Don't Let Mortgage Madness Endanger Your Home

If you expect to buy a home this year, don't make the mistake of falling for a mortgage come-on. What looks like a steal today can rob you of your home if you don't know what you're signing on for down the line.

As we head into prime home-buying season, watch out for lenders luring cash-strapped homebuyers with super-risky mortgages. "All you need to pay for the first 5 or 10 years is interest," they say. "Yep, you heard me: No principal. Just interest, which can knock down your monthly payments by hundreds of dollars!"

Some lenders went the extra yard with their absurd offers: "If the interest-only option is still too pricey, well, we can set up a deal where you can start by paying me even less than the interest due on the loan."

And sure enough, plenty of home buyers were suckered into negative amortization loans, where their initial payments don't even cover the interest bill. So each month their loan balance keeps rising as the lender simply tacks on any unpaid interest to the loan amount due.

Let me explain the key details that mortgage lenders hungry for your business will try to gloss over.

Temporary Savings, Lasting Costs

A quick review of basic mortgage mechanics: You have two separate costs to pay off. The principal amount that you borrow, plus the interest the lender is going to charge for loaning you that principal.

As you can guess by its name, an interest-only mortgage is a bit different. You don't have to make any principal payments for a set initial period, say 5 or 10 years. So let's say you have a $200,000 mortgage at 6.28 percent. With a traditional 30-year mortgage your monthly cost will be $1,235. If you take out an interest-only loan, the monthly payment sinks to just $1,047, a reduction of nearly $200.

But remember: It's only a temporary savings. The lender is one day going to make you pay back every penny of that principal. You're merely delaying when you have to pay it.

A typical arrangement is that you might just pay interest for the first 10 years of a standard 30-year fixed mortgage. That means from years 11 to 30 you have to hustle to get the interest and principal paid off. If you need to pay off $200,000 in principal over 20 years -- at a 6.28 percent interest rate -- your monthly payment will be $1,465. That's nearly a 40 percent jump in your mortgage cost!

Even worse is the lost opportunity to build up equity over the 10 years by paying down some of the loan's principal. With a standard 30-year fixed rate loan that requires some principal payment each month, in our above example you would have paid off about $32,000 of your principal in 10 years. With an interest-only mortgage, you've saved zilch over the decade.

Staking Your Home on "Maybes"

Now many have told me how they can work around this problem. But all the strategies have the same problem: They're just "maybes."

Maybe you'll have the higher income to handle the higher payment.

Maybe you'll move before then and make enough money on the sale to be able to easily repay the loan.

Maybe you'll have strong price appreciation, and with the home-equity buildup you can refinance into a conventional mortgage.

But maybe not. None of those strategies come tied up in a ribbon with a 100 percent guarantee.

You could switch careers, get caught in a downsizing or economic downturn that could keep your income from rising. Or you could have to sell at a point where home prices have stagnated or maybe even fallen slightly from when you bought, so now you have no equity in the home and have to repay all of the loan balance. Or when you decide to refinance, rates are higher than they were when you took out the mortgage. So you're going to refinance into a higher rate loan?

You're taking the risk that you won't be able to keep up with the payments. A home is where you live, not a speculative stock. You can always sell a losing stock and lick your wounds, but if you lose on your mortgage choice, you might have to sell the house. Do you really want to put yourself in that position?

Negative in Many Ways

Worse than the interest-only loans is the Option Adjustable Rate Mortgage (ARM). The option refers to what sort of payment you choose for the first year of the loan. You typically have three or four options, and the most dangerous one is the "minimum payment" option -- paying an absurdly low initial interest rate of just 1 percent or 2 percent compared to the market rate of 6 percent or so.

But again, you're not really getting a deal. You're just delaying reality. In this case, the lender recalculates the interest rate each month based on the going market rate and works out the difference between what you're paying and payments based on that market rate. That difference is added onto your loan balance each month. And with short-term interest rates on the rise, that recalculation will work against you.

