Beware of "Extreme" Mortgages

These have been good years for many homeowners, with interest rates for mortgages at or near record lows. Those in the market for a home have been getting good deals. Many of those not in the market have been taking advantage of low rates and refinancing their mortgages. (It's not too late for you to do so -- we've got some guidance for you.) But not everything is rosy. Home prices in many regions have been rising, dramatically so in some areas. According to a Christian Science Monitor report, the median home price in Orange County, Calif., is $649,000, and it's $366,500 in Boston, $392,000 in the New York City metropolitan region, and $352,000 in metropolitan Washington, D.C. Making matters worse, interest rates, though still low, appear to be on the rise.

If you're buying a $400,000 home, a 20% down payment amounts to $80,000, not a sum that many people can come up with easily. Monthly payments on a $320,000 loan at 6% come to about $1,900, or nearly $23,000 per year. Ouch. That's not going to leave most folks with much to spend on closet organizers and paint at Home Depot (NYSE: HD  ) or Lowe's (NYSE: LOW  ) .

In the face of these challenges, more people have been turning to what may be called "extreme" mortgages. Here's a quick rundown of some of them:

  • With "interest-only" mortgages, you enjoy low monthly payments, but you're paying off only the interest you owe in the first years, meaning you're building no equity for quite a while.

  • With "80-20" mortgages, you get a main mortgage for 80% of your home's value, and a secondary loan (at a higher interest rate) to cover the remaining 20%. You essentially buy a home without a down payment.

  • Adjustable-rate mortgages (ARMs) are another option. They aren't necessarily extreme, but if you're planning on staying in your home for many years, you are taking on some risk. If interest rates rise, as they inevitably will at some point, so will your monthly payments. (ARMs are good, though, for those who plan to move within a few years.)

Think things through before buying a home with aggressive financing strategies. They may pay off, especially if your home keeps appreciating. But if home prices fall -- as they do sometimes! -- you could get burned. Imagine that you owe $300,000 on the home you bought for $400,000. If its value falls to $280,000 and you need to sell, you'll be in trouble.

For more guidance on the home-buying process and on how mortgages work, as well as some special interest rate offers, visit our Home Center. And drop by our Buying or Selling a Home discussion board, where folks will be happy to answer your questions. We're currently offering a free trial of our entire discussion board community.

Here are some Fool articles related to homes:

LongtimeFoolcontributorSelena Maranjianowns shares of Home Depot.

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