We've all heard of sticker shock, but what about payment shock?
That's the scary term that Susan Schmidt Bies, a member of the Federal Reserve board, used in a speech yesterday to describe the cold sweat that will come over certain homeowners when their mortgage interest rates or monthly payments go way up.
The Fed has been worried about the risk that goes with certain mortgages -- the ones that entice borrowers with low payments in the early years but leave them with higher payments looming later. You'd be wise, Fool, to avoid these arrangements.
One type of mortgage to avoid is the interest-only mortgage. This variety can offer buyers low payments early on because they at first pay only interest on the home loan. The payments increase later on, when the lender wants the borrower to start paying down on the principal.
A second type, which the Fed calls "payment option" adjustable-rate mortgages, lets borrowers pay as much as they want each month as long as they meet a certain minimum payment. But that minimum may not cover the month's interest, and any leftover interest is added to the loan balance. There's a risk that the loan could grow larger than the property value, especially if housing prices drop.
The mortgages are enticing because they carry a little bit of that sentiment expressed by Wimpy, the Popeye cartoon character, who was forever promising, "I'd gladly pay you Tuesday for a hamburger today."
Can these products be used wisely? Probably, if borrowers understand exactly what they're getting into. Someone who's self-employed or works a seasonal job might welcome the flexibility of picking his or her own payment. A couple buying a home they can very comfortably afford might decide that an interest-only loan makes some sense.
But the buyers should ask themselves whether they can afford the later payments, not just the early, easier payments that lure in new customers.
That's the question the Fed wants banks to ask prospective borrowers, under guidance it issued late last month with four other government financial agencies. That guidance also urges banks to make sure customers know exactly what they're getting into when they agree to one of these nontraditional mortgages.
Wise Fools shouldn't wait for the bank to do those things for them. Before agreeing to any mortgage terms, from these exotic types to the seemingly antique 30-year fixed-rate, make sure you understand how much each monthly payment will be and whether that covers interest and principal. Then find out how or when that payment could change.
That also goes for more common adjustable-rate mortgages (ARMs). They typically offer an extra-low interest rate for the first few years and then allow the rate to reset, sometimes every year, to reflect movements in interest rates. A lot of people have grabbed onto ARMs to take advantage of their extremely low rates.
Although many adjustable-rate loans come with rate caps, there's some risk involved if interest rates suddenly surge.
If you're in the market for a home, look at all of the different types of mortgages available. Use the Fool's Home Center to learn about those options, as well as the many other things involved in buying a home.
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