The bottom line is that you're actually getting farther and farther away from owning the home each month because the principal you owe is rising, not falling. That's where the term "negative amortization" comes in. And all that money eventually needs to be repaid.

Instead of taking on such loans, lower your price range. Risky mortgages may seem a great way to get monthly payments down to a level an affordable level. But they offer the easy solution rather than the right solution. Don't get into a house at any price. Buy a house at a price you can truly afford.

Real Estate Is Due for a Breather

The current stage of the real estate cycle makes it even more essential that you not lose your financial mind. For the past few years, booming home values would pretty much bail you out of any risky mortgage. And interest rates stayed near historical lows so refinancers weren't hit with interest rate shock. But times they are a-changing.

Buying a home is one of the best investments you will ever make -- in the long term. But over the short term -- say the next few years -- the property market is due for a breather. We're already seeing it in certain markets, where prices are stagnating or falling slightly and more homes are staying on the market longer, with fewer bidding wars.

And the new Federal Reserve Chairman Ben Bernanke has signaled the federal funds rate could keep rising. This means rates for adjustable-rate mortgages climb, too.

It's important to understand that all ARMs are tied to any one of a handful of short-term indexes. A popular index used for ARMs is the MTA, or Monthly Treasury Average. It's basically an index of the average yield on a 12-month Treasury bill. In January, 2005, the MTA was 2.02 percent. A year later, it was at 3.75 percent.

If you had a one-year ARM tied to the MTA, you've seen your underlying index rise more than 1.5 percentage points. And it's not like you're paying just 3.75 percent today. That's because every ARM has a "margin" added to the underlying index rate -- 2.5 percent to 3 percent is typical. If we assume a 2.8 percent margin, that means the one-year ARM interest rate has jumped from 5 percent in January, 2005, to 6.55 percent. On a $200,000 30-year mortgage, this translates into a monthly payment spike from $1,073 to $1,271 -- nearly $200 more a month.

Smart Housing Moves

Adjustable rate mortgages and interest-only mortgages just don't cut it in today's market. Right now your goal should be to insulate yourself from rate risk.

A 30-year fixed-rate loan gives you the most protection. And with the small spread between interest rates on fixed-rate and adjustable-rate loans, it's not as if you're going to save so much on the ARM that it compensates you for the future risk that your rate will rise.

But a fixed-rate loan does carry a higher interest rate -- a premium for the protection of an unchanging rate. The average 30-year fixed rate mortgage now is 6.28 percent -- a great deal when rates were north of 8 percent as recently as 2000. But you might be able to do even better than a standard 30-year fixed-rate mortgage -- without increasing your rate risk -- by choosing a hybrid ARM.

This type of mortgage gives you a fixed interest rate at the start of the loan before it converts to a standard ARM where the interest rate adjusts every year. That initial "fixed" period can be three, five, seven or even ten years.

A nice mortgage strategy is to choose a hybrid that dovetails with your housing plans. For example, if you plan on moving within five years, consider a 5/1 hybrid.

The payoff? The initial rate on a 5/1 is going to be lower than that on a 30-year fixed rate loan. Right now, a 5/1 hybrid carries a 5.9 percent interest rate. The difference between that and a 6.28 percent interest rate (on the 30-year fixed rate) over the five years on a $200,000 mortgage will save you nearly $3,000. If you move before year six, you will never be hit with an interest-rate change.

One important note on hybrids: Make sure you ask the lender to explain if there's any prepayment penalty. Some lenders will impose a prepayment charge if you decide to move or refinance during the first few years of the loan. If that's a possibility for you, you need to do the math to understand the risk of getting hit with the prepayment charge.

Or if you're one of the lucky souls with excess cash to burn, my absolute favorite mortgage move -- assuming you're settled into a home you intend to stay in -- is a 15-year fixed rate mortgage. Not only is the interest rate on a 15-year fixed rate mortgage about a half point lower than on a 30-year, by paying off the loan in half the time, you will save a bundle on interest charges.

And you have the security of owning your home outright much faster than on a 30-year repayment schedule. That's housing smarts.