these loans is that you don’t make any progress with paying off the property. You send interest payments every month without gaining any equity in your home. Eventually, you’ll be required to start paying off your loan, or you’d be in debt forever. Here are a few ways this could happen:
Interest only loans are often structured as balloon loans. As discussed above, this means you pay interest only for several years and then owe a huge lump sum. Some terms may have a short interest-only period, afterwards, you’ll start to pay both principal and interest. These payments will be much higher than if you’d simply been paying principal and interest from the start. These loans carry a lot of risk. You could struggle to afford the higher monthly payments or balloon payments down the road. Since you aren’t building any equity in the property, you could be in trouble if property values decline. You could even end up owing more on the loan than the overall value of the home.
A 40-year fixed-rate loan
40-year fixed-rate loans are very similar to 20- or 30-year fixed loans. The difference, obviously, is that the loan repayment timeline is 10 years longer. While these terms will lower your monthly payments, they also add a lot to your total interest owed. An extra decade is a very long time when someone is trying to be debt free. There’s a high probability you will carry your loan into your retirement years. This would also mean you will need to save additional funds for later. These loans may also reduce your ability to accomplish other financial goals because your interest costs would be much higher and you’d have to make that mortgage payment for an extra decade.
Instead of going with any of the above risky loan types as interest rates rise, it’s still best practice to stay with a traditional 15-year, 20-year, or 30-year fixed-rate loan. These loans have stood the test of time and remain the right options for most borrowers. The above loan types often sound like good opportunities to potentially save on your mortgage. Chances are; however, interest rates won’t stay put for much longer and avoiding the above mortgage loan types will help keep you financial fit long term